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Advance Financial Management 
Capital Budgeting and Leverages 
Prepared by Bhooshan Kanani
Topics 
1. Net Present Value 
2. IRR ( Internal rate of return) 
3. Payback period 
4. Profitability Index 
5. Financial Leverage 
6. Operating leverage 
Capital Budgeting 
What is capital budgeting? 
Capital budgeting is a process used by companies for evaluating and ranking potential expenditures or investments that are significant in amount. The large expenditures could include the purchase of new equipment, rebuilding existing equipment, purchasing delivery vehicles, constructing additions to buildings, etc. The large amounts spent for these types of projects are known as capital expenditures. Capital budgeting usually involves the calculation of each project's future accounting profit by period, the cash flow by period, the present value of the cash flows after considering the time value of money, the number of years it takes for a project's cash flow to pay back the initial cash investment, an assessment of risk, and other factors. Capital budgeting is a tool for maximizing a company's future profits since most companies are able to manage only a limited number of large projects at any one time. 
Capital budgeting, which is also called investment appraisal, is the planning process used to determine whether an organization's long term investments, major capital, or expenditures are worth pursuing.
The methods used in capital budgeting, include the following techniques: 
Net present value 
Internal rate of return 
Payback period 
Profitability index 
Net Present Value 
Net present value (NPV) is used to estimate each potential project's value by using a discounted cash flow (DCF) valuation. This valuation requires estimating the size and timing of all the incremental cash flows from the project. The NPV is greatly affected by the discount rate, so selecting the proper rate–sometimes called the hurdle rate–is critical to making the right decision. 
This should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. A common practice in choosing a discount rate for a project is to apply a weighted average cost of capital that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole. 
Internal Rate of Return 
The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. 
The IRR method will result in the same decision as the NPV method for non-mutually exclusive projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR, which is often used, may select a project with a lower NPV. 
Payback Period 
Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. Payback period intuitively measures how long something takes to "pay for itself". All else being equal, shorter payback periods are preferable to longer payback periods. 
The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk, financing, or other important considerations, such as the opportunity cost.
Profitability Index 
Profitability index (PI) is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects, because it allows you to quantify the amount of value created per unit of investment. 
Example: 
Years 
Project A 
Project B 
(500) 
Discounting Rate 12% 
Present Value 
(500) 
Discounting Rate 12% 
Present Value 
0 
1/(1.R)0 
1/(1.R)0 
1 
200 
1/(1.R)1 
178.57 
100 
1/(1.R)1 
89.29 
2 
600 
1/(1.R)2 
478.32 
200 
1/(1.R)2 
159.44 
3 
100 
1/(1.R)3 
71.18 
300 
1/(1.R)3 
213.53 
4 
400 
1/(1.R)4 
254.21 
400 
1/(1.R)4 
254.21 
5 
300 
1/(1.R)5 
170.23 
600 
1/(1.R)5 
340.46 
1152.51 
1056.93 
Simple Payback period: 
Project A: 1 year + (300/600) year 
Project B: 2 year + (200/300) year 
Discount Payback period 
Project A: 1 year + (321.43/478.32) year 
Project B: 3 year + (37.74/ 254.21) year 
Net Present Value 
Project A: Current Value – Initial Investment = 1152.51 – 500 = 652.51 
Project B: Current Value – Initial Investment = 1056.93 – 500 = 556.93 
Profitability Index 
Project A: 1152.51 / 500 = 2.30 
Project B: 1056.93/ 500 = 2.11 
The above value shows we should invest in Project A
Capital Structure and Leverages 
What Is Capital Structure? 
When you are asking about what the capital structure is and what it relates to what you will find is that it is regarding the debt and equity within a business environment. It is the amount of debt and equity that mixes together to give the amount of return on investment while keeping the cost at minimum level. 
When looking at the financial management of a company you will find that to be effective a company should have effective leverage. . 
Types of Leverage: 
When working on capital structure you will find that there are many different types of leverage. 
1. Financial Leverage 
2. Operational Leverage 
Financial Leverage 
The first type that needs to mention is financial leverage. This is the ratio of the EBIT/EBT earning before the interest and the taxes compared to the earnings. The financial leverage is created when the company/business is relying solely on the funds they have borrowed for the financial operations of the company. 
Operating Leverage 
Any change in the amount of operating income can have impact on different financial aspects of a company. A large percentage change when talking about the firm’s net income can cause changes in the earnings per share while a small change can result in major changes in the reduction of net income. It is best to have a long term financing plan in place that will also involve the perfect solution of debt and equity. 
Operating Structure 
The operating structure of the business can often be changed accordingly if needed. This will include the fixed operating costs. Examples of these costs are any administrative overhead, contractual salaries of your employees, mortgage/lease payments or any other expense that you may be paying every month that does not change from month to month. As a business owner, you will see that you operating leverage come into play when there is a change in the net sales that results in a change in the operating income earnings.
Combined Leverage 
The combined leverage is defined as the combination of the effects of a business risk combined with the financial risk of the business. When speaking of leverage relationships there is a direct correlation between the degrees of operating leverage, financial leverage and combined leverage. There are many different calculations that can be created within these different operating margins. In a sense, operating leverage is a means to calculating a company's breakeven point. 
Example: 
Selling price per unit Rs.120, Variable cost per unit Rs.80, Fixed cost Rs.6,00,000 
Interest Rs.2 lakhs, Number of units sold 30,000 
Sales Value: Rs 120 * 30,000 = Rs 3,600,000 
Variable Cost: Rs 80 * 30000 = Rs 2,400,000 
Contribution: Sales Value – VC = Rs 1,200,000 
Fixed Cost: Rs 600,000 
EBIT: Contribution – FC = Rs 600,000 
Interest: Rs 200,000 
EBT: EBIT – Interest = Rs 400,000 
Operational Leverage = Contribution / EBIT 
= Rs 1,200,000 / Rs 600,000 
= 2 
More the Fixed Cost, higher is the operating leverage 
Financial Leverage = EBIT – EBT 
= 600,000 – 400,000 
= 1.5 
Minimum computation for operational leverage and financial leverage is 1, there is no business risk. Similarly, higher the operational leverage and higher the financial leverage, the risk is high. 
Reference Links: 
http://www.accountingcoach.com/blog/what-is-capital-budgeting 
http://www.capitalbudgetingtechniques.com/capital-structure/ 
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Advance Financial Management Techniques: Capital Budgeting, Leverage, NPV, IRR, Payback Period

  • 1. Advance Financial Management Capital Budgeting and Leverages Prepared by Bhooshan Kanani
  • 2. Topics 1. Net Present Value 2. IRR ( Internal rate of return) 3. Payback period 4. Profitability Index 5. Financial Leverage 6. Operating leverage Capital Budgeting What is capital budgeting? Capital budgeting is a process used by companies for evaluating and ranking potential expenditures or investments that are significant in amount. The large expenditures could include the purchase of new equipment, rebuilding existing equipment, purchasing delivery vehicles, constructing additions to buildings, etc. The large amounts spent for these types of projects are known as capital expenditures. Capital budgeting usually involves the calculation of each project's future accounting profit by period, the cash flow by period, the present value of the cash flows after considering the time value of money, the number of years it takes for a project's cash flow to pay back the initial cash investment, an assessment of risk, and other factors. Capital budgeting is a tool for maximizing a company's future profits since most companies are able to manage only a limited number of large projects at any one time. Capital budgeting, which is also called investment appraisal, is the planning process used to determine whether an organization's long term investments, major capital, or expenditures are worth pursuing.
  • 3. The methods used in capital budgeting, include the following techniques: Net present value Internal rate of return Payback period Profitability index Net Present Value Net present value (NPV) is used to estimate each potential project's value by using a discounted cash flow (DCF) valuation. This valuation requires estimating the size and timing of all the incremental cash flows from the project. The NPV is greatly affected by the discount rate, so selecting the proper rate–sometimes called the hurdle rate–is critical to making the right decision. This should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. A common practice in choosing a discount rate for a project is to apply a weighted average cost of capital that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole. Internal Rate of Return The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. The IRR method will result in the same decision as the NPV method for non-mutually exclusive projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR, which is often used, may select a project with a lower NPV. Payback Period Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. Payback period intuitively measures how long something takes to "pay for itself". All else being equal, shorter payback periods are preferable to longer payback periods. The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk, financing, or other important considerations, such as the opportunity cost.
  • 4. Profitability Index Profitability index (PI) is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects, because it allows you to quantify the amount of value created per unit of investment. Example: Years Project A Project B (500) Discounting Rate 12% Present Value (500) Discounting Rate 12% Present Value 0 1/(1.R)0 1/(1.R)0 1 200 1/(1.R)1 178.57 100 1/(1.R)1 89.29 2 600 1/(1.R)2 478.32 200 1/(1.R)2 159.44 3 100 1/(1.R)3 71.18 300 1/(1.R)3 213.53 4 400 1/(1.R)4 254.21 400 1/(1.R)4 254.21 5 300 1/(1.R)5 170.23 600 1/(1.R)5 340.46 1152.51 1056.93 Simple Payback period: Project A: 1 year + (300/600) year Project B: 2 year + (200/300) year Discount Payback period Project A: 1 year + (321.43/478.32) year Project B: 3 year + (37.74/ 254.21) year Net Present Value Project A: Current Value – Initial Investment = 1152.51 – 500 = 652.51 Project B: Current Value – Initial Investment = 1056.93 – 500 = 556.93 Profitability Index Project A: 1152.51 / 500 = 2.30 Project B: 1056.93/ 500 = 2.11 The above value shows we should invest in Project A
  • 5. Capital Structure and Leverages What Is Capital Structure? When you are asking about what the capital structure is and what it relates to what you will find is that it is regarding the debt and equity within a business environment. It is the amount of debt and equity that mixes together to give the amount of return on investment while keeping the cost at minimum level. When looking at the financial management of a company you will find that to be effective a company should have effective leverage. . Types of Leverage: When working on capital structure you will find that there are many different types of leverage. 1. Financial Leverage 2. Operational Leverage Financial Leverage The first type that needs to mention is financial leverage. This is the ratio of the EBIT/EBT earning before the interest and the taxes compared to the earnings. The financial leverage is created when the company/business is relying solely on the funds they have borrowed for the financial operations of the company. Operating Leverage Any change in the amount of operating income can have impact on different financial aspects of a company. A large percentage change when talking about the firm’s net income can cause changes in the earnings per share while a small change can result in major changes in the reduction of net income. It is best to have a long term financing plan in place that will also involve the perfect solution of debt and equity. Operating Structure The operating structure of the business can often be changed accordingly if needed. This will include the fixed operating costs. Examples of these costs are any administrative overhead, contractual salaries of your employees, mortgage/lease payments or any other expense that you may be paying every month that does not change from month to month. As a business owner, you will see that you operating leverage come into play when there is a change in the net sales that results in a change in the operating income earnings.
  • 6. Combined Leverage The combined leverage is defined as the combination of the effects of a business risk combined with the financial risk of the business. When speaking of leverage relationships there is a direct correlation between the degrees of operating leverage, financial leverage and combined leverage. There are many different calculations that can be created within these different operating margins. In a sense, operating leverage is a means to calculating a company's breakeven point. Example: Selling price per unit Rs.120, Variable cost per unit Rs.80, Fixed cost Rs.6,00,000 Interest Rs.2 lakhs, Number of units sold 30,000 Sales Value: Rs 120 * 30,000 = Rs 3,600,000 Variable Cost: Rs 80 * 30000 = Rs 2,400,000 Contribution: Sales Value – VC = Rs 1,200,000 Fixed Cost: Rs 600,000 EBIT: Contribution – FC = Rs 600,000 Interest: Rs 200,000 EBT: EBIT – Interest = Rs 400,000 Operational Leverage = Contribution / EBIT = Rs 1,200,000 / Rs 600,000 = 2 More the Fixed Cost, higher is the operating leverage Financial Leverage = EBIT – EBT = 600,000 – 400,000 = 1.5 Minimum computation for operational leverage and financial leverage is 1, there is no business risk. Similarly, higher the operational leverage and higher the financial leverage, the risk is high. Reference Links: http://www.accountingcoach.com/blog/what-is-capital-budgeting http://www.capitalbudgetingtechniques.com/capital-structure/ Duncan Williamson image