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    financial management book @ Bec doms bagalkot financial management book @ Bec doms bagalkot Document Transcript

    • FINANCIAL MANAGEMENT 1. FINANCE FINANCIAL MANAGEMENT -AN OVERVIEWINTRODUCTIONFinance may be defined as the art and science of managing money. The majorareas of finance are: (1) financial services and (2) managerial finance/corporatefinance/financial management. While financial services is concerned with thedesign and delivery of advice and financial products to individuals, businessesand governments within the areas of banking and related institutions, personalfinancial planning, investments, real estate, insurance and so on, financialmanagement is concerned with the duties of the financial managers in thebusiness firm. Financial managers actively manage the financial affairs of anytype of business, namely, financial and non-financial, private and public, large
    • and small, profit-seeking and not-for-profit. They perform such varied tasks asbudgeting, financial forecasting, cash management, credit administration,investment analysis, funds management and so on. In recent years, thechanging regulatory and economic environments coupled with the globalisationof business activities have increased, the complexity as well as the importanceof the financial managers duties. As a result, the financial management functionhas become more demanding and complex. This Chapter provides an overviewof financial management function. It is organised into seven Sections: . Relationship of finance and related disciplines . Scope of financial management . Goal /objectives ,of financial management . Agency problem . Organisation of the finance function . Emerging role of finance managers in India . An overviewFINANCE –FINANCE AND RELATED DISCIPLINEFinancial management, as an integral part of overall management, is not a totallyindependent area. It draws heavily on related disciplines and fields of study, suchas economics, "accounting, marketing, production and quantitative methods.Although these disciplines are interrelated, there are key differences amongthem. In this Section, we discuss these relationships.Finance and EconomicsThe relevance of economics. to financial management can be described in thelight of the twobroad areas of economics: macroeconomics andmicroeconomics. Macroeconomics is concerned with the overall institutional environment inwhich the firm operates. It looks at the economy as a whole. Macroeconomics isconcerned with the institutional structure of the banking system, money andcapital markets, financial intermediaries, monetary, credit and fiscal policies andeconomic policies dealing with, and controlling level of, activity within aneconomy. Since business firms operate in the macroeconomic environment, it isimportant for financial managers to understand the broad economic environment.Specifically, they should (1) recognise and understand how monetary policyaffects the cost and the availability of funds; (2) be versed in fiscal policy and itseffects on the economy; (3) be ware of the various financial institutions/financingoutlets; (4) understand the consequences of various levels of economic activityand changes in economic policy for their decision environment and so on.Microeconomics deals with the economic decisions of individuals andorganisations. It concerns itself with the determination of optimal operatingstrategies. In other words, the theories of microeconomics provide for effectiveoperations of business firms. They are concerned with defining actions that willpermit the firms to achieve success. The concepts and theories ofmicroeconomics relevant to financial management are, for instance, thoseinvolving (1) supply and demand relationships and profit maximisation strategies,(2) issues related to the mix of productive factors, optimal sales level andproduct pricing strategies, (3) measurement of utility preference, risk and thedetermination of value, and (4) the rationale of depreciating assets. In addition,the primary principle that applies in financial management is marginal analysis; itsuggests that financial decisions should be made on the basis of comparison of
    • marginal revenue and marginal cost. Such decisions will lead to an increase inprofits of the firm. It is, therefore, important that financial managers must befamiliar with basic microeconomics. To illustrate, the financial manager of a department store is contemplating toreplace one of its online computers with a new, more sophisticated one thatwould both speed up processing time and handle a large volume of transactions.The new computer would require a cash outlay of Rs 8,00,000 and the oldcomputer could be sold to net Rs 2,80,000. The total benefits from the newcomputer and the old computer would be Rs 10,00,000 and Rs 3,50,000respectively. Applying marginal analysis, we get:Benefits with new computer Rs10,00,000 Less: Benefits with old computer Marginal benefits (a) Cost of new computer3,50,000 Marginal Benefits (a)Rs 6,50,000Cost of new computerRs 8,00,000 Less: Proceeds from sale of old computer Marginal cost (b) Net benefits [(a) -(b)] Rs 2,80,000Marginal cost (b)Rs 5,20,000Net benefits (a) –(b)1,30,0000As the store would get a net benefit of Rs 1,30,000, the old computer should bereplaced by the new one. Thus, a knowledge of economics is necessary for a financial manager tounderstand both the financial environment and the decision theories whichunderline contemporary financial management. He should be familiar with thesetwo areas of economics. Macroeconomics provides the financial manager with aninsight into policies by which economic activity is controlled. Operating within thatinstitutional framework, the financial manager draws on microeconomic theoriesof the operation of firms and profit maximisation. A basic knowledge ofeconomics is, therefore, necessary to understand both the environment and thedecision. techniques of financial management.Finance and AccountingThe relationship between finance and accounting, conceptually speaking, hastwo dimensions: CO they are closely related to the extent that accounting is animportant input in financial decisionmaking; and (ii) there. are key differences in viewpoints between them. . Accounting function is a necessary input into the finance function. That is,accounting is a subfunction of finance. Accounting generates information/datarelating to operations/activities of the firm. The end-product of accountingconstitutes financial statements such as the balance sheet, the income statement(profit and loss account) and the statement of changes in financial position/sources and uses of funds statement/cash flow statement. The informationcontained in these statements and reports assists financial managers inassessing the past performance and future directions of the firm and in meetinglegal obligations, such as payment of taxes and so on. Thus, accounting andfinance are functionally closely related. Moreover, the finance (treasurer) andaccounting (controller) activities are typically within the control of the vice-president/director (finance)/Chief financial officer (CFO) as shown in Fig. 1.2.
    • These functions are closely related and generally overlap; indeed, financialmanagement and accounting are often not easily distinguishable. In small firmsthe controller often carries out the finance function and in large firms manyaccountants are intimately involved in various finance activities. But there are two key differences between finance and accounting. The firstdifference relates to the treatment of funds, while the second relates to decisionmaking.Treatment of Funds The viewpoint of accounting relating to the funds of the firmis different from that of finance. The measurement of funds (income andexpenses) in accounting is based on the accrual principle/system. For instance,revenue is recognised at the point of sale and not when collected. Similarly,expenses are recognised when they are incurred rather than when actually paid.The accrual-based accounting data do not reflect fully the financialcircumstances of the firm. A firm may be quite profitable in the accounting sensein that it has earned profit (sales less expenses) but it may not be able to meetcurrent obligations owing to shortage of liquidity. due to uncollectablereceivables, for instance. Such a firm will not survive regardless of its levels ofprofits. ,The viewpoint of finance relating to the treatment of funds is based oncashflows. The revenues are recognised only when actually received in cash(Le. cash inflow) and expenses are recognised on actual payment (Le. cashoutflow). This is so because the financial manager is concerned with maintainingsolvency of the firm by providing the cashflows necessary to satisfy itsobligations and acquiring and financing the assets needed to achieve the goalsof the firm. Thus, cashflow-based returns help financial managers avoidinsolvency and achieve the desired financial goals. To illustrate, total sales of a trader during the year amounted to Rs 10,00,000while the cost of sales was Rs 8,00,000. At the end of the year, it has yet tocollect Rs 8,00,000 from the customers. The accounting view and the financialview of the firms performance during the year are given below. Accounting View FinancialView (Income Statement) (Cash Flow Statement) Sales Rs 10,00,000 Cash inflowRs 2,00,000 Less: Cost Rs 8,00,000 Less cash outflowRs 8,00,000 _____________ ___________ Net Profit Rs 2,00,000 Net cashoutflow Rs 6,00,000Obviously, the firm is quite profitable in accounting sense, it is a financial failurein, terms of actual cash flows resulting from uncollected receivables. Regardlessof its profits, the firm would not survive due to inadequate cash inflows to meet itsobligations.Decision Making Finance and accounting also differ in respect of theirpurposes. The purpose of accounting is collection and presentation of financialdata. It provides consistently developed and easily interpreted data on the past,present and future operations of the firm. The financial manager uses such datafor financial decision making. It does not mean that accountants never makedecisions or financial managers never collect data. But the primary focus of thefunctions of accountants is on collection and presentation of data while the
    • financial managers major responsibility relates to financial planning, controllingand decision making. Thus, in a sense, finance begins where accounting ends.Finance and Other RelatedDisciplinesApart from economics and accounting, finance also draws-for its day-to-daydecisions-on supportive disciplines such as marketing, production andquantitative methods. For instance, financial managers should consider theimpact of new product development and promotion plans made in marketing areasince their plans will require capital outlays and have an impact on the projectedcash flows. Similarly, changes in the production process may necessitate capitalexpenditures which the financial managers must evaluate and finance. And,finally, the tools of analysis developed in the quantitative methods area arehelpful in analysing complex financial management problems. The marketing, production and quantitative methods are, thus, only indirectlyrelated to day-today decision making by financial managers and are supportive innature while economics and accounting are the primary disciplines on which thefinancial manager draws substantially. The relationship between financial management and supportive disciplines isdepicted in Fig 1.1.Financial Decision AreaPrimary Discipline 1. Accounting1. Investment analysis Support2. Macroeconomics2~ Working capital management:3. Micro economics3. Sources and cost of funds4. Determination of capital structure5. Dividend policy. 6. Analysis of risks and returns SupportOther Relates Discipline 1. Marketing 2. Production 3. Quantatative method Resulting inShareholders Wealth MaximisationSCOPE OF FINANCIAL MANAGEMENTThe approach to the scope and functions of financial management is divided, for
    • purposes of exposition, into two broad categories: (a) The Traditional Approach,and (b) The Modem Approach.Traditional ApproachThe traditional approach to the scope of financial management refers to itssubject-matter, in academic literature in the initial stages of its evolution, as aseparate branch of academic Study. The term corporation finance was used todescribe what is now known in the academic world as financial management. Asthe name suggests, the concern of corporation finance was with the financing ofcorporate enterprises. In other words, the scope of the finance function wastreated by the traditional approach in the narrow sense of procurement of fundsby corporate enterprise to meet their financing needs. The term procurementwas used in a broad sense so as to include the whole gamut of raising fundsexternally. Thus defined, the field of study dealing with finance was treated asencompassing three interrelated aspects of raising and administering resourcesfrom outside: (i) the institutional arrangement in the form of financial institutionswhich comprise the organisation of the capital market; (ii) the financialinstruments through which funds are raised from the capital markets and therelated aspects of practices and the procedural aspects of capital markets; and(iii) the legal and accounting relationships between a firm and its sources offunds. The coverage of corporation finance was, therefore, conceived to describethe rapidly evolving complex of capital market institutions, instruments andpractices. A related aspect was that firms require funds at certain episodic eventssuch as merger, liquidation, reorganisation and so on. A detailed description ofthese major events constituted the second element of the scope of this field ofacademic study. That these were the broad features of the subject-matter ofcorporation finance is eloquently reflected in the academic writings around theperiod during which the traditional approach dominated academic thinking. 1Thus, the issues to which literature on finance addressed itself was howresources could best be raised from the combination of the available sources.The traditional approach to the scope of the finance function evolved during the1920s and 1930s and dominated academic thinking during th~ forties andthrough the early ftfties. It has now been discarded as it suffers from seriouslimitations. The weaknesses of the traditional approach fall into two broadcategories: (i) those relating to the treatment of various topics and the emphasisattached to them; and (ii) those relating to the basic conceptual and analyticalframework of the definitions and scope of the finance function. The first argument against the traditional approach was based on its emphasison issues relating to the procurement of funds by corporate enterprises. Thisapproach was challenged during the period when the approach dominated thescene itself.2 Further, the traditional treatment of finance was criticised3 becausethe finance function was equated with the issues involved in raising andadministering funds, the theme was woven around the viewpoint of the suppliersof funds such as investors, investment bankers and so on, that, is the outsiders.It implies that no consideration was given to viewpoint of those who had to takeinternal financial decisions. The traditional treatment was, in other words, theoutsider-looking-in approach. The limitation was that internal decision making (ie.insider-looking-out) was completely ignored. The second ground of criticism of the traditional treatment was that the focuswas on financing problems of corporate enterprise. To that extent the scope offinancial management was confirmed only to a segment of the industrialenterprises, as non-corporate organisations lay outside its scope. Yet another basis on which the traditional approach was challenged was thatthe treatment was built too closely around episodic events, such as promotion,incorporation, merger, consolidation, reorganisation and so on. Financial
    • management was confirmed to a description of these infrequent happenings inthe life of an enterprise. As a logical corollary, the day-to-day financial problemsof a normal company did not receive much attention. Finally, the traditional treatment was found to have a lacuna to the extent thatthe focus was on long-term financing. Its natural implication was that the issuesinvolved in working capital management were not in the purview of the financefunction. The limitations of the traditional approach were not entirely based on treatmentor emphasis of different aspects. In other words, its weaknesses were morefundamental. The conceptual and analytical shortcoming of this approach arosefrom the fact that it confirmed financial management to issues involved inprocurement of external funds, it did not consider the important dimension ofallocation of capital. The conceptual framework of the traditional treatmentignored what Solomon aptly described as the central issues of financialmanagement. These issues were reflected in the following fundamentalquestions which a finance manager should address. Should an enterprisecommit capital funds to certain purposes? Do the expected returns meet financialstandards of performance? How should these standards be set and what is thecost of capital funds to the enterprises? How does the cost vary with the mixtureof financing methods used? In the absence of the coverage of these crucialaspects, the traditional approach implied a very narrow scope for financialmanagement. The modem approach provides a solution to these shortcomings.Modem ApproachThe modern approach views the term financial management in a broad senseand provides a conceptual and analytical framework for financial decisionmaking. According to it, the finance function covers both acquisition of funds aswell as their allocations. Thus, apart from the issues involved in acquiringexternal funds, the main concern of financial management is the efficient andwise allocation of funds to various uses. Defined in a broad sense, it is viewed asan integral part of overall management. The new approach is an analytical way of viewing the financial problems of afirm. The main contents of this approach are: What is the total volume of fundsan enterprise should commit? What specific assets should an enterprise acquire?How should the funds required be financed? Alternatively, the principal contentsof the modem approach to financial management can be said to be: (0 how largeshould an enterprise be, and how fast should it grow? (ii) In what form should ithold assets? and (Hi) what should be the composition of its liabilities? The three questions posed above cover between them the major financialproblems of a firm. In other words, the financial management, according to thenew approach, is concerned with the solution of three major problems relating tothe financial operations of a firm, corresponding to the three questions ofinvestment, financing and dividend decisions. Thus, financial management inmodern sense of a firm can be broken down into three major decisions asfunctions of finance: (D The investment decision, (ii) the financing decision, and(iii) the dividend policy decision.Investment Decision The investment decision relates to the selection of assetsin which funds will be invested by a firm. The assets which can be acquired fallinto two broad groups: (I) long-term assets which yield a return over a period oftime in future, (ii) short-term or current assets, defined as those assets which inthe normal course of business are convertible into cash without diminution invalue, usually within a year. The first of these involving the first category ofassets is popularly known in financial literature as capital budgeting. The aspectof financial decision making with reference to current assets or short-term assetsis popularly termed as working capital management.
    • Capital Budgeting Capital budgeting is probably the most crucial financialdecision of a firm. It relates to the selection of an asset or investment proposal orcourse of action whose benefits are likely to be available in future over thelifetime of the project. The long-term assets can be either new or old/existingones. The first aspect of the capital budgeting decision relates to the choice ofthe new asset out of the alternatives available or the reallocation of capital whenan existing asset fails to justify the funds committed. Whether an asset will beaccepted or not will depend upon the relative benefits and returns associatedwith it. The measurement of the worth of the investment proposals is, therefore, amajor element in the capital budgeting exercise. This implies a discussion of themethods of appraising investment proposals.The second element of the capital budgeting decision is the analysis of risk anduncertainty. Since the benefits from the investment proposals extend into thefuture, their accrual is uncertain. They have to be estimated under variousassumptions of the physical volume of sale and the level of prices. An element ofrisk in the sense of uncertainty of future benefits is, thus, involved in theexercise. The returns from capital budgeting decisions should, therefore, beevaluated in relation to the risk associated with it. Finally, the evaluation of the worth of a long-term project implies a certain normor standard against which the benefits are to be judged. The requisite norm isknown by different names such as cut-off rate, hurdle rate, required rate,minimum rate of return and so on. This standard is broadly expressed in termsof the cost of capital. The concept and measurement of the cost of capital is,thus, another major aspect of capital budgeting decision. In brief, the mainelements of capital budgeting decisions are: (I) the long-term assets and theircomposition, (ii) the business risk complexion of the firm, and (Hi) the conceptand measurement of the cost of capital. Working Capital Management Working capital management is concernedwith the management of current assets. It is an important and integral part offinancial management as short-term survival is a prerequisite for long-termsuccess. One aspect of working capital management is the trade-off betweenprofitability and risk (liquidity). There is a conflict between profitability andliquidity. If a firm does not have adequate working capital, that is, it does notinvest sufficient funds in current assets, it may become illiquid and consequentlymay not have the ability to meet its current obligations and, thus, invite the risk ofbankruptcy.. If the current assets are too large, profitability is adversely affected.The key strategies and considerations in ensuring a trade-off between profitabilityand liquidity is one major dimension of working capital management. In addition,the individual current assets should be efficiently managed so that neitherinadequate nor unnecessary funds are locked up. Thus, the management ofworking capital has two basic ingredients: (1) an overview of working capitalmanagement as a whole, and (2) efficient management of the individual currentassets such as cash, receivables and inventory.Financing Decision the second major decision involved in financialmanagement is the financing decision. The investment decision is broadlyconcerned with the asset-mix or the composition of the assets of a firm. Theconcern of the financing decision is with the financing-mix or capital structure orleverage. The term capital structure refers to the proportion of debt (fixed-interest sources of financing) and equity capital (variable-dividendsecurities/source of funds). The financing decision of a firm relates to the choice
    • of the proportion of these sources to finance the investment requirements. Thereare two aspects of the financing decision. First, the theory of capital structurewhich shows the theoretical relationship between the employment of debt andthe return to the shareholders. The use of debt implies a higher return to theshareholders as also the financial risk. A proper balance between debt andequity to ensure a trade-off between risk and return to the shareholders isnecessary. A capital structure with a reasonable proportion of debt and equitycapital is called the optimum capital structure. Thus, one dimension of thefinancing decision whether there is an optimum capital structure and in whatproportion should funds be raised to maximise the return to the shareholders?The second aspect of the financing decision is the determination of to anappropriate capital structure, given the facts of a particular case. Thus, thefinancing decision covers two interrelated aspects: (1) the capital structuretheory, and (2) the capital structure decision.Dividend Policy Decision The third major decision area of financialmanagement is the decision relating to the dividend policy. The dividend decisionshould be analysed in relation to the financing decision of a firm. Twoalternatives are available in dealing with the profits of a firm: (0 they can bedistributed to the shareholders in the form of dividends or (i0 they can be retainedin the business itself. The decision as to which course should be followeddepends largely on a significant element in the dividend decision, the dividend-payout ratio, that is, what proportion of net profits should be paid out to theshareholders. The fmal decision will depend upon the preference of theshareholders and investment opportunities available within the firm. The secondmajor aspect of the. dividend decision is the factors determining dividend policyof a firm in practice. . To conclude, the traditional approach to the functions of financial managementhad a very narrow perception and was devoid of an integrated conceptual andanalytical framework. It had rightly been discarded in the ac:ldemic literature. Themodem approach to the scope of financial management has broadened its scopewhich involves the solution of three major decisions, namely, investment,fmancing and dividend. These are interrelated and should be jointly taken so thatfinancial decision making is optimal. The conceptual framework for optimumfinancial decisions is the objective of financial management. In other words, toensure an optimum decision in respect of these three areas, they should berelated to the objectives of financial management.Key Activities of the Financial Manager The primary activities of a financial manager are: (i) performing financialanalysis and planning, (i0 making investment decisions and (HO makingfinancing decisions.
    • The gross present worth of a course of action is equal to the capitalised value of the flow of futUre expected benefit, discounted (or captialised) at a rate which reflects their certainty or uncertainty. Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits being discussed. Any financial action which creates wealth or which has a net present worth above zero is a desirable one and should be undertaken. Any financial action which does not meet this test should be rejected. If two or more desirable courses of action are mutUally exclusive (Le. if only one can be undertaken), then the decision should be to doPerforming Financial Analysis and Planning The concern of financial analysisand planning is with (a) transforming financial data into a form that can be used tomonitor financial condition, (b) evaluating the need for increased (reduced) productivecapacity and (c) determining the additional/reduced financing required. Although thisactivity relies heavily on accrual-based financial statements, its underlying objective is toassess cash flows and develop plans to ensure adequate cash flows to supportachievement of the firms goalsMaking Investment Decisions Investment decisions determine both the mixand the type of assets held by a firm. The mix refers to the amount of currentassets and fixed assets. Consistent with the mix, the financial manager mustdetermine and maintain certain optimal levels of each type of current assets. Heshould 211so decide the best fixed assets to acquire and when existing fixedassets need to be modified/replaced/liquidated. The success of a firm inachieving its goals depends on these decisions.Making Financing Decisions Financing decisions involve two major areas:first, the most appropriate mix of short-term and long-term financing; second, thebest individual short-term or long-term sources of financing at a given point oftime. Many of these decisions are dictated by necessity, but some require an in-depth analysis of the available financing alternatives, their costs and their long-term implications OBJECTIVES OF FINANCIAL MANAGEMENTTo make wise decisions a clear understanding of the objectives which are soughtto be achieved is necessary. The objective provide a framework for optimumfinancial decision making. In other words, they are concerned with designing amethod of operating the internal investment and financing of a firm. The termobjective is used in the sense of a goal or decision criterion for the threedecisions involved in financial management. It implies that what is relevant is notthe overall objective or goal of a business but a operationally useful criterion bywhich to judge a specific set of mutually interrelated business decisions, namely,investment, financing and dividend policy. Moreover, it provides a nOffilativeframework. That is, the focus in financial literature is on what a firm should try toachieve and on policies that should b~ followed if certain goals are to beachieved. The implication is that these are not necessarily followed by firms inactual practice. They are rather employed to serve as a basis for theoreticalanalysis and do not reflect contemporary empirical industry practices. Thus, theterm is used in a rather narrow sense of what a finn should anempt to achievewith its investment, fmancing and dividend policy decisions. Firms in practice state their vision, mission and values in broad terms and arealso concerned about technology, leadership, productivity, market standing,image, profitability, financial resources, employees satisfaction and so on. We discuss in this Section the alternative approaches in financial literature,There are two widely-discussed approaches: (0 Profit (total)/Earning Per Share
    • (EPS) maximisation approach, and (i0 Wealth maximisation approach.Profit/EPS Maximisation DecisionCriterionAccording to this approach, actions that increase profits (total)/EPS should beundertaken and those that decrease profits/EPS are to be avoided, In specificoperational terms, as applicable to financial management, the profit maximisationcriterion implies that the investment, financing and dividend policy decisions of afirm should be oriented to the maximisation of profits/EPS. The term profit can be used in two senses. As a owner-oriented concept, itrefers to the amount and share of national income which is paid to the owners ofbusiness, that is, those who supply equity capital. As a variant, it is described asprofitability. It is an operational concept and signifies economic efficiency. In otherwords, profitability refers to a situation where output exceeds input, that is, the valuecreated by the use of resources is more than the total of the input resources. Used in thissense, profitability maximisation would imply that a firm should be guided in financialdecision making by one test; select assets, projects and decisions which are profitable andreject those which are not. In the current financial literature, there is a general agreementthat profit maximisation is used in the second sense. The rationale behind profitability maximisation, as a guide to financial decisionmaking, is simple. Profit is a test of economic efficiency. It provides the yardstickby which economic performance can be judged. Moreover, it leads to efficientallocation of resources, as resources tend to be directed to uses which in termsof profitability are the most desirable. Finally, it ensures maximum social welfare.The individual search for maximum profitability provides the famous invisiblehand by which total economic welfare is maximised. Financial management isconcerned with the efficient use of an important economic resource (jnput) ,namely, capital. It is, therefore, argued that profitability maximisation shouldserve as the basic criterion for financial" management decisions. The profit maximisation criterion has, however, been questioned and criticisedon several grounds. The reasons for the opposition in academic literature fall intotwo broad groups: (1) those that are based on misapprehensions about theworkability and fairness of the private enterprise itself, and (2) those that ariseout of the difficulty of applying this criterion in actual situations. It would berecalled that the term objective, as applied to financial management, refers to anexplicit operational guide for the internal investment and financing of a firm andnot the overall goal of business operations. We, therefore, focus on the secondtype of limitations to profit maximisation as an objective of financialmanagement.7 The main tecbnical flaws of this criterion are ambiguity, timingof benefits, and quality of benefits. Ambiguity One practical difficulty with profit maximisation criterion for financialdecision making is that the term profit is a vague and ambiguous concept. It hasno precise connotation. It is amenable to different interpretations by differentpeople. To illustrate, profit may be short-term or long-term; it may be total profitor rate of profit; it may be before-tax or after-tax; it may return on total capitalemployed or total assets or shareholders equity and so on. If profit maximisationis taken to be the objective, the question arises, which of these variants of profitshould a firm try to maximise? Obviously, a loose expression like profit cannotform the basis of operational criterion for financial management.Timing of Benefits A more important technical objection to profit maximisation,as a guide to financial decision making, is that it ignores the differences in thetime pattern of the benefits received over the working life of the asset,irrespective of when they were received. Consider Table 1.1.
    • Time-Pattern of Benefits (Profits) Time Alternate A(Rs inlakh)__________Alternate B(Rs in lakh)Period I 50 --Period II 100 100 Period III 50 100___________________________________________________________________________________ Total 200 200It can be seen from Table 1.1 that the total profits associated with thealternatives, A and B, are identical. If the profit maximisation is the decisioncriterion, both the alternatives would be ranked equally. But the returns from boththe alternatives differ in one important respect, while alternative A provideshigher returns in earlier years, the returns from alternative B are larger in lateryears. As a result, the two alternative courses of action are not strictly identical.This is primarily because a basic dictum of financial planning is the earlier thebetter as benefits received sooner are more valuable than benefits received later.The reason for the superiority of benefits now over benefits later lies in the factthat the former can be reinvested to earn a return. This is referred to as timevalue of money. The profit maximisation criterion does not consider thedistinction between returns received in different time periods and treats allbenefits irrespective of the timing, as equally valuable. This is not true in actualpractice as benefits in early years should be valued more highly than equivalentbenefits in later years. The assumption of equal value is inconsistent with the realworld situation.Quality of Benefits Probably the most important technical limitation of profitmaximisation as an operational objective, is that it ignores the quality aspect ofbenefits associated with a financial course of action. The term quality here refersto the degree of certainty with which benefits can be expected. As a rule, themore certain the expected return, the higher is the quality of the benefits.Conversely, the more uncertain/fluctuating is the expected benefits, the lower isthe quality of the benefits. An uncertain and fluctuating return implies risk to theinvestors. It can be safely assumed that the investors are risk-averters, that is,they want to avoid or at least minimise risk. They can, therefore, be reasonablyexpected to have a preference for a return which is more certain in the sense thatit has smaller variance over the years. The problem of uncertainty renders profit maximisation unsuitable as anoperational criterion for financial management as it considers only the size ofbenefits and gives no weight to the degree of uncertainty of the future benefits.This is illustrated in Table 1.2.Uncertainty About Expected Benefits (Profits) Profit(Rscrore) __________________________________________ State of Economy Alternate ABenefits Recession (Period I) 9 0
    • Normal (Period II) 1010 Boom (Period III) 1120 Total 3030 It is clear from Table 1.2 that the total returns associated with the twoalternatives are identical in a normal situation but the range of variations is verywide in case of alternative B, while it is narrow in respect of alternative A. To putIt differently, the earnings associated with alternative B are more uncertain (risky)as they fluctuate widely depending on the state of the economy. Obviously,alternative A is beuer in terms of risk and uncertainty. The profit maximisationcriterion fails to reveal this. To conclude, the profit maximisation criterion is inappropriate and unsuitableas an operational objective of investment, financing and dividend decisions of afirm. It is not only vague and ambiguous but it also ignores two importantdimensions of financial analysis, namely, risk, and time value of money. It followsfrom the above that an appropriate operational decision criterion for financialmanagement should (j) be precise and exact, (ij) be based on the bigger thebetter principle, (iij) consider both quantity and quality dimensions of benefits,and (iv) recognise the time value of money. The alternative to profitmaxirnisation, that is, wealth maximisation is one such measure.Wealth Maximisation Decision Criterion This is also known as value maximisation or net present worth maximisation. Incurrent academic literature value maximisation is almost universally accepted asan appropriate operational decision criterion for financial management decisionsas it removes the technical limitations which characterise the earlier profitmaximisation criterion. Its operational features satisfy all the three requirementsof a suitable operational objective of financial course of action, namely,exactness, quality of benefits and the time value of money. The value of an asset should be viewed in terms of the benefits it can produce.The worth of a course of action can similarly be judged in terms of the value ofthe benefits it produces less the cost of undertaking it. A significant element incomputing the value of a financial course of action is the precise estimation ofthe benefits associated with it. The wealth maximisation criterion is based on theconcept of cash flows generated by the decision rather than accounting profitwhich is the basis of the measurement of benefits in the case of the profitmaximisation criterion. Cash flow is a precise concept with a definite connotation.Measuring benefits in terms of cash flows avoids the ambiguity associated withaccounting profits. This is the first operational feature of the net present worthmaximisation criterion The second important feature of the wealth maximisation criterion is that itconsiders both the quantity and quality dimensions of benefits. At the same time,it also incorporates the time value of money. The operational implication of theuncertainty and timing dimensions of the benefits emanating from a financialdecision is that adjustments should be made in the cash-flow pattern, firstly, toincorporate risk and, secondly, to make an allowance for differences in the timingof benefits. The value of a stream of cash flows with value maximisation criterionis calculated by discounting its element back to the present at a capitalisationrate that reflects both time and risk. The value of a course of action must beviewed in terms of its worth to those providing the resources necessary for itsundertaking. In applying the value maximisation criterion, the term value is usedin terms of worth to the owners, that is, ordinary shareholders. The
    • capitaIisation (discount) rate that is employed is, therefore, the rate thatreflects the time and risk preferences of the owners or suppliers of capital. As ameasure of quality (risk) and timing, it is expressed in decimal notation. Adiscount rate of, say, 15 per cent is written as 0.15. A large capitalisation rate isthe result of higher risk and longer time period. Thus, a stream of cash flows thatis quite certain might be associated with a rate of 5 per cent, while a very riskystream may carry a 15 per cent discount rate. For the above reasons, the net present value maximisation is superior to theprofit maximisation as an operational objective. As a decision criterion, it involvesa comparison of value to cost. An action that has a discounted value-reflectingboth time and risk-that exceeds its cost can be said to create value. Such actionsshould be undertaken. Conversely, actions, with less value than cost, reducewealth and should be rejected. In the case of mutually exclusive alternatives,when only one has to be chosen the alternative with the greatest net presentvalue should be selected. In the words of Ezra Solomon, The gross present worth of a course of action is equal to the capitalisedvalue of the flow of futUre expected benefit, discounted (or captialised) at a ratewhich reflects their certainty or uncertainty. Wealth or net present worth is thedifference between gross present worth and the amount of capital investmentrequired to achieve the benefits being discussed. Any financial action whichcreates wealth or which has a net present worth above zero is a desirable oneand should be undertaken. Any financial action which does not meet this testshould be rejected. If two or more desirable courses of action are mutuallyexclusive (Le. if only one can be undertaken), then the decision should be to dothat which creates most wealth or shows the greatest amount of net presentworth. Using Ezra Solomons symbols and methods, the net present worth canbe calculated as shown below: . (i) w= v- C (1.1)Where W = Net present worth V = Gross present worth C = Investment (equity capital) required to acquire the asset or to purchasethe course of action (ii) V = FJ K (1.2)Where E = Size of future benefits available to the suppliers of the input capital K = The capitalisation (discount) rate reflecting the quality(certainty/uncertainty)and timing of benefits attached to E (iii) E = G - (M + 1+ 1) (1.3)Where G = Average future flow of gross annual earnings expected from thecourse of action, before maintenance charges, taxes and interest and other priorcharges like preference dividendM = Average annual reinvestment required to maintain G at the projected levelT= Expected annual outflow on account of taxes and other prior charges. The operational objective of financial management is the maximisation of W inEq. (1.1). Alternatively, W can be expressed symbolically by a short-cut methodas in Eq. (1.4). Net present value (worth) or wealth is A1 A2 A3 W = ------------ + ----------- +…+ --------------(1.4) 2 3 (1+K) (1+K) (1+K)
    • where ~, A1 A2, ... An represents the stream of cash flows expected to occur from a course of action over a period of time; K is the appropriate discount rate to measure risk and timing; and C is the initial outlay to acquire that asset or pursue the course of action. It can, thus, be seen that in the value maximisation decision criterion, the timevalue of money and handling of the risk as measured by the uncertainty of theexpected benefits is an integral part of the exercise. It is, moreover, a preciseand unambiguous concept, and therefore, an appropriate and operationallyfeasible decision criterion for financial management decisions. It would also be noted that the focus of financial management is on the value tothe owners or suppliers of equity capital. The wealth of the owners is reflected inthe market value of shares. So wealth maximisation implies the rnaxirnisation ofthe market price of shares. In other words, maxirnisation of the market price ofshares is the operational ;substitute for value/wealth/net present valuernaximisation as a decision criterion. In brief, what is relevant is not the overall goal of a firm but a decision criterion,which should guide the financial course of action. Profit EPS maxirnisation wasinitially the generally accepted theoretical criterion for making efficient economicdecisions, using profit as an economic concept and defining profit rnaximisationas a criterion for economic efficiency. In current financial literature, it has beenreplaced by the wealth maxirnisation decision criterion because of theshortcomings of the former as an operational criterion, as (j) It does not takeaccount of uncertainty of risk, (ij) it ignores the time value of money, and (ill) it isambiguous in its computation. Owing to these technical limitations, profitmaximisation cannot be applied in real world situations. Its modified form is thevalue rnaximisation criterion. It is important to note that value maxirnisation issimply extension of profit rnaxirnisation to a world that is uncertain andmultiperiod in nature. Where the time period is short and degree of uncertainty isnot great, value maxirnisation and profit rnaximisation amount to essentially thesame thing. However, two important issues are related to the value/share price-rnaximisation, namely, economic value added and focus on stakeholders Economic Value Added (EVA) It is a popular measure currently being usedby several firrns to determine whether an existing/proposed investment positivelycontributes to the owners/shareholders wealth. The EVA is equal to after-taxoperating profits of a firm less the cost of funds used to finance investments. Apositive EVA would increase owners value/wealth. Therefore, only investmentswith positive EVA would be desirable from the viewpoint of maximizingshareholders wealth. To illustrate, assuming an after-tax profit of Rs 40 croreand associated costs of financing the investments of Rs 38 crore, the EVA = Rs 2crore (Rs 40 crore - Rs 38 crore). With a positive EVA, the investment would addvalue and increase the wealth of the owners and should be accepted. Thecomputation of the after-tax operating profits attributable to the investment underconsideration as well as the cost of funds used to finance it would, however,involve numerous accounting and financial issues. The merits of EVA are: (a) its relative simplicity and (b) its strong link with thewealth rnaximisation of the owners. It prima facie exhibits a strong link to shareprices, that is, positive EVA is associated with increase in prices of shares andvice versa. However, EVA is, in effect, a repackaged and well-marketedapplication of the NPV technique of investment decision. But EVA is certainly auseful tool for operationalising the owners value rnaximisation goal, particularlywith respect to the investment decision. .Focus on Stakeholders The shareholders wealth rnaximisation as the primarygoal notwithstanding, there is a broader focus in financial management to includethe interest of the stakeholders as well as the shareholders. The stakeholders
    • include employees; customers, suppliers, creditors and owners and others whohave a direct link to the firm. The implication of the focus on stakeholders is thata firm should avoid actions detrimental to them through the transfer of theirwealth to the firm arid, thus, damage their wealth. The goal should be preservethe well-being of the stakeholders and not to maximise it. The focus on the stakeholders does not, however, alter the shareholderswealth maximisation goal. It tends to limit the firms actions to preserve thewealth of the stakeholders. The stakeholders view is considered part of its "socialresponsibility" and is expected to provide maximum long term benefit to theshareholders by maintaining positive stakeholders relationship which wouldminimize stakeholder turnover, conflict and litigation. In brief, a firm can betterachieve its goal of shareholders wealth maximisation with the cooperation of,rather than conflict with, its other stakeholders. Shareholder Orientation in India Traditionally, the corporate industrial sector in India was. dominated by group companies with close links with the promoter groups. Their funding primarily was through institutional borrowings from public development finance institutions like IFCI, ICICI, IDBI! and so on. There was preponderance of loan capital in their financial structure and shareholders equity played a rather marginal role. It was no wonder, therefore, that corporate India paid scant attention to shareholders wealth maximisation with few exceptions such as Reliance Industries Ltd. In the post-90 liberalisation era, the goal of shareholders wealth maximisation has emerged almost at the centre-stage. The main contributory factors have been (0 greater dependence on capital market, (ii) growing importance of institutional investors, (iii) tax concessions/ incentives to shareholders and (iv) foreign exposure. With the gradual decline in the significance of the development/public term/term lending institutions over the years and their disappearance from the Indian financial scene recently (as a result of their conversion/proposed conversion into banks) and the consequent emergence of the capital market as the main source of corporate financing, shareholders wealth maximisation is emerging as the prime goal of corporate financial management. Secondly, as a result of the institutionalisation of savings, institutional investors such as mutual funds, insurance organisations, foreign institutional investors and so on dominate the structure of the Indian capital market. To cater to the requirements of these institutional investors, corporates are pursuing more shareholder - friendly policies as reflected in their efforts to focus on shareholders wealth maximisation. Thirdly, the abolition of wealth tax on equity shares and other financial assets coupled with tax. exemption on dividends in recent years has provided an incentive to corporates to enhance share prices and, thus, focus on shareholders wealth. Finally, the family-owned corporate are also undergoing major transformation. The scions of most business families are acquiring higher professional education in India and abroad. With the foreign exposure, they also appreciate the importance of shareholders wealth. Thus, shareholder orientation is unmistakably visible in the corporate India. ____________________________
    • CONCEPT OF TIME VALUE OF MONEY PRESENTVALUE1.0 OBJECTIVESThe objective is to understand the concept that money has a time value. Thenotion that a rupee today is preferable to the same rupee in the future is intuitiveenough for most people to grasp. This can be grasped without the use of modelsand mathematics. The principal of present value provides the backing for this andenables us to calculate exactly how much a rupee some time in the future isworth today. In this chapter we shall examine the following questions: · What do we mean by time value of money? · What is the basis for present value? What factors affect the timing of cash flows and how does this affect the time value?1.1 INTRODUCTIONThe principles of present value also underlie most of what we do in CorporateFinance by evaluating projects and valuation of company shares and a greatdeal of personal finance and investment. The simplest tools in finance are oftenthe most powerful. Present value is a concept which shows that money has atime value. It is an intuitive and simple concept, simple to calculate and can beapplied in a wide range of situations in corporate finance. We can use thisconcept in buying a house, saving for a childs education, picking a project ormore complex situations like valuing a buyout of a company share. That moneyhas time value stems from the concept that the value of money gets eroded bythe concept of inflation. How often have we heard our elders say that a kilo ofrice was so cheap or that a house was so cheap and had they invested wisely itmight have been better? How often are clothes cheaper,education cheaper andall the common essentials becoming dearer year after year? In the followingpages you will understand the concept and learn to apply .it on real lifeexamples.1.2 DESCRIPTIONDealing with Cash Flows at different points of time can be made easier using atime line that shows both the value and timing of cash flows. The followingfigure shows a cash flow of Rs 100 at the end of five years.
    • In the figure above 0 time on the time line depicts now, at the presentmoment or today. Thus a cash flow or rupees received by you today has thesame value today. Thus it need not be adjusted for time value. Now a distinctionshould be made between a period in time and a point in time. The portion of thetime line between 0 and 1 and 2 and 3, etc. refers to period 1 and period 3 whichin this example is the first year and third year. The cash flow that occurs in apoint in time -1- refers to the cash flow that occurs at the end of period 1. Finallythe discount rate which is 10 per cent in this example is specified in each periodof the time line and may be different for each period. Had the cash flows beenat 0 1 yr Rs 100 2 yrs Rs 100 3 yrs Rs 100 4 yrs Rs 100 5 yrs Rs 100 10% 10% 10% 10% 10% Fig 1 (a) A Time Line for Cash Flows- End of Each Period0 Rs 100 1 yr Rs 100 2 yrs Rs 100 3 yrs Rs 100 4 yrs Rs 100 5 yrs10% 10% 10% 10% 10% Fig 1.1(b) A Time Line for cash Flows- Beginning of Each Periodthe beginning of each year instead of the end of each year, the time line wouldbe as redrawn above. Please note that the beginning of year 2 is the end ofyear 1. It depends how you look at it. Positive and negatives cash flows: Cash flows can neither be negative orpositive.Cash inflows are called Positive Cash Flows and Csh outflows arecalled Negative Cash flows.NotationsNotation MeaningPV Present ValueFV Future ValueCf Cash flow at the end of period tA Annuity-Constant Cash Flows over several periodsr Discount Rateg Expected growth rate in cash flowsn Number of periods over which cash flows are received or paid
    • 1.3 COMMON SENSE APPROACH TO PRESENT VALUE A cash flow in the future is worthless than a. similar cash flow today because:● People prefer present consumption to future consumption.● People would have to be offered more in the future to give up present consumption.● Due to inflation the value of money/currency depreciates or erodes over a period of time. This happens due to inflation. The greater the inflation the greater is the erosion in the value of the rupee today and in the future.● Due to the uncertainty of receiving the cash flow in the future the value of the cash flow in the future reduces further. This means there is a risk associated with receiving the cash flow in future and this reduces the, value associated with the cash flow. The greater the risk the greater the erosion in value.The process by which future cash flows are adjusted to reflect these factors iscalled discounting, and the magnitude of these factors is reflected in thediscount rate.What is Discount Rate?The discount rate is a rate at which present and future cash flows are traded off.It incorporates 1. The preference for currrent consumption ( greater preference 2. Expected inflation (higher inflation _ higher discount rate). 3. The uncertainty in the future cash flows (higher risk ___ higher discount rate).A higher discount rate will lead to a lower present value for future cash flows. 1.4 TRADE OFF IN REAL CONSUMPTION OVER TIME Although individuals prefer present consumption to future consumption, the degree of this preference varies across individuals. This trade off between present consumption (Co) and future consumption (C1) can be explained as follows. In the real world people can get the same amount of money in each period and they can either consume it or save it or lend it. A may choose to consume the whole amount, B may consume more money by borrowing and C may consume less and save and lend the remaining portion. If the preference for current consumption is strong then we have to offer more in terms of future. consumption to give up current consumption. Thus there is always a trade off which is always reflected by the high-real
    • rate of return or discount rate. If the preference for current consumption is weak then a person can settle for a lower real rate of return or discount rate. The assumption here is that any money. or wealth saved will always be lent out as because it can earn a return for the saver. The story of the grasshopper and the ant reflects this. The grasshopper may make merry and use all of his money whereas the ant may save to enjoy during winter. Many an old couple enjoy their retirement because they have intuitively used the concept of time value of money properly and when their earning capacity goes down they can enjoy the fruits of their savings ans investment decisions.1.5 THE CALCULATION OF PRESENT VALUEThe process of discounting future cash flows converts them into cash flows inpresent value terms. Conversely the process of compounding converts presentcash flows into future cash flows. Cash flows at different points to time cannot be compared and aggregatedunless they are all brought to the same point in time before we can compare oraggregate them. There are five types of cash flows:1. Simple cash flows2. Annuities3. Growing Annuities4. Perpetuities and5. Growing Perpetuities1. Simple cash flows A simple cash flow is a single cash flow in a specified future time period. On a time line CF t = Cash Flow at Time t 0 tThis cash flow can be discounted back to the present discount rate that reflectsthe uncertainty of the cash flow. Conversely,cash flows in the present can becompounded to arrive at an expected future cash flow.Discounting: is the process by which a cash flow which is expected to occur inthe future is brought to its present value.
    • Compounding: is the process by which a cash flow today is converted into itsexpected future value.Calculating Present ValueThe present value of Rs 1,00,000 a year from now must be less than Rs1,00,000 today. Thus the present value of the delayed payoff can be found outby multiplying the payoff with the discount factor which is less than 1. If thediscount factor is more than 1 a rupee today would be worthless than a rupeetomorrow. If C1 denotes the expected payoff at period 1, one year hence then Present Value (PV) = Discount factor x C1Or In the example earlier Present Value (PV) = __CF1__ (1 + r) Thus the discount factor is the value received today of Rs 1 received in thefuture. It is usually expressed as a reciprocal of 1 plus a rate of return. Discount factor = 1 (1 + r) Similarly you have a compounding factor. To calculate discount factor andcompound factors we have tables to aid us in complex calculations. Thesearegiven as an appendix to the chapter below. The rate of return r is the rewardthat investors demand for accepting a delayed payment. You are considering investing in a house or property worth Rs 4,00,000today and your real estate advisor has estimated that the cost would go uptoRs 5,00,000 in a year if you sold it. That is not the only way you can earnmoney as you have various investment options. You can invest in PublicProvident Fund with an interest rate of 9 per cent. How much would you have;to invest in PPF to receive Rs 5,00,000 after a year. That is easy as theinterest rate is 9 per cent, you would have to invest Rs 5,00,000/1.09, which isRs 458715.59. Thus the building investment is a better option as you get ahigher rate of return. However you must bear in mind that the real estateinvestment has a higher risk in terms of variability of return. Thus risk isrelated to return whereas the PPF option has a lower risk and lower return. To calculate present value, we discount the expected payoff by the rateof return offered by equivalent investment alternatives in the capital orfinancial! markets. This rate of return is often referred to as the discount
    • rate, hurdle rate or opportunity cost of capital. It is called opportunity costbecause it is the return forgone by investing in the project rather thaninvesting in securities. In our example the opportunity cost was 9 per cent.Present value was obtained by dividing Rs 5,00,000 by 1.09. PV = Discount factor x C1 = _1____x C1 1+r = 5,00,000 = Rs 458715.59 1.093. Net Present ValueLet us suppose that your property is worth Rs 458715.59 today but youcommitted Rs 4,00,000 initial outgo to purchase the property. So your NETPRESENT VALUE is Rs 58715.59. Net Present Value is found by subtracting therequired investment NPV= PV - Required Investment = Rs 4,58,715.59 - Rs 4,00,000 = Rs 58,715.59 In other words your investment in the property is worth more than it costs - itmakes a net contribution to value. The formula for calculating NPV can be writtenas C1 NPV= C 0 +_____ 1+r Remember that Co the cash flow at time 0 (that is today), will usually be anegative number. In other words, Co is an investment and therefore a cashoutflow. In our example Co is - Rs 4,00,000.Relation of Risk to Present Value In many of our calculations we feel it is enough to compare the present valuesand aggregates, however we make the unrealistic assumption of assigning thesame level of risk and only taking decisions based on the comparative returns ofalternative means of adjustments. The real estate advisor or property advisorcannot be sure about the return in the market. If the future value of this propertyis risky our calculation is wrong. Public Provident Fund is certainly less risky as it
    • is akin to Government security. Thus if you were asking someone else to investin this property along with you they may not agree to give you the present valueamount but something less than that. Thus we invoke another financial principalthat a safe rupee is worth more than a risky one. Thus we do not use the samediscount factor while comparing alternative investment avenues. The discountrate for PPF may be 9 per cent OR 0.09 but the discount rate for the buildingproperty may be 11 per cent or 0.11. Only after the present values are calculatedusing these two different discount rates is the best investment avenue or projectdecided. Most investors avoid risk when they can do so without sacrificing return.However, the concepts of present value and the opportunity cost of capital stillmake sense for risky investments. It is still proper to discount the payoff by therate of return offered by an equivalent investment. But we have to think ofExpected payoffs and the expected rates of returns on other investments. Youwill learn more about expected payoffs when you do Capital Budgeting Later.For now it will be enough if you think of an expected payoff and the expectedrates of returns on other investments. You will learn more about expectedpayoffs when you do Capital Budgeting Later. For now it will be enough if youthink of an expected payoff as a realistic forecast,neither pessimistic noroptimistic. Concept check: India has a low savings rate as compared to Japan. Thisleads to greater budget and trade deficits. How does a low saving rate affectdiscount rates? Effect of Inflation on Discount Rate: The effect of inflation on present value isevident because it reduces the purchasing power of future cash flows. Thisadjustment reduces the value of future cash flows, but these real cash flows, willhave to be reduced further to reflect real returns (i.e. the trade offs betweencurrent and future consumption) and any uncertainty associated with the cashflows to arrive at the present value. Thus, an investor who expects to make 10.5million Mexican pesos a year from now will have to reduce this expected cashflow to arrive at the present value. Thus, an investor who expects 1 million ItalianLire a year from now will have to reduce this expected cash flow to 1 reflect theexpected inflation rate in Mexico. If that inflation rate is 25 per cent,for instance,the real cash flow will be only 0.8 million Italian lire.The general formula for converting nominal cash flows at a future period ‘t to realcash flows is Real Cash Flow = (Nominal cash flow)/(1 + inflation rate).Effect of Risk on Discount Rate: Although both the preference for currentconsumption, and expected inflation affect the present value of all cash flows notall cash flows are equally predictable. A promised cash might not be deliveredfor a number of reasons: the promisor (lnterest and investment not received ascompany winds up) might default on the payment- the promisee might not bearound to receive payment - (might have died) or some other contingency or
    • some happening may intervene to prevent the promised payment or to reduce it.The greater the uncertainty associated with a cash flow in the future, the higherthe discount rate used to calculate the present value of this cash flow will be andthe present value of that cash flow will consequently be lower.ExampleYou have decided to invest in a construction of an office building as it is worthmore than it costs- it has positive net present value. To calculate how much it isworth- would have to pay to achieve the same pay off by investing directly insecurities. The projects future value is equal to its future income discounted atthe rate of return offered by these securities. We can say this another way. Our building venture is worth undertakingbecause its rate of return exceeds its cost of capital. The rate of return is simplythe profit as a proportion of the initial outlay. Return = Profit/Investment =(5,00,000-4,30,000)/4,30,000 =(70,000) /(4,30,000) = 0.163 about 16 per centThe cost of capital is once again the return foregone by not investing insecurities. If the office building is as risky as investing in stock market securitieswhere the expected return is 14 per cent then the return forgone is 14 per cent.Since the 16 per cent return on the office building exceeds the 14 per centopportunity cost, you should go ahead with the project. Hence we have two equivalent decision rules for capital investment.· Net present value rule. Accept investments that have positive net presentvalues.· Rate of return rule. Accept investments that offer rates of return in excess oftheir opportunity costs of capital1.6 DISCOUNTING A SIMPLE CASH FLOW - WHY IT IS IMPORTANTDiscounting a cash flow converts it into present value rupees and enables theuser to do several things. First, once cash flows are converted into present valuerupees, they can be aggregated and compared. Second, if present values areestimated correctly the user should be indifferent between the future cash flowand the present value of the cash flow.
    • Other things remaining equal, the present value of a cash flow will decrease asthe discount rate increases and continue to decrease the further into the futurethe cash flow occurs. Thus present value is a decreasing function of the discountrate.1.7COMPOUNDING A CASH FLOW - WHY IT IS IMPORTANTCurrent cash flows can be moved into the future by compounding the cash flowat the appropriate discount rate. The future value of a simple cash flow is Future Value of a Simple Cash Flow = CFo (1+ r) where CF o = Cash Flow Now ,r = Discount RateAgain, the compounding effect increases with both the discount rate and thecompounding period. Compounding. is the process by which cash flows are converted from presentvalue to future value rupees.Ibbotson and Sinquefields StudyAs the length of the holding period is extended, small differences in discountrates can lead to large differences in future value. In a study of returns on stocksand bonds between 1926 and 1992, Ibbotson and Sinquefield found that stockson the average made 12.4 per cent Treasury Bonds made 5.2 percent, andTreasury Bills made 3.6 per cent. Assuming that these returns continue into thefuture, the table below provides the future value of dollar 100 invested n eachcategory at the end off a number of holding periods - 1 year, 5 years, 10 years,20 years, 30 years and 40 years. The differences in future value from investing at these different rates of returnare small for short compounding periods( such as one year) but become largeras the compounding period is extended. For instance, with a 40 year timehorizon, the future value of investing in stocks, at an average return of 12.4 percent, is more than 12 times larger than the future value of investing in Treasurybonds at an average return of 5.2 per cent and more than 25 times the futurevalue of investing in Treasury Bills at an average return of 3.6 per cent.Future Value of Investments - Asset ClassesHolding Period Stocks T. Bonds T. Bills1 112.40 105.20 103.605 179.40 128.85 119.3410 321.86 166.02 142.43
    • 20 1035.92 275.62 202.8630 3334.18 457.59 288.9340 10731.30 759.68 411.52Concept CheckMost pension funds allow individuals to decide where their pension fundswill be invested- stocks (equity), bonds (debt) or money market accounts,etc. Where would you choose to invest your pension fund? Do you thinkyour allocation should change as you get older ? Why?The Rule of 72- A shortcut to estimating the Compounding effectIn a pinch, the rule of 72 provides an approximate answer to the question"How quickly will this amount double in value?" by dividing 72 by thediscount on interest rate used in the analysis. Thus, a cash flow growing at 6per cent will, double in value in approximately 12 years, while a cash flowgrowing at 9 percent will double in value in approximately 8 years.Effective Interest RateThis is the true rate of interest, taking into account the compounding effectsof more frequent interest payments.The Frequency of Discounting and CompoundingThe frequency of compounding affects both the future and present values ofcash flows. In the examples above, the Cash flows were assumed to bediscounted and compounded annually - that is, interest payments and incomewere computed at the end of each year, based on the balance at the beginningof each year. In some cases however the interest may be computed morefrequently, such as on a monthly or semi annual basis. In these cases, thepresent and future values may be very different from those computed on annualbasis; the stated interest rate on an annual basis can deviate significantly fromthe effective or true interest rate. The effective interest rate can be computed asfollows. Effective Interest Rate= (1+Stated Annual Interest Rate) n --------------------------------------------------- -1 NWhere N=number of compounding periods (2=semi annual;12 =monthly)
    • For Instance, a 10 per cent annual interest rate, if there is semi annualcompounding works out to an effective interest rate of Effective Interest Rate = (1.052 - 1) =(1.1025 - 1.0) = 10.25 per cent As compounding becomes continuous, the effective interest rate can becomputed as follows: Effective Interest Rate = (exp )r - 1 where exp = exponential function r = stated annual interest rate The Table below provides the effective rates as a function of the compoundin!gfrequency.Effect of Compounding Frequency on Effective Interest Rates Frequency Rate(% ) T Formula Effective Annual Rate(%) Annual 10 1 .10 10 Semi-Annual 10 2 (1 +.10/2)2 -1 10.25 Monthly 10 12 (1 +.10112)12 - 1 10.47, (1 +.10/365)365 - Daily 10 365 10.5156 1 Continuous 10 continuous e,10 - 1 1 O5171As you can see, as compounding becomes more frequent, the effective rateincreases, and the present value of future cash flows decreases. For example the home loans which various companies offer you requiremonthly repayments and may have monthly compounding. Thus the interest ratequoted to you may be too low and actually quite deceptive. To get the effectiveAnnual rate you should use the formula above and see what the actual effectiveinterest rate is.AnnuityAn annuity is a constant cash flow occurring at regular intervals of time.Annuities
    • An annuity is a constant cash flow that occurs at regular intervals at fixed periodof time. Defining A to be the annuity time, the time line for an annuity may bedrawn as follows: A A AA0 1 2 34 An annuity can occur at the end of each period, as in this time line, or at the,;beginning of each period. Present Value of an end-of-the period annuityThe present value of an annuity can be calculated by taking each cash flow anddiscounting it back to the present and then adding up the present values.Alternatively, a formula can be used in the calculation. In the case of annuitiesthat occur at the end of each period, this formula can be written as (1- 1 )PV of an Annuity =PV(A, r, n)=A ( (1+r)n ) ( r )where A = Annuity r = Discount Rate n = Number of years Accordingly the notation used internationally for the present value of an.annuity is PV(A, r, n). Suppose you start a rent-a-car business and want to buy an automobile.You have choice of buying the car cash down for Rs 400,000 or paying Rs90,000 a year for five years for the same car. What would you rather do, if theopportunity cost is 12% then calculate your decision? PV of Rs 90,000 each year for the next 5 years 1 ( 1 - -------) ( 5) = 90,000 ( (1.12) = 3,24,429.75
    • ( 0.12) Obviously it is better to take the auto loan rather than pay cash down andnaturally no auto loan company or bank will come up with such a scheme. Thepresent values of your instalments versus cash down will always be higher but ifyou do not have the money right now or you can get a higher return by using thisloan then it is worthwhile taking the loan. Thus you will also have to look intoyour inflows by hiring out the carls in your rent-a-car business. When the present values of your instalment payments exceed the cash downprice it is better to pay cash down and acquire the asset. Alternatively above you could have discounted each instalment separately landadded up the present values for all five and arrived at the same figure. Nowadaysspreadsheets like excel are used to calculate the values of different annuities orusing advanced programme calculators which all insurance company agents use.Thus using the formulas programmed in the spreadsheet and changing thevariables like amount, time and rate of interest/discount factor you can calculatethe present value of different annuities and take financial decisions both personaland commercial.Concept CheckOften you have a choice of buying an asset like a car, computer, plane,etc. Is it appropriate to compare the present value of just your leasepayments to your purchase price? Why or why not?Future Value of End-of-the-Period Annuitiesn some cases, an individual may plan to set aside a fixed annuity each period fora number of periods and will want to know how much he or she will have at theend of the period. The future value of an end-of-the-period annuity can becalculated as follows FV of an annuity = FV(A, r ,n)= A{ (1+r)n - 1} rThus the standard notation widely practiced for Future Value of an annuity is FV(A, r , n)Concept CheckKnowing the future value formula can you calculate the future value of Rs 5000tax exempted PPF you deposit every year for twenty years? Or for forty yeanAssume you start at age 25 years.
    • If it is taxed obviously you have a lower return. Juggling the above formula if you know the future value of what you haverepay and you want to set aside a fixed sum even year so that you can repay thesum you can calculate the annuity. Thus Annuity given future value - which means you are given the future valueand are looking for the annuity - A (FV, r, n) can be calculated as follow Annuity given the future value= A (FV, r, n) = FV{__r__} ( 1+r)n -1 Balloon Repayment Loan: A balloon Repayment loan refers to a Ioan onwhich only interest is paid for the life of the Ioan, and the-entire principal is paidat the end of the loans life. Companies that borrow money using balloonrepayment loans like bonds or debentures often set aside money in sinking fundsduring the life of the loan to ensure they have enough at maturity to pay theprincipal on the loan or the face value of the bonds. Thus any company will haveto set aside a fixed amount each year till the date of redeeming of bonds/debentures to avoid defaulting on repayment to bondholders or debentureholders. The size of the sinking fund will vary with the change in interest rate. Sinking Fund: A sinking fund is a fund to which firms make annual contributionsin order to have enough funds to meet a large financial liability in future.Concept Check Do Insurance Companies and Pension Funds provide for sinking funds? Wheninsurance is only a contingent/uncertain liability why do these companies alsoprovide for sinking funds?Effect of Annuities at the Beginning of Each YearThe annuities we talked about till now are end of the period cash flows. Both thepresent and future values are affected if the cash flow occurs at the beginning ofeach period instead of the end. To illustrate this effect, consider an annuity of Rs100 at the end of each year for the next four years,with a discount rate of 10%. Rs 100 Rs 100 Rs 100 Rs1000 10% 1 10% 2 10% 3 10%4
    • 0 1 2 3 4Rs 100 Rs 100 Rs 100 Rs 100 Rs 100 Fig 1.4Because the first of these annuities occurs right now, and the remaining cash flowstake the form of an end-of-the-period annuity over three years. The present value ofthis annuity can be written as follows: PV of Rs 100 at beginning = 100 + 100[1- 1___ 3of each of next four year 1.10__ 0.10In general, the present value of a beginning – of- a- period annuity over an yearcan be written as followsPV of Period Annuities at beginning = A + A [1-__1_ ] of each of next n years (1+r) n-1 _________ rThis present value will be higher than the present value of an equivalen toannuity at the end of each period. The future value of a beginning-of-a-period annuity typically can be estimatedby allowing for one additional period of compounding for each cash flow: PV of Period Annuities at beginning = A (1+r) (1+r) n-1 of each of next n years _________ rThis future value will be higher than the future value of an equivalent annuity atthe end of each period. Thus if you invest your annuity at the beginning of eachyear instead of the end of each year, your future value will be higher.
    • Growing AnnuitiesA growing annuity is a cash flow that grows at a constant rate for a specifiedperiod of time. If A is the current cash flow, and g is the expected growth rate,;the time line for a growing annuity is as follows: I A(1+ g)1 A(1+ g) 2 A(1+ g)3 A(1+g)40 1 2 3 4 Note that to qualify as a growing annuity, the growth rate in each period ha~ tobe the same as the growth rate in the prior period.The Process of Discounting a Growing AnnuityThe present value of a growing annuity can be estimated by using the followingformula:PV of a Growing Annuity = A(1+g) { 1 _ (1 + g)" } (1+r)" r–9 The present value of a growing annuity can be estimated in all cases but one -if the growth rate is equal to the discount rate. In that case, the preseni value isequal to the nominal sums of the annuities over the period, without the growtheffect. PV of a Growing Annuity for n years (when r = g) = nA It is important to note that the expanded formulation works even when th~growth rate is greater than the discount rate.PerpetuityA perpetuity is a constant cash flow paid (or received) at regular time intervalsforever.
    • Thus a lifetime pension can be considered as perpetually or rentals receivedfrom exploitation of land which is passed on from generation to generation. The present value of a perpetuity can be written as PV of Perpetuity = A r A Console Bond is a bond that has no maturity and pays a fixed coupon (rate ofinterest). Assume that you have a 6 per cent coupon console bond. The original facevalue = Rs 1000. The current value of this bond if the interest rate is 9 per centis as follows. Current value of Console Bond = Rs 6010.09 = Rs 667The value of a Console bond will be equal to its face value only if the couponrate is equal to the interest rate. In this case Rs 1000, Le. 60/0.06Growing PerpetutiesA growing perpetuity is a cash flow that is expected to grow at a constant rate.forever. The present value of a growing perpetuity can be-written as - PV of Growing Perpetuity = C___ (r - g) A growing perpetuity is a constant cash flow, growing at a constant rate, andpaid at regular time intervals forever. Although a growing annuity and a growing perpetuity share several features,the fact that a growing perpetuity lasts forever puts constraints on the growthrate. It has to be less than the discount rate for the formula to work. Recommended Readings Financial Management By Khan & Jain
    • CAPITAL EXPENDITURE DECISIONSOBJECTIVESThis chapter provides a broad overview of the field of project appraisal andcapital budgeting. It is divided into five sections as follows:· Capital expenditures: importance and difficulties· Phases of capital budgeting· Levels of decision-making· Facets of project analysis· Feasibility study: a schematic diagram· Objectives of capital budgetingCAPITAL EXPENDITURE DECISIONSCapital Expenditures: Importance and Difficulties
    • ImportanceCapital expenditure decisions often represent the most important decisions takenby a firm. Their importance stems from three inter-related reasons:Long-term effects: The consequences of capital expenditure decisions extend farinto the future. The scope of current manufacturing activities of a firm isgoverned largely by capital expenditures in the past. Likewise current capitalexpenditure decisions provide the framework for future activities. Capitalinvestment decisions have an enormous bearing on the basic character of a firm. Irreversibility: The market for used capital equipment in general is iIl- organised. Further, for some types of capital equipments,custom made to meet specific requirement, the market may virtually be non-existent. Once such an equipment is acquired, reversal of decision may mean scrapping the capital equipment. Thus, a wrong capital investment decision, often cannot be reversed without incurring a substantial loss ● Substantial outlays: Capital expenditures usually involve substantial outlays. An integrated steel plant, for example, involves an outlay of several thousand millions. Capital costs tend to increase with advanced.DifficultiesWhile capital expenditure decisions are extremely important, they also postdifficulties which stem from three principal sources: .● Measurement problems: Identifying and measuring the costs and benefits of a capital expenditure proposal tends to be difficult. This is more so when a capital expenditure has a bearing on some other activities of the firm (like cutting into the sales of some existing product) or has some intangible consequences (like improving the morale of workers).● Uncertainty: A capital expenditure decision involves costs and benefits that extend far into future. It is impossible to predict exactly what will happen in future. Hence, there is usually a great deal of uncertainty characterising the costs and benefits of a capital expenditure decision.● Temporal spread: The costs and benefits associated with a capital expenditure decision are spread out over a long period of time, usually 10-20 years for industrial projects and 20-50 years for infrastructural projects. Such a temporal spread creates some problems in estimating discount rates and establishing equivalences.PHASES OF CAPITAL BUDGETING
    • Capital budgeting is a complex process which may be divided into five broadphases: planning, analysis, selection, implementation, and review. Exhibit11.1portrays the relationship among these phases. The solid arrows reflect themain sequence: planning precedes analysis; analysis precedes selection; andso on. The dashed arrows indicate that the phases of capital budgeting are notrelated in a simple, sequential manner. Instead, there are several feedbackloops reflecting the iterative nature of the process.PlanningThe planning phase of a firms capital budgeting process is concerned with thearticulation of its broad investment strategy and the generation and preliminaryscreening of project proposals. The investment strategy of the firm delineatesthe broad areas or types of investments the firm plans to undertake. Thisprovides the framework which shapes, guides, and circumscribes theidentification of individual project opportunities.Exhibit 11.1 Capital Budgeting Process
    • Once a project proposal is identified, it needs to be examined. To begin with, apreliminary project analysis is done. A prelude to the full blown feasibility study,this exercise is meant to assess (i) whether the project is prima facie worthwhileto justify a feasibility study and (ii) What aspects of the project are critical to itsviability and hence warrant an in-depth investigation.AnalysisIf the preliminary screening suggests that the project is prima facie worthwhile,detailed analysis of the marketing, technical, financial, economic, and ecologicalaspects is undertaken. The questions and issues raised in such a detailedanalysis are described in the following section. The focus of this phase of capitalexpenditure decisions is on gathering, preparing, and summarising relevantinformation about various project proposals which are being considered forinclusion in the capital budget. Based on the information developed in thisanalysis, the stream of costs and benefits associated with the project can bedefined.SelectionSelection follows, and often overlaps, analysis. It addresses the question-Is theproject worthwhile? A wide range of appraisal criteria have been suggested tojudge the worthwhileness of a project. They are divided into two broad categories,viz., non-discounting criteria and discounting criteria. The principal non-discountingcriteria are the payback period and the accounting rate of return. The keydiscounting criteria are the net present value, the internal rate of return, and thebenefit cost ratio. The selection rules associated with these criteria are asfollows:_________________________________________________________________Criterion Accept Reject
    • Payback period(PBP) PBP< target period PBP> Target period Accounting rate of return(ARR) ARR>target rate ARR<TargetrateNet present value(NPV) NPV>0 NPV<0Internal rate of return(IRR) IRR>cost of capital IRR< cost of capitalBenefit cost ratio(BCR) BCR>1 BCR<1_________________________________________________________________To apply the various appraisal criteria suitable cut-off values (hurdle rate targetrate, and cost of capital) have to be specified. These essentially a function ofthe mix of financing and the level of project risk. While the former can be definedwith relative ease, the latter truly tests the ability of the project evaluator. Indeeddespite a wide range of tools and techniques for risk analysis (sensitivityanalysis, scenario analysis, Monte Carlo simulation, decision tree analysisportfolio theory, capital asset pricing model, and so on), risk analysis remains themost intractable part of the project evaluation exercise.ImplementationThe implementation phase for an industrial project, which involves setting ofmanufacturing facilities, consists of several stages: (i) project and engineeringdesigns, (ii) negotiations and contracting, (iii) construction, (iv) training, and (v)plant commissioning. What is done in these stages is briefly described below_ ________________________________________________________________Stages Concerned withProject and engineering designs Site probing and prospecting, preparation of blueprint and plant designs , plant engineering, selection of specific machineries and equipment.Negotiations and contracting Negotiating and drawing up of legal contracts with respect to project financing, acquisition of technology, construction of building and civil works, provision of
    • utilities, supply of machinery and equipment, marketing arrangements, etc.Construction Site preparation, construction of buildings and civil works, erection and installation of machinery and equipment.Training Training of engineers, technicians, and workers. (This can proceed simultaneously along with the construction work)Plant commissioning Start up of the plant. (This is a brief but commissioning is technically crucial stage in the project development cycle.) Translating an investment proposal into a concrete project is a complex time-consuming, and risk-fraught task. Delays in implementation,which is common,can lead to substantial cost overruns. For expeditious implementation at areasonable cost, the following are helpful. 1. Adequate formulation of projects: A major reason for delay is inadequate formulation of projects. Put differently, if necessary homework in terms of preliminary studies and comprehensive and detailed formulation of the project is not done, many surprises and shocks are likely to Spring on the way. Hence, the need for adequate formulation of the project cannot be over- emphasised. 2. Use of the principle of responsibility accounting : Assigning specific responsibilities to project managers for completing the project within the defined time frame and cost limits is helpful in expeditious execution and cost control.3. Use of network techniques: For project planning and control two basic techniques are available - PERT (Programme Evaluation Review Technique) and CPM (Critical Path Method). These techniques have, of late, merged and are being referred to by a common terminology, that is network techniques. With the help of these techniques, monitoring becomes easier.ReviewOnce the project is commissioned the review phase has to be set in motion.Performance review should be done periodically to compare actual performancewith projected performance. A feedback device is useful in several ways: (i) It
    • throws light on how realistic were the assumptions underlying the project; (ii)It provides a documented log of experience that is highly valuable in futuredecision-making; (iii) It suggests corrective action to be taken in the light ofactual performance; (iv) It helps in uncovering judgemental biases; (v) It inducesa desired caution among project sponsors.LEVELS OF DECISION-MAKING Operating AdministrativeStrategic decisions decisions decisionWhere is the decision Lower level Middle level Top leveltaken management managementmanagementHow structured is the Routine Semi-structured UnstructureddecisionWhat is the level of Minor resource Moderate resource Majorresourceresource commitment commitment commitment commitmentWhat is the time horizon Short-term Medium term Long-termThe three levels (operating, administrative, and strategic) of decision making canbe readily applied to capital expenditure budgeting decision. Examples are givenbelow: Operating capital budgeting decision : Minor office equipment Administrative capital budgeting decision : Balancing equipment Strategic capital budgeting decision : Diversification project While the methods and techniques covered in this book are applicable to alllevels of capital budgeting decision. Our discussion will mainly be orientedtowards administrative and strategic budgeting decisions. Project Appraisal and Control techniques PROFITABILITY STUDY-VARIOUS FACTS OF PROJECT ANALYSISThe important facets of project analysis are: · Market analysis · Technical analysis
    • · Financial analysis · Economic analysis · Ecological analysisMarket AnalysisMarket analysis is concern with primarily two questions: · What would be the aggregate demand of the proposed product/service in future · What would be the market share of the project under appraisal? To answer the above question, the market analyst requires a widevarietyof information and appropriate forecasting methods. The kinds of informationrequired are: ● Consumption trends in the past and the present consumption ● Past and present supply position ● Production possibilities and constraints ● Import and exports ● Structure of competition ● Cost structure ● Elasticity of demand ● Consumer behaviour, innovations, motivations, attitudes, references and requirements ● Distribution channels and marketing policies in useful ● Administrative, technical and legal constraints Technical AnalysisAnalysis of the technical and engineering aspects of a project needs to be donecontinually when a project is formulated. Technical analysis seeks to determinewhether the prerequisites for the successful commissioning of the Project have
    • been considered and reasonably good choices have been made with respect tolocation, size, process, etc. The important questions raised in technicalanalysis are: · Whether the preliminary tests and studies have been done or provided for? · Whether the availability of raw materials, power, and other inputs has been established? · Whether the selected scale of operation is optimal? · Whether the production process chosen is suitable? · Whether the equipment and machines chosen are appropriate? · Whether the auxiliary equipments and supplementary engineering works have been provided for ? · Whether provision has been made for the treatment of effluents? · Whether the proposed layout of the site, buildings, and plant is sound? · Whether work schedules have been realistically drawn up? · Whether the technology proposed to be employed is appropriate from the social point of view?Financial AnalysisFinancial analysis seeks to ascertain whether the proposed project will befinancially viable in the sense of being able to meet the burden of servicing debtand whether the proposed project will satisfy the return expectations of thosewho provide the capital. The aspects which have to be looked into whileconducting financial appraisal are: · Investment outlay and cost of project · Means of financing · Cost of capital · Projected profitability · Break-even point · Cash flows of the project · Investment worthwhileness judged in terms of various criteria of merit · Projected financial position · Level of riskEconomic AnalysisEconomic analysis, also referred to as social cost benefit analysis, is concerned
    • with judging a project from the larger social point of view. In such anevaluation the focus is on the social costs and benefits of a project which mayoften be different from its monetary costs and benefits. The questions soughtto be answered in social cost benefits analysis are:● What are the direct economic benefits and costs of the project measured in terms of shadow (efficiency) prices and not in terms of market prices?● What would be the impact of the project on the distribution of income in the society?● What would be the impact of the project on the level of savings and investment in the society?● What would be the contribution of the project towards the fulfillment of certain merit wants like self-sufficiency, employment, and social order?Ecological AnalysisIn recent years, environmental concerns have assumed a great deal ofsignificance-and rightly so. Ecological analysis should be done particularlyfor major projects which have significant ecological implications like powerplants and irrigation schemes, and environmental-polluting industries (likebulk drugs, chemicals, and leather processing-). The key questions r~sedin ecological analysis are: . What is the likely damage caused by the project to the environment? . What is the cost of restoration measures required to ensure that the damage to the environment is contained within acceptable limits? Exhibit 11.2 summarises the key issues considered indifferent types ofanalysis:Exhibit 11.2 Key Issues in Project AnalysisMarket Analysis ________Potential Market Market ShareTechnical Analysis _________Technical Viability Sensible ChoicesFinancial Analysis ___________Risk ReturnEconomics Analysis ___________Benefits and Cost in shadow Prices Other ImpactEcological Analysis _________ Environmental Damage Restoration Measures
    • Feasibility Study: A Schematic Diagram We have looked at the five broad phases of capital budgeting andexamined the key facets of project analysis. The feasibility study isconcerned with the first three phases of capital budgeting, viz., planning,analysis, and selection (evaluation) and involves market, technical,financial, economic, and ecological analysis.Objectives of Capital BudgetingFinancial theory, in general, rests on the premise that the goal offinancial management (which subsumes investment decision-making)should be to maximise the present wealth of the firms equityshareholders. For a firm whose equity shares are actively traded on thestock market, the wealth of the equity shareholders is reflected in themarket value of the equity shares. Hence, the goal of financialmanagement for such firms should be to maximise the market value ofequity shares.The pursuit of the welfare of equity shareholders is justified on thegrounds that it contributes to an efficient allocation of capital in theeconomy. The bases for allocation of savings in the economy areexpected return and risk. Since equity share prices are based onexpected return and risk, efforts to maximise equity share prices wouldresult in an efficient allocation of resources. Another justification may beprovided for the goal of shareholder wealth maximisation. Equity shareholders provide the venture (risk) capital required to starta business firm and appoint the management of the firm indirectlythrough the board of directors. Hence, it behoves on corporatemanagements to promote the welfare of equity shareholders. What about a public sector firm the equity stock of which, being fullyowned, by the government, is not traded on the stock market? In such acase, the goal of financial management should be to maximise thepresent value of the stream of equity returns. Of course, in determiningthe present value of the stream of equity returns, an appropriatediscount rate has to be applied. A similar observation may be made withrespect to other companies whose equity shares are either not traded orvery poorly traded.AlternativesAre there other goals, besides the goal of maximum shareholder wealth
    • expressing the shareholders viewpoint? Several alternatives have bee,nsuggested: maximisation of profit, maximisation of earnings per share,maximisation of return on equity (defined as equity earnings/net worth). Maximisation of profit is not as inclusive a goal as maximisation ofshareholderswealth. It suffers from several limitations: · Profit in absolute terms is not a proper guide to decision-making. ItShould be expressed on a per share basis or related to investment. · It leaves considerations of timing and duration undefined. There is no guidefor comparing profit now with profit in future or for comparing profitstreams of different durations. · It glosses over the factor of risk. It cannot, for example, discriminate between an investment. project which generates a certain profit of Rs 50,000 and an investment project which has a variable profit outcome with an expected value of Rs 50,000. The goals of maximisation of earnings per share and maximisationof retum on equity do not suffer from the first limitation mentioned above.They, however suffer from the other limitations and hence are not suitable. In view of the shortcomings of the alternatives discussed above,maximisation of the wealth of equity shareholders (as reflected in themarket price of equity) appears to be the most appropriate goal forfinancial decision-making. Though the strict validity of this goal rests oncertain rigid assumptions about capital markets, it can be reasonablydefined as a guide for financial decision making under fairly plausibleassumptions.Other Concerns of the BusinessDo firms really act or should solely act to further shareholders welfare? This doesnot seem to be the issue here. Firms may pursue or ought to pursue several othergoals. Business firms seek to achieve a high rate of growth, enjoy a substantialmarket share, attain product and technological leadership, promote employeewelfare, further customer satisfaction, support education and research, improvecommunity life, and solve other societal problems. Some of these goals, may, ofcourse, be in consonance with the goal of shareholder wealth maximisation. Fora rapid growth rate, a dominant market position, and a higher customersatisfaction may lead to increasing returns for equity shareholders. Even effortstoward solving societal problems may further the interest of shareholders in the
    • long run by improving the image of the firm and strengthening its relationship withthe environment. When these other goals seem to conflict with the goal ofmaximising the wealth of equity shareholders, it is helpful to know the cost ofpursuing these goals. The trade-off has to be understood. It should beappreciated that the maximisation of the wealth of equity shareholders constitutesthe principal guarantee for efficient allocation of resources in the economy andhence is to be regarded as the normative goal from the financial point of view.Basic Considerations: Risk and ReturnSuppose a firm is evaluating an investment proposal. What aspects are relevantfrom the financial angle? From the financial point of view the relevantdimension are return and risk. Take another decision situation in which thefirm is considering a financing proposal. The aspects along which such aproposal is examined are cost and risk. Since cost is the inverse of return,here too the basic dimensions are return and risk. In general, we find thatthese are the two basic dimensions of financial analysis. What is the relationship between return, risk and market value of equity?Higher the return, ceteris paribus, higher the market value; higher the risk,ceteris paribus, lower the market value. Exhibit 11.4 shows the schematicdiagram of how decisions, return, risk, and market value are related.Exhibit 11.4 Decision, Return,Risk and market value Return Investment Market Value of Decision the Firm Financing Risk Decision It may be emphasized that typically, risk and return go hand in hand.This means that in a decision situation, an alternative which has ahigher return tends to have higher risk too. Likewise, an alternativewhich has a lower return tends to have a lower risk. In financial
    • analysis, the trade-off between risk and return needs to be carefullyanalysed.Let Us Sum Up ● Essentially a capital project represents a scheme for investing resources that can be analysed and appraised reasonably independently. ● The basic characteristic of a capital project is that it typically involves a current outlay (or current and future outlays) of funds in the expectation of a stream of benefits extending far into future. ● Capital expenditure decisions often represent the most important decisions taken by a firm. Their importance stems from three inter- related reasons: long-term effects, irreversibility, and substantial outlays. ● While capital expenditure decisions are extremely important, they pose difficulties which stem from three principal sources: measurement problems, uncertainty, and temporal spread. ● Capital budgeting is a complex process which may be divided into five broad phases: planning, analysis, selection, implementation, and review. ● One can look at capital budgeting decisions at three levels: operating, administrative, and strategic. ● The important facets of project analysis are: market analysis, technical analysis, financial analysis, economic analysis, and ecological analysis. ● Financial theory, in general, rests on the premise that the goal of financial management should be to maximise the present wealth of the firms equity shareholders. Business firms may pursue other goals. When these other goals conflict with the goal of maximising the wealth of equity shareholders, the trade-off has to be understood. KeywordsAccounting rate of return method: A selection criterion using average netincome and investment outlay to compute a rate of return for a project. Themethod ignores the time value of money and cash flows.Capital budget: The schedule of investment project selected to beundertaken over some interval of time.Internal rate of return method: A selection method using the compoundingrate of return on the cash flow of a project.Net present value: A selection method using the difference between thepresent value of the cash inflows of the project and the investment outlay.The method evaluates differential cash flow between proposals.
    • Payback method: A selection method in which a firm sets a maximumpay. back period during which cash inflow must be sufficient to recoverthe initial outlay. This method ignores the time value of money and cashflows beyond the pay back period.