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1. CAPITAL
STRUCTURE
&
BUDGETING

2. Contoso
S u i t e s
CAPITAL
STRUCTURE.
2

3. Contoso
S u i t e s
• The term ‘structure’ means the arrangement of the
various parts. So capital structure means the
arrangement of capital from different sources so that
the long-term funds needed for the business are raised.
• Thus, capital structure refers to the proportions or
combinations of equity share capital, preference share
capital, debentures, long-term loans, retained earnings
and other long-term sources of funds in the total
amount of capital which a firm should raise to run its
business.
MEANING
3

4. Contoso
S u i t e s
IMPORTANCE
OF
CAPITAL
STRUCTRE
• Increase in value of the firm.
• Utilisation of available funds.
• Maximisation of return.
• Minimization of cost of capital.
• Solvency or liquidity position.
• Flexibility.
• Undisturbed controlling.
• Minimisation of financial risk.
• Minimisation of financial risk.
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5. Contoso
S u i t e s
FACTOR
DETERMINING
OF
CAPITAL
STRUCTRE
• Risk of cash insolvency.
• Risk in variation of earnings.
• Cost of capital.
• Control.
• Trading on equity.
• Government policies.
• Size of the company.
• Needs of the investors.
• Flexibility.
• Nature of business.
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6. Contoso
S u i t e s
CAPITAL
STRUCTURE
PLANNING
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7. Contoso
S u i t e s
CAPITAL
STRUCTRE
PLANNING
• Return: ability to generate maximum returns
to the shareholders, i.e. maximize EPS and
market price per share.
• Cost: minimizes the cost of capital (WACC).
Debt is cheaper than equity due to tax shield
on interest & no benefit on dividends.
• Risk: insolvency risk associated with high debt
component.
• Control: avoid dilution of management
control, hence debt preferred to new equity
shares.
• Flexible: altering capital structure without
much costs & delays, to raise funds whenever
required.
• Capacity: ability to generate profits to pay
interest and principal.
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8. Contoso
S u i t e s
CAPITAL
STRUCTRE
THEORIES
ASSUMPTIONS:
• Firms use only two sources of funds –
equity & debt.
• No change in investment decisions of the
firm, i.e. no change in total assets.
• 100 % dividend payout ratio, i.e. no
retained earnings.
• Business risk of firm is not affected by the
financing mix.
• No corporate or personal taxation.
• Investors expect future profitability of the
firm.
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9. Contoso
S u i t e s
CAPITAL
STRUCTRE
THEORIES
A) NET INCOME APPROACH (NI).
• Net Income approach proposes that there
is a definite relationship between capital
structure and value of the firm.
• The capital structure of a firm influences
its cost of capital (WACC), and thus
directly affects the value of the firm.
• NI approach assumptions –
• NI approach assumes that a continuous
increase in debt does not affect the risk
perception of investors.
• Cost of debt (Kd) is less than cost of equity
(Ke) [i.e. Kd < Ke ]
• Corporate income taxes do not exist.
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10. Contoso
S u i t e s
CAPITAL
STRUCTRE
THEORIES
b) NET OPERATING INCOME (NOI)
• Net Operating Income (NOI) approach is the exact
opposite of the Net Income (NI) approach.
• As per NOI approach, value of a firm is not
dependent upon its capital structure.
• Assumptions –
• WACC is always constant, and it depends on the business
risk.
• Value of the firm is calculated using the overall cost of
capital i.e. the WACC only.
• The cost of debt (Kd) is constant.
• Corporate income taxes do not exist.
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11. Contoso
S u i t e s
CAPITAL
STRUCTRE
THEORIES
b) NET OPERATING INCOME (NOI)
• NOI propositions (i.e. school of thought) –
• The use of higher debt component
(borrowing) in the capital structure
increases the risk of shareholders.
• Increase in shareholders’ risk causes
the equity capitalization rate to
increase, i.e. higher cost of equity (Ke)
• A higher cost of equity (Ke) nullifies
the advantages gained due to
cheaper cost of debt (Kd )
• In other words, the finance mix is
irrelevant and does not affect the
value of the firm.
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12. Contoso
S u i t e s
CAPITAL
BUDGETING.
12

13. Contoso
S u i t e s
• Capital budgeting is the process a business undertakes
to evaluate potential major projects or investments.
Construction of a new plant or a big investment in an
outside venture are examples of projects that would
require capital budgeting before they are approved or
rejected.
• As part of capital budgeting, a company might assess a
prospective project's lifetime cash inflows and outflows
to determine whether the potential returns that would
be generated meet a sufficient target benchmark. The
capital budgeting process is also known as investment
appraisal.
MEANING
13

14. Contoso
S u i t e s
PROCESS OF
CAPITAL
BUDGETING
• Idea Generation
• The most important step of the capital budgeting process is
generating good investment ideas. These investment ideas
can come from a number of sources like the senior
management, any department or functional area,
employees, or sources outside the company.
• Analysing Individual Proposals
• A manager must gather information to forecast cash flows
for each project in order to determine its expected
profitability. This is because the decision to accept or reject
a capital investment is based on such an investment’s future
expected cash flows.
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15. Contoso
S u i t e s
PROCESS OF
CAPITAL
BUDGETING
• Planning Capital Budget
• An entity must give priority to profitable projects as per the
timing of the project’s cash flows, available company
resources, and a company’s overall strategies. The projects
that look promising individually may be undesirable
strategically. Thus, prioritizing and scheduling projects is
important because of the financial and other resource
issues.
• Monitoring and Conducting a Post Audit
• It is important for a manager to follow up or track all the
capital budgeting decisions. He should compare actual with
projected results and give reasons as to why projections did
not match with actual performance. Therefore, a systematic
post-audit is essential in order to find out systematic errors
in the forecasting process and hence enhance company
operations.
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16. Contoso
S u i t e s
• Capital budgeting techniques are the methods to
evaluate an investment proposal in order to help the
company decide upon the desirability of such a
proposal. These techniques are categorized into two
heads : traditional methods and discounted cash flow
methods
TECHNIQUE
S OF
CAPITAL
BUDGETING
16

17. Contoso
S u i t e s
TECHNIQUES
OF CAPITAL
BUDGETING
• Traditional Methods
• Traditional methods determine the desirability of an investment project
based on its useful life and expected returns. Furthermore, these
methods do not take into account the concept of time value of money.
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18. Contoso
S u i t e s
TECHNIQUES
OF CAPITAL
BUDGETING
• Pay Back Period Method
• Payback period refers to the number of years it takes to
recover the initial cost of an investment. Therefore, it is a
measure of liquidity for a firm. Thus, if an entity has
liquidity issues, in such a case, shorter a project’s payback
period, better it is for the firm.
• Therefore,
• Payback period = Full years until recovery + (unrecovered
cost at the beginning of the last year)/
• Cash flow during the last year
• Here, full years until recovery is nothing but the payback
that occurs when cumulative net cash flow equals to
zero. Cumulative net cash flow is the running total of cash
flows at the end of each time period.
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19. Contoso
S u i t e s
TECHNIQUES
OF CAPITAL
BUDGETING
• Average Rate of Return Method (ARR)
• Under ARR method, the profitability of an investment proposal can be determined
by dividing average income after taxes by average investment, which is average
book value after depreciation.
• Thus, ARR = Average Net Income After Taxes/Average Investment x 100
• Where, Average Income After Taxes = Total Income After Taxes/Total Number of
Years
• Average Investment = Total Investment/2
• Based on this method, a company can select those projects that have ARR higher
than the minimum rate established by the company. And, it can reject the projects
having ARR less than the expected rate of return.
• Discounted Cash Flow Methods
• As mentioned above, traditional methods do not take into the account time value
of money. Rather, these methods take into consideration present and future flow
of incomes. However, the DCF method accounts for the concept that a rupee
earned today is worth more than a rupee earned tomorrow. This means that DCF
methods take into account both profitability and time value of money.
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20. Contoso
S u i t e s
TECHNIQUES
OF CAPITAL
BUDGETING
• Net Present Value Method (NPV)
• NPV is the sum of the present values of all the expected incremental
cash flows of a project discounted at a required rate of return less than
the present value of the cost of the investment.
• In other words, NPV is the difference between the present value of cash
inflows of a project and the initial cost of the project. As per this
technique, the projects whose NPV is positive or above zero shall be
selected.
• If a project’s NPV is less than zero or negative, the same must be
rejected. Further, if there is more than one project with positive NPV,
then the project with the highest NPV shall be selected.
• NPV = CF1/(1 + k)1 + ……….. CFn/ (1 + k)n + CF0
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21. Contoso
S u i t e s
TECHNIQUES
OF CAPITAL
BUDGETING
• Profitability Index
• Profitability Index is the present value of a project’s future cash flows
divided by initial cash outlay. Thus, it si closely related to NPV. NPV is
the difference between the present value of future cash flows and the
initial cash outlay.
• Whereas, PI is the ratio of the present value of future cash flows and
initial cash outlay.
• PI = PV of future cash flows/CF0 = 1 + NPV/CF0
• Thus, if the NPV of a project is positive, PI will be greater than 1. If NPV
is negative, PI will be less than 1. Therefore, based on this, if PI is
greater than 1, accept the project otherwise reject.
• Reference Material
• Thus, the manager has to evaluate the project in terms of costs and
benefits as all the investment possibilities may not be rewarding. This
evaluation is done based on the incremental cash flows from a project,
opportunity costs of undertaking the project, timing of cash flows and
financing costs.
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22. Contoso
S u i t e s
ESTIMATION
OF PROJECT
CASH FLOWS
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23. Contoso
S u i t e s
• The projection of income and expense during the life of
a project can be developed from several time-scheduling
aids used by the contractor.
MEANING
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24. Contoso
S u i t e s
24
ESTIMATION OF PROJECT CASH FLOWS
• CASH OUTFLOW
• Payment of wages & salaries payment of suppliers
buying equipment interest on bank loan or overdraft
payment of dividends payment of loans payment of
leasing or hire purchase rentals income tax , vat &
corporation tax.
• CASH INFLOW
• Cash sales receipts from trade sale of spare assets
investment of share capital personal funds invested
receipt of bank loan government grants receipts from
factoring.

25. Contoso
S u i t e s
ESTIMATION OF
PROJECT CASH
FLOWS
BASIC PRINCIPLES OF CASH FLOW ESTIMATION:
• The following principles should be followed while
estimating the cash flows of a project:
• Incremental principle.
• Separation principle.
• Post-tax principle.
• Consistency principle.
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26. Contoso
S u i t e s
ESTIMATION OF
PROJECT CASH
FLOWS
INCREMENTAL PRINCIPLE.
• The cash flow of a project must be measured
in incremental terms.
• To ascertain a project’s incremental cash flow
one has to look at what happens to the cash
flows of the firm with the project and without
the project.
• The difference between the two reflects the
incremental cash flows attributable to the
project.
• PROJECT CASH FLOW OF THE YEAR =
Cash flow for the firm with the project for the
year - Cash flow for the firm without the project
for the year
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27. Contoso
S u i t e s
ESTIMATION OF
PROJECT CASH
FLOWS
INCREMENTAL PRINCIPLE.
• In estimating the incremental cash flows
of a project, the following guidelines must
be borne in mind:
• Consider all incidental effects.
• Ignore sunk costs.
• Include opportunity costs.
• Question the allocation of overhead
costs.
• Estimate working capital properly
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28. Contoso
S u i t e s
ESTIMATION OF
PROJECT CASH
FLOWS
Separation principle.
• There are two sides of a project:
• The investment (or asset) side
• The financing side
• The cash flows associated with these sides
should be separated.
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29. Contoso
S u i t e s
ESTIMATION OF
PROJECT CASH
FLOWS
Consistency principle.
• Once you adopt an accounting principle or
method, you should continue to follow it
consistently in future accounting periods.
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30. Thank You
RUTVIK RABADIYA
IU2084000029
ASSIGNMENT 4
UNIT 3