MCM606_Financial Management-converted-converted

REFERENCES • Chandra, P. (2012). Financial Management. New Delhi: Tata McGraw Hill. • James, C. (2014). Financial Management. New Delhi: Prentice-Hall. • Khan, M.Y. & Jain, P.K. (2012). Financial Management. New Delhi: Tata McGraw Hill. • Pandey, I.M (2009). Financial Management. New Delhi: Vikas Publishing House. • Maheshwari S.N. (2014). Principles of Financial Management. New Delhi: Sultan Chand & Sons. • Kulkarni P.V. (2014). Financial Management. Mumbai: Himalaya Publishing House. • Khan and Jain, Financial Management, Tata McGraw-Hill, 2009 • Pandey I M, Financial Management, Vikas Publishers, 2007. 49 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT -5 TIME VALUE OF MONEY L C Structure I T 5.0 S earning Objectives Introduction K L 5.1 U oncept of Time Value of money R 5.2 llustrations in Time Value of money 5.3 echniques of time value of money 5.4 ummary 5.5 eywords 5.6 earning Activity 5.7 nit End Questions 5.8 eferences LEARNING OBJECTIVES After studying this unit you will be able to • Describe the basic concepts of time value of money • Describe various techniques of time value of money INTRODUCTION The time value of money is a basic financial concept that holds that money in the present is worth more than the same sum of money to be received in the future. This is true because money that you have right now can be invested and earn a return, thus creating a larger amount of money in the future. (Also, with future money, there is the additional risk that the money may never actually be received, for one reason or another.) This is true because money that you have right now can be invested and earn a return, thus creating a larger amount of money in the future. (Also, with future money, there is the additional risk that the money may never actually be received, for one reason or another.) The time value of money is sometimes referred to as the net present value (NPV) of money. Time value of money is 50 CU IDOL SELF LEARNING MATERIAL (SLM)

the concept that the value of a dollar to be received in future is less than the value of a dollar on hand today. One reason is that money received today can be invested thus generating more money. Another reason is that when a person opts to receive a sum of money in future rather than today, he is effectively lending the money and there are risks involved in lending such as default risk and inflation. Default risk arises when the borrower does not pay the money back to the lender. Inflation is the decrease in purchasing power of money due to a general increase level of overall price level. CONCEPT OF TIME VALUE OF MONEY The time value of money concept states that cash received today is more valuable than cash received at a later date. The reason is that someone who agrees to receive payment at a later date foregoes the ability to invest that cash right now. In addition, inflation gradually reduces the purchasing power of money over time, making it more valuable now. The only way for someone to agree to a delayed payment is to pay them for the privilege, which is known as interest income. s the idea that money that is available at the present time is worth more than the same amount in the future, due to its potential earning capacity. This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received. One of the most fundamental concepts in finance is that money has a time value attached to it. In simpler terms, it would be safe to say that a dollar was worth more yesterday than today and a dollar today is worth more than a dollar tomorrow. The value of money which changes with respect to change in time is called the time value of money. For example, if an individual is offered an alternative either to accept Rs.100 at present or one year later he would prefer Rs. 100 at present. The basic reason of his choice of receiving the amount of Rs.100 at present is the time value of money which means the value of money is changed with the change in time. Figure 5.1 E The importance of time value of money is explained below: • xistence of interest: If the present and future value of a certain amount of money would be equal, and the system of paying interest did not exist, then the rate of interest can never be zero, and this is due to the existence of the time value of 51 CU IDOL SELF LEARNING MATERIAL (SLM)

money. D T • ecision making: If the investment is made into a project at present, return is obtained from that project in future and in order to take the decision whether the project should be accepted or not, the future returns of the project have to be compared with the present investment and the money value of the future returns can never be equal to the money value of the present investment due to the existence of the time value of money. •I nvention of compounding and discounting techniques :This concept have been invented fir the existence of the time value of money and the future value of present money and the present value of future money can be known with the help of compounding and discounting techniques respectively. • ime preference for money: People prefers present money to future money because if an individual is offered an alternative either to accept Rs.100 at present or one year later, he would prefer Rs.100 at present. Present value (PV) - This is your current starting amount. It is the money you have in your hand at the present time, your initial investment for your future. Future value (FV) - This is your ending amount at a point in time in the future. It should be worth more than the present value, provided it is earning interest and growing over time. The number of periods (N) - This is the timeline for your investment (or debts). It is usually measured in years, but it could be any sale of time such as quarterly, monthly, or even daily. Interest rate (I) - This is the growth rate of your money over the lifetime of the investment. It is stated in a percentage value, such as 8% or .08. Payment amount (PMT) - These are a series of equal, evenly-spaced cash flows. Future Value vs. Present Value A comparison of present value with future value (FV) best illustrates the principle of the time value of money and the need for charging or paying additional risk-based interest rates. Simply put, the money today is worth more than the same money tomorrow because of the passage of time. Future value can relate to the future cash inflows from investing today's money, or the future payment required to repay money borrowed today. Future value (FV) is the value of a current asset at a specified date in the future based on an assumed rate of growth. The FV equation assumes a constant rate of growth and a single upfront payment left untouched for the duration of the investment. The FV calculation allows 52 CU IDOL SELF LEARNING MATERIAL (SLM)

investors to predict, with varying degrees of accuracy, the amount of profit that can be generated by different investments. Present value (PV) is the current value of a future sum of money or stream of cash flows given a specified rate of return. Present value takes the future value and applies a discount rate or the interest rate that could be earned if invested. Future value tells you what an investment is worth in the future while the present value tells you how much you'd need in today's dollars to earn a specific amount in the future. ILLUSTRATIONS IN TIME VALUE OF MONEY Future Value of a Single cash Flow: Formula for future value of a single cash flow: FVn= future value for n years PV=cash flow R=rate of interest N= Time gap after which FV is to be ascertained Example1: Mr. Amit makes a deposit of Rs. 10000, in a bank which pays 8% interest compounded annually for 8 years. You are required to find out the amount to be received by him after years. Solution: FV= Present Value (PV) × (1 + i)n So PVn = Rs.10000, r=8% and n=8years 53 FVn= 10000(1+ .08)8 FVn=Rs. 10000(1.8509) FVn= Rs.18,509. Future value of a series of cash flows: Future Value of an Annuity Formula P = PMT [((1 + r)n - 1) / r] where: CU IDOL SELF LEARNING MATERIAL (SLM)

P=Future value of an annuity stream PMT=Dollar amount of each annuity payment r=Interest rate (also known as discount rate) n=Number of periods in which payments will be made Present Value of a future sum Example 2: Find out the present value of Rs.3000 received after 8years hence, if the discount rate is10% r=10% n=8years PV=3000/(1+.1)8 PV=3000(.46651) = Rs.1, 3999.53 The time value of money -- the idea that money received in the present is more valuable than the same sum in the future because of its potential to be invested and earn interest -- is one of the founding principles of Western finance. Let's say you lent your friend $2000. Would you rather he repaid you today, or tomorrow? The logical choice would be today, because you'll be able to use your money, and potential gains that come with it, sooner. What if you bought a bike and the dealer gives an option to pay Rs 3, 00,000, its total cost, 54 CU IDOL SELF LEARNING MATERIAL (SLM)

now, or 3 installments of Rs 1,00,000 for the next three years at the end of each year. It’d be wrong if you add the installments and provide a comparison with the current amount that you’ll have to pay. Why? Let’s find out by learning about the two main calculations that we encounter in the situations of time value. 1. Present Value (PV) The present value is known as the current value of a sum of money that we will receive in the future. We have mentioned that the purchasing power of money reduces over time. The formula of PV accounts for this reduction by applying a discounting rate to the sum that we will receive in the future. Due to the use of the discounting rate, the process of calculating the present value of a sum of money is also known as discounting a sum of money. The PV of a sum of money can be used to determine the current value of a projected cash flow from a bond, an annuity, a loan, or any such instance where you are supposed to receive money from a third party in the future and you want to know exactly how much that money will be worth today. It is given by the following formula – PV = FV / (1 + i)^n Here, we require three things to calculate the present value – What is the value of the sum we will receive in the future? (FV); What is the rate of discounting at which the purchasing power of the money will fall? (i); and After how many years will we receive the concerned sum of money? (n). 2. Future Value (FV) As the name goes, the FV denotes the value of a sum of money at some date in the future. This calculation is useful for investors and businesses who want to know the future value of their potential investments to make a good investment decision. The formula for FV is given by – FV = PV (1+i) n This formula requires only three things to give us a future value – What amount of money do we have right now? (PV); 55 CU IDOL SELF LEARNING MATERIAL (SLM)

What is the assumed interest rate at which it will grow? (i); and C D After how many years will we need the money? (n) What Is the Time Value of Money and Why Does It Matter? What is the Time Value of Money, and why is it important? Everything you need to know. Formula for Calculating the Time Value of Money So how do you measure the time value of money? The formula takes the present value, and then multiplies it by compound interest for each of the payment periods and factors in the time period over which the payments are made. Formula: FV = PV x [ 1 + (i / n) ] ^(n x t) (PV) Present Value = what your money is worth right now. (FV) Future Value = what your money will be worth at some future time after it (hopefully) earns interest. (I) Interest = Paying someone for the time their money is held. (N) Number of Periods = Investment (or loan) period. (T) Number of Years = Amount of time money is held For instance, if you start with a present value of $2,000 and invest it at 10% for one year, then the future value is: FV = $2,000 x (1 + (10% / 1) ^ (1 x 1) = $2,200 TECHNIQUES OF TIME VALUE OF MONEY The techniques which are used for this as follows:- 1. alculation of the present value: - in this the worth of the future sum is given and the specified rate of return is been shown. It has lots of variations in this is that the future cash flow are discounted at the discount rate and it also represents the low present value of future cash flow. 2. iscounted cash flow: - in finance it is the analysis of a method which talks about the value of the project, company and the asset which is being used using the time value of money. In this all estimation has been taken and discounted for the present value as it shows both incoming and outgoing. This kind is used for investment of the finance and used for financial management. 56 CU IDOL SELF LEARNING MATERIAL (SLM)

3. C OMPOUNDING TECHNIQUE is the method of calculating the future values of cash flows and involves calculating compound interest. Under this process, interest is compounded when the amount earned on an initial deposit (the initial principal) becomes part of the principal at the end of the first compounding period. Principal refers to the amount of money on which interest is received that is, in compounding, future values of cash flows at a given interest rate at the end of the specified period of time are found. The future value (F) of a lump sum today (P) for n periods at i rate of interest is given by the formula Fn = P(1+i) n= P(CVFn,i). And the compound value factor can be found out by referring to the table of compound values. For example: if Rs 1000 is invested @ 10% compound interest for 3 years, the return for first year will be Amount at the end of the 1st year = (1000) + (1000 x 0.10) = Rs, 1,100 Amount at the end of the 2nd year = (1000) + (1100 x 0.10) = Rs, 1,210 Amount at the end of the 3rd year = (1000) + (1210 x 0.10) = Rs, 1,331 The compound interest phenomenon is most generally associated with several savings deposited with them. As the interest rate increases for some given year, the compound interest factor also increases. Therefore, the higher the interest rate, the greater is the future sum. You are borrowing Rs. 80,000 for 25 years at 10% nominal annual interest. How much must your annually payments be if you will completely retire the loan over the 25-year period by factor formula? Solution: Answer: Rs. 8,813.48 SUMMARY • T ime value of money (TVM) is the idea that money that is available at the present 57 CU IDOL SELF LEARNING MATERIAL (SLM)

time is worth more than the same amount in the future, due to its potential earning ‘ capacity. This core principle of finance holds that provided money can earn interest, T any amount of money is worth more the sooner it is received. The time value of N money matters because, as the basis of Western finance, you will use it in your daily consumer, business and banking decision making. All of these systems are driven by P the idea that lenders and investors earn interest paid by borrowers in an effort to F maximize the time value of their money. The different techniques of time value of T money include the compounding techniques and discounted value technique and present value technique. • A bird in hand is worth two in the bush’ – this adage applies to financial transactions too. Say, someone borrowed a certain amount from you and it is due. Just as you are expecting the money to be credited to your account, you get a call from the borrower saying that he will pay you after 3 months. You are not happy about this. This is because you are aware of time value of money or TVM, albeit subconsciously. • he relevance of TVM depends on how much returns you can generate from the capital available. Money has immense growth potential and the more you delay employing this potential, the more you lose the chance to earn on it. For instance, if a friend or lender gives you two options – to take Rs. 10,000 today or to take Rs, 10,500 next year. • ow, even if this promise is from someone or an entity you trust implicitly, chances are more that the second option is a raw deal. With more and more schemes ranging from low-risk to high-risk – tax-saving FDs, ELSS et. – there is a high chance that you can make at least 7% on this sum, which is Rs. 10,700. But if the interest rate offered is less than 5%, then you may consider taking the money next year. So, it depends on the possible returns as per the RBI guidelines or the market. • resent Value is the same as Time Value as elaborated above. It is the money you have currently that is equal to a future one-time disbursal or several part-payments – discounted by a suitable rate of interest. • uture Value is the sum of money that any saving scheme with a compounded interest will build to by a pre-decided future date. It applies to both lumpsum as well as recurring investments like SIP. KEY WORDS /ABBREVIATIONS • 58 CU IDOL SELF LEARNING MATERIAL (SLM)

ime Value of money: Time Value of Money states that money today is worth more P than will tomorrow. F P • resent Value: The value of single amount (one time cash flow) at present time evaluated at a given interest rate assuming that discounting take place one time in a year (annually) • uture Value: The future value of a single amount (one-time cash flow) at some future time evaluated at a given interest rate assuming that compounding takes place one time in a year (annually). Two methods for calculation: • resent Value of Annuity: is a series of constant cash Flows (CCF) over limited period of time say monthly rent, installment payments, lease rental. LEARNING ACTIVITY 1. If you wish to accumulate $140,000 in 13 years, how much must you deposit today in an account that pays an annual interest rate of 14%? 2. How many years will it take for $136,000 to grow to be $468,000 if it is invested in an account with an annual interest rate of 8%? UNIT END QUESTIONS (DESCRIPTIVE AND MCQ) A. Descriptive Questions: 1. D escribe the concept of Time Value of Money with respect to investment of Rs. 10,000 D in equity. A 2. efine the concepts of future value , present value, annuity, with respect to time value of money 3. nalyze the limitations of time value of money to earn profit with investment of Rs. 50,000 59 CU IDOL SELF LEARNING MATERIAL (SLM)

4. S tate the advantages of time value of money which can help an individual make profit E with investment of Rs. 1,00,000 in debenture. 6.I Y 5. xplain the process of calculating the present value of Sum received after n years. f you wish to accumulate $140,000 in 13 years, how much must you deposit today in an account that pays an annual interest rate of 14%? 7. ou are offered an annuity that will pay $17,000 per year for 7 years (the first payment will be made today). If you feel that the appropriate discount rate is 11%, what is the annuity worth to you today? B. Multiple Choice Questions: G T 1. Time preference of money prevails because M a. A oods will become dearer after a certain time period b. he worth of money in hand is more than the same amount received after a particular time period c. oney promotes the purchase of necessary items d. ll of these 2. Compounding Technique is s a. ame as discounting technique s b. lightly different from discounting technique e c. xactly opposite of discounting technique N d. 60 CU IDOL SELF LEARNING MATERIAL (SLM)

one of these 3. Interest paid (earned) on only the original principal borrowed (lent) is often referred to as? C F a. P ompound interest S b. h uture l o c. N resent P d. F imple interest T N 4. The value of money received in the future is _ the value of the same amount of money in hand today a. igher b. ower c. f the same d. one of these 5. The real rate of interest reflects compensation for 61 a. resent Value b. uture Value c. ime Value d. one of these CU IDOL SELF LEARNING MATERIAL (SLM)

Answers: b 1. 2. c) 3. d) 4. a) 5. c) ), REFERENCES • Chandra, P. (2012). Financial Management. New Delhi: Tata McGraw Hill. • James, C. (2014). Financial Management. New Delhi: Prentice-Hall. • Khan, M.Y. & Jain, P.K. (2012). Financial Management. New Delhi: Tata McGraw Hill. • Pandey, I.M (2009). Financial Management. New Delhi: Vikas Publishing House. • Maheshwari S.N. (2014). Principles of Financial Management. New Delhi: Sultan Chand & Sons. • Kulkarni P.V. (2014). Financial Management. Mumbai: Himalaya Publishing House. • Prasanna Chandra, Financial Management, McGraw Hill, 2008. • Khan and Jain, Financial Management, Tata McGraw-Hill, 2009 62 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-6 CAPITAL INVESTMENT DECISIONS L C Structure 6.0 U earning Objectives R 6.1 Introduction 6.2 Nature and Importance of Capital Budgeting 6.2.1 Need and Importance of Capital budgeting decisions 6.3 apital Budgeting-Meaning 6.4 Process of Capital Budgeting 6.5 Summary 6.6 Keywords 6.7 Learning Activity 6.8 nit End Questions 6.9 eferences LEARNING OBJECTIVES After studying this unit, you will be able to • Assess the basic concept of capital budgeting • Describe the importance of capital budgeting • Explain the process of capital budgeting INTRODUCTION Capital budgeting involves choosing projects that add value to a company. The capital budgeting process can involve almost anything including acquiring land or purchasing fixed assets like a new truck or machinery. Involves choosing projects that add value to a company. The capital budgeting process can involve almost anything including acquiring land or purchasing fixed assets like a new truck or machinery. Corporations are typically required, or at least recommended, to undertake those projects that will increase profitability and thus 63 CU IDOL SELF LEARNING MATERIAL (SLM)

enhance shareholders' wealth. However, the rate of return deemed acceptable or unacceptable is influenced by other factors specific to the company as well as the project. For example, a social or charitable project is often not approved based on the rate of return, but more on the desire of a business to foster goodwill and contribute back to its community. Capital budgeting is the process by which investors determine the value of a potential investment project. The three most common approaches to project selection are payback period (PB), internal rate of return (IRR), and net present value (NPV).The payback period determines how long it would take a company to see enough in cash flows to recover the original investment. The internal rate of return is the expected return on a project—if the rate is higher than the cost of capital, it's a good project. The net present value shows how profitable a project will be versus alternatives and is perhaps the most effective of the three methods. Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project without understanding the risks and returns involved would be held as irresponsible by its owners or shareholders. Furthermore, if a business has no way of measuring the effectiveness of its investment decisions, chances are the business would have little chance of surviving in the competitive marketplace. involves choosing projects that add value to a company. The capital budgeting process can involve almost anything including acquiring land or purchasing fixed assets like a new truck or machinery. Corporations are typically required, or at least recommended, to undertake those projects that will increase profitability and thus enhance shareholders' wealth. However, the rate of return deemed acceptable or unacceptable is influenced by other factors specific to the company as well as the project. For example, a social or charitable project is often not approved based on the rate of return, but more on the desire of a business to foster goodwill and contribute back to its community. Capital budgeting is the process by which investors determine the value of a potential investment project. The three most common approaches to project selection are payback period (PB), internal rate of return (IRR), and net present value (NPV).The payback period determines how long it would take a company to see enough in cash flows to recover the original investment. The internal rate of return is the expected return on a project—if the rate is higher than the cost of capital, it's a good project. The net present value shows how profitable a project will be versus alternatives and is perhaps the most effective of the three methods. Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project without understanding the risks and returns involved would be held as irresponsible by its owners or shareholders. Furthermore, if a business has no way of measuring the effectiveness of its investment 64 CU IDOL SELF LEARNING MATERIAL (SLM)

decisions, chances are the business would have little chance of surviving in the competitive marketplace. Capital budgeting is made up of two words ‘capital’ and ‘budgeting.’ In this context, capital expenditure is the spending of funds for large expenditures like purchasing fixed assets and equipment, repairs to fixed assets or equipment, research and development, expansion and the like. Budgeting is setting targets for projects to ensure maximum profitability. NATURE AND IMPORTANCE OF CAPITAL BUDGETING Capital budgeting is the process of making investment decisions in capital expenditures. W Capital Expenditure may define as an expenditure for the benefits of which are expected to be received over a period exceeding one year. According to Charles T. Horngren: “Capital Budgeting is long-term planning for making and financing proposed capital outlays. According to L.J. Gitman: “Capital Budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives.” Capital Budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives.” Nature of Capital Budgeting 1. It is a long-term investment decision. 2. It is irreversible in nature. 3. It requires a large amount of funds. 4. It is most critical and complicated decision for a finance manager. 5. It involves an element of risk as the investment is to be recovered in future. The main characteristic of capital expenditure is that the expenditure incurs at one point in time whereas the benefits of the expenditure are realized at different points in time in the future. In simple language, we may say that capital expenditure Gutman incurs for acquiring or improving the fixed assets, the benefits of which expect to receive over several years in the future. Capital budgeting means planning for capital assets. Capital budgeting decisions are vital to any organization as they include the decisions as to: • hether or not funds should invest in long-term projects such as setting an industry, purchase of plant and machinery, etc. 65 CU IDOL SELF LEARNING MATERIAL (SLM)

• A nalyze the proposal for expansion or creating additional capacities. T T • o decide the replacement of permanent assets such as building and types of T equipment. E • o make the financial analysis of various proposals regarding capital investments to choose the best out of many alternative proposals. The importance of capital budgeting can well understand from the fact that an unsound investment decision may prove to be fatal to the very existence of the concern. The success and failure of business mainly depends on how the available resources are being utilized. Main tool of financial management. All types of capital budgeting decisions are exposed to risk and uncertainty. They are irreversible in nature.  Capital rationing gives sufficient scope for the financial manager to evaluate different proposals and only viable project must be taken up for investment. Capital Budgeting offers effective control on cost of capital  expenditure projects. It helps the management to avoid over investment and under  investments. 6.2.1 Need and Importance of Capital budgeting decisions Capital budgeting decisions are of paramount importance in financial decision. The profitability of a business concern depends upon the level of investment made for long period. Moreover, the investments are made properly through evaluating the proposals by capital budgeting. So it needs special care. In this context, the capital budgeting is getting importance. Such importance are briefly explained below MEANING OF CAPITAL BUDGETING Capital budgeting is the process of making investment decisions in long term assets. It is the process of deciding whether or not to invest in a particular project as all the investment possibilities may not be rewarding. Thus, the manager has to choose a project that gives a rate of return more than the cost financing such a project. That is why he has to value a project in terms of cost and benefit. Capital budgeting involves • he decision to buy new machinery • xpansion of business in other geographical areas 66 CU IDOL SELF LEARNING MATERIAL (SLM)

• R eplacement of an obsolete equipment N • ew product or market development etc Thus, capital budgeting is the most important responsibility undertaken by a financial manager. This is because: It involves the purchase of long term assets and such decisions may determine the future success of the firm. These decisions help in maximizing shareholder’s value. Principles applicable to capital budgeting process also apply to other corporate decisions like working capital management. PROCESS OF CAPITAL BUDGETING Figure 6.1 Identification of Potential Investment Opportunities: The first step in the capital budgeting process is to explore the investment opportunities. There is generally a committee that identifies the expected sales from a certain course of action, and then the investment opportunities are identified keeping these targets as a basis. Before initiating the search for 67 CU IDOL SELF LEARNING MATERIAL (SLM)

the potential investments, there are certain points that need to be taken care of: monitor the external environment on a regular basis to know about the new investment opportunities, define the corporate strategy based on the analysis of the firm’s strengths, weaknesses, opportunities and threats, share the corporate strategy and objectives with the members of capital budgeting process and seek suggestions from the employees. Assembling of Investment Proposals: Once the investment opportunities are identified, several proposals are submitted by different departments. Before reaching the capital budgeting process committee, the proposals are routed through several persons who ensures that the proposals are in line with the requirements and then classify these according to their categories Viz, Replacement, Expansion, New product and Obligatory & welfare investments. This categorization is done to simplify the task of committee members and facilitate quick decision making, budgeting, and control. Decision Making: At this stage, the executives decide on the investment opportunity on the basis of the monetary power, each has with respect to the sanction of an investment proposal. For example, in a company, a plant superintendent, work manager, and the managing director may okay the investment outlays up to the limit of 15, 00,000, and if the outlay exceeds beyond the limits of the lower level management, then the approval of the board of directors is required. Analyzing 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. 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. Preparation of Capital Budget and Appropriations: The next step in the capital budgeting process is to classify the investment outlays into the smaller value and the higher value. The smaller value investments okayed by, the lower level management, are covered by the blanket appropriations for the speedy actions. And if the value of an investment outlay is 68 CU IDOL SELF LEARNING MATERIAL (SLM)

higher than it is included in the capital budget after the necessary approvals. The purpose of these appropriations is to evaluate the performance of the investments at the time of the implementation. Implementation: Finally, the investment proposal is put into a concrete project. This may be time-consuming and may encounter several problems at the time of implementation. For expeditious processing, the capital budgeting process committee must ensure that the project has been formulated and the homework in terms of preliminary studies and comprehensive formulation of the project is done beforehand. Selecting a project: After the evaluation of cash flow the decision is to accept or reject a project, or selecting a project from amongst the alternatives which is taken as the basis of decision criteria and it is done by the owner /entrepreneur on the basis of evaluation done by the financial analysis and making the final decision. Performance Review: Once the project has been implemented the next step is to compare the actual performance against the projected performance. The ideal time to compare the performance of the project is when its operations are stabilized. Through a review, the committee comes to know about the following: how realistic were the assumptions, was the decision making efficient, what were the judgmental biases and were the desires of the project sponsors fulfilled. Thus, the Capital Budgeting, due to its complex behavior comprises a series of steps that should be strictly followed before finalizing the investments. SUMMARY • C apital budgeting is the process of evaluating a company’s potential investments and C deciding which ones to accept. A company’s market value added (MVA) is the sum of all its projects’ net present values (NPVs). Basically, one can calculate the free cash flows (FCFs) for a project in much the same way as for a firm. Capital Budgeting is the process of making capital investment decisions and these are important as they have long term impact on the firm, which involves heavy losses for the firm .Capital budgeting involves estimation of the future cash flows associated with the investment and appraising the stream of costs and benefits to determine the feasibility of the project. The capital budgeting projects may be classified as new projects, organization projects, exploration projects, R& D projects requiring certain statutory compliances. Capital budgeting process involves generation of investment ideas b) estimation of cash flows c) evaluating cash flows d) selection a project e) execution and monitoring. • 69 CU IDOL SELF LEARNING MATERIAL (SLM)

apital budgeting is the process of making investment decisions in long term assets. It C is the process of deciding whether or not to invest in a particular project as all the C investment possibilities may not be rewarding. H • F apital budgeting involves choosing projects that add value to a company. The capital T budgeting process can involve almost anything including acquiring land or purchasing fixed assets like a new truck or machinery. C • C orporations are typically required, or at least recommended, to undertake those M projects that will increase profitability and thus enhance shareholders' wealth. • C owever, the rate of return deemed acceptable or unacceptable is influenced by other factors specific to the company as well as the project. • or example, a social or charitable project is often not approved based on the rate of return, but more on the desire of a business to foster goodwill and contribute back to its community. • hus, the manager has to choose a project that gives a rate of return more than the cost financing such a project. That is why he has to value a project in terms of cost and benefit. KEY WORDS/ABBREVIATIONS • apital Budgeting: Capital budgeting is the process a business undertakes to evaluate potential major projects or investment • apital investment: Capital investment is the procurement of money, obtained by a company in order to further its business goals and objectives. • utually exclusive projects: In capital budgeting, mutually-exclusive projects refer to a set of projects out of which only one project can be selected for investment. •I ndependent Projects: A project that is not part of or dependent on any other project. Thus, the funding of an independent project does not depend on another ... • apital asset management: Capital Asset Management is required to reduce money 70 CU IDOL SELF LEARNING MATERIAL (SLM)

risk, increase benefits and provide palatable levels of service to clients in a C supportable way E C • apital investment: Capital investment is the procurement of money, obtained by a H company in order to further its business goals and objectives. • valuation: Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or equipment. The process involves analyzing a project's cash inflows and outflows to determine whether the expected return meets a set benchmark. • apital expenditure: Capital expenditure or capital expense is the money an organization or corporate entity spends to buy, maintain, or improve its fixed assets, such as buildings, vehicles, equipment, or land LEARNING ACTIVITY 1. ow do you analyze the capital budgeting for a company taking new project? 2.I f you are the manager of an organization, how would you implement the technique of capital budgeting. UNIT END QUESTIONS (MCQ AND DESCRIPTIVE) A. Descriptive Types Questions 1. What is capital budgeting to select best option to invest in a project? 2. What is the biggest shortcoming of payback period when making an investment in retail industry? 3. Why is the NPV method considered a better capital budgeting method than the payback and ROI methods in an mutually exclusive projects? 4. Explain what is meant by capital expenditure in construction of a building. 71 CU IDOL SELF LEARNING MATERIAL (SLM)

5. Discuss briefly the objectives of capital budgeting in expanding business in a new product o line. u o B. Multiple Choice Questions o 1. Capital budgeting is the process: c n a. d f determining how much capital stock to issue. R b. E sed in sell or process further decisions. d A c. f determining special orders. d. f making capital expenditure decisions 2. The process of planning expenditures that will influence the operation of a firm over a number of years is called a.i nvestment b. apital value c. et present value d. ividend valuation 3. Which of the following is an example of a capital investment project? a. eplacement of worn out equipment b. xpansion of production facilities c. evelopment of employee training programmes d. ll of the above 4. The method of raising funds for capital investment that involves the greatest risk to the firm is: 72 CU IDOL SELF LEARNING MATERIAL (SLM)

a. b orrowing by selling bonds r b. r elying on retained profits c c.i p ssuing common stock c b d. aising dividend rate 5. The review of projects after they have been implemented a. apital budgeting. b. ost audit c. ontext correlation d. lame spreading Answer 1. d) 2. a) 3. a) 4. c) 5. b) REFERENCES • Chandra, P. (2012). Financial Management. New Delhi: Tata McGraw Hill. • James, C. (2014). Financial Management. New Delhi: Prentice-Hall. • Khan, M.Y. & Jain, P.K. (2012). Financial Management. New Delhi: Tata McGraw Hill. • Pandey, I.M (2009). Financial Management. New Delhi: Vikas Publishing House. • Maheshwari S.N. (2014). Principles of Financial Management. New Delhi: Sultan Chand & Sons. • Kulkarni P.V. (2014). Financial Management. Mumbai: Himalaya Publishing House. • Jeff Madura, International Financial Management, South-Western College Pub., 2010 • Prasanna Chandra, Financial Management, McGraw Hill, 2008. 73 CU IDOL SELF LEARNING MATERIAL (SLM)

74 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-7 TECHNIQUES OF CAPITAL BUDGETING Structure earning Objectives L I M ntroduction T S ethods and Techniques for Capital Budgeting K L raditional and Modern Techniques S R ummary eywords earning Activity elf-Assessment Questions eferences LEARNING OBJECTIVES After studying this unit, you will be able to: • Interpret the techniques of capital budgeting • Outline Payback period method • Describe Net present value method INTRODUCTION Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the best returns on investment. An organization is often faced with the challenges of selecting between two projects/investments or the buy versus replace decision. Ideally, an organization would like to invest in all profitable projects but due to the limitation on the availability of capital an organization has to choose between different projects/investments. Capital Budgeting Techniques are adopted to assist the organization in selecting the best investment there are various techniques available based on the comparison of cash inflows and outflows. These 75 CU IDOL SELF LEARNING MATERIAL (SLM)

techniques are: Payback period method, Net Present value, Accounting rate of return, internal rate of return, profitability index. Each technique comes with inherent advantages and disadvantages. An organization needs to use the best-suited technique to assist it in budgeting. It can also select different techniques and compare the results to derive at the best profitable projects. There are different methods adopted for capital budgeting. The traditional methods or non- discount methods include: Payback period and Accounting rate of return method. The discounted cash flow method includes the NPV method, profitability index method and IRR. Capital budgeting is made up of two words ‘capital’ and ‘budgeting.’ In this context, capital expenditure is the spending of funds for large expenditures like purchasing fixed assets and equipment, repairs to fixed assets or equipment, research and development, expansion and the like. Budgeting is setting targets for projects to ensure maximum profitability. METHODS OF CAPITAL BUDGETING 1. 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, a full year 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. The payback period is a unique capital budgeting method. Specifically, the payback period is a financial analytical tool that defines the length of time necessary to earn back money that has been invested. A subcategory, price-to-earnings growth payback period, is used to define the time required for a company’s earnings to find equivalence with the stock price paid by investors. The price-to-earnings growth payback period is also widely used to get a basic understanding of how risky an investment opportunity may be. Understanding the payback period of an investment limits the risks associated with taking on costly projects. Payback periods are an integral component of capital budgeting and should always be incorporated when analyzing the value of projected investments and projects. The payback period can prove especially useful for companies that focus on smaller investments, mainly 76 CU IDOL SELF LEARNING MATERIAL (SLM)

because smaller investments usually don’t involve overly complex calculations. Payments made at a later date still have an opportunity cost attached to the time that is spent, but the payback period disregards this in favor of simplicity. As with each method mentioned so far, the payback period does have its limitations, such as not accounting for the time value of money, risk factors, financing concerns or the opportunity cost of an investment. Therefore, using the payback period in combination with other capital budgeting methods is far more reliable. Salient features of Payback period method Payback period is a simple calculation of time for the initial investment to return. It ignores the time value of money. All other techniques of capital budgeting consider the concept of time value of money. Time value of money means that a rupee today is more valuable than a rupee tomorrow. So other techniques discount the future inflows and arrive at discounted flows. It is used in combination with other techniques of capital budgeting. Owing to its simplicity the payback period cannot be the only technique used for deciding the project to be selected. Illustration 1 Let us understand the payback period method with a few illustrations. Apple Limited has two project options. The initial investment in both the projects is Rs. 10, 00,000. Project A has even inflow of Rs. 1, 00,000 every year. Project B has uneven cash flows as follows: Year 1 – Rs. 2, 00,000 Year 2 – Rs. 3, 00,000 Year 3 – Rs. 4, 00,000 Year 4 – Rs. 1, 00,000 Now let us apply the payback period method to both the projects. The formula for computing payback period with even cashflows is: Payback period = Total outflows Initial investment or Inflow every year Net annual cash inflows 77 CU IDOL SELF LEARNING MATERIAL (SLM)

Project A If we use the formula, Initial investment / Net annual cash inflows then: 10, 00,000/ 1,00,000 = 10 years Project B Total inflows = 10,00,000 (2,00,000+ 3,00,000+ 4,00,000+ 1,00,000) Total outflows = 10,00,000 Project B takes four years to get back the initial investment. Now, let us modify the cash flows of project B and see how to get the payback period: Say, cash inflows are – Year 1 – Rs. 2, 00,000 Year 2 – Rs. 3, 00,000 Year 3 – Rs. 7, 00,000 Year 4 – Rs. 1, 50,000 The payback period can be calculated as follows: Year Total flow ( in Lakhs) Cumulative flow 0 (10) (10) 12 (8) 23 (5) 37 2 4 1.5 3.5 Now to find out the payback period: Step 1: We must pick the year in which the outflows have become positive. In other words, the year with the last negative outflow has to be selected. So, in this case, it will be year two. Step 2: Divide the total cumulative flow in the year in which the cash flows became positive by the total flow of the consecutive year. 78 CU IDOL SELF LEARNING MATERIAL (SLM)

So that is: 5/7 = 0.71 Step 3: Step 1 + Step 2 = The payback period is 2.71 years. Therefore, between Project A and B, solely on the payback method, Project B (in both the examples) will be selected. The example stated above is a very simple presentation. In an actual scenario, an investment might not generate returns for the first few years. Gradually over time, it might generate returns. That too will play a major role in determining the payback period. Note: In case an organization is replacing existing machinery, the inflows will be considered on an incremental basis. What are the shortcomings of this method? This method does not take into account the time value of money and treats all flows at par. For example, Rs.1,00,000 invested yearly to make an investment of Rs.10,00,000 over a period of 10 years may seem profitable today but the same 1,00,000 will not hold the same value ten years later. Also, the method does not take into account the cash flows post the return of investment. Some projects may generate higher cash flows in the later life of the project. Despite its drawbacks, payback method is the simplest method to analyze different project/investments. It is based on the principle of liquidity. The project that provides a faster return of investment is chosen. More liquidity means more availability of funds to invest in more projects. It is used by the management to get a quick analysis of the project. Payback method is used by individuals also to analyze investment decisions. It is based on a very simple need to get back at least how much has been spent. In fact, even as individuals when we invest in shares, mutual funds our first question are always about the time period within which we will get back our invested money. So, it is simple and very easy to understand. 2. Discounted cash flow method: The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset. These are then discounted through a discounting factor. The discounted cash inflows and outflows are then compared. This technique takes into account the interest factor and the return after the payback period. 3.I nternal Rate of Return The internal rate of return calculation is used to determine whether a particular investment is worthwhile by assessing the interest that should be yielded over the course of a capital investment. It is determined by using a particular formula that must be calculated through trial-and-error or by using specific software. As the internal rate of return helps aid investors 79 CU IDOL SELF LEARNING MATERIAL (SLM)

in measuring the profitability of their potential investments, the ideal internal rate of return for a project should be greater than the cost of capital required for the project, as it can be assumed that the project will be a profitable one. Professionals who hope to maximize the potential of their capital investments need to leverage the internal rate of return when necessary, especially in instances where they are planning on analyzing an investment in venture capital, private equity or other operations that require a consistent cash investment that ends with a large payout, like a sale. When using this calculation, finance professionals should recognize that the measurement for the internal rate of return is similar to the net present value metric (another capital budgeting method); however, the internal rate of return is formulated to make the net present value of all cash flows in a project equal to zero. It is for this reason that companies shouldn’t rely solely on the internal rate of return calculation to project profitability of a project and should use it in conjunction with at least one other budgeting metric, like net present value. Illustration 2 The management of VGA Textile Company is considering to replace an old machine with a new one. The new machine will be capable of performing some tasks much faster than the old one. The installation of machine will cost $8,475 and will reduce the annual labor cost by $1,500. The useful life of the machine will be 10 years with no salvage value. The minimum required rate of return is 15%. Required: Should VGA Textile Company purchase the machine? Use internal rate of return (IRR) method for your conclusion. Solution: To conclude whether the proposal should be accepted or not, the internal rate of return promised by machine would be found out first and then compared to the company’s minimum required rate of return. The first step in finding out the internal rate of return is to compute a discount factor called internal rate of return factor. It is computed by dividing the investment required for the project by net annual cash inflow to be generated by the project. The formula is given below: Formula of internal rate of return factor: In our example, the required investment is $8,475 and the net annual cost saving is $1,500. The cost saving is equivalent to revenue and would, therefore, be treated as net cash inflow. Using this information, the internal rate of return factor can be computed as follows: 80 CU IDOL SELF LEARNING MATERIAL (SLM)

Internal rate of return factor = $8,475 /$1,500 = 5.650 After computing the internal rate of return factor, the next step is to locate this discount factor in “present value of an annuity of $1 in arrears table“. Since the useful life of the machine is 10 years, the factor would be found in 10-period line or row. After finding this factor, see the rate of return written at the top of the column in which factor 5.650 is written. It is 12%. It means the internal rate of return promised by the project is 12%. The final step is to compare it with the minimum required rate of return of the VGA Textile Company. That is 15%. According to internal rate of return method, the proposal is not acceptable because the internal rate of return promised by the proposal (12%) is less than the minimum required rate of return (15%). Notice that the internal rate of return promised by the proposal is a discount rate that equates the present value of cash inflows with the present value of cash out flows as proved by the following computation: *Value from “present value of an annuity of $1 in arrears table“. 4. 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. 81 CU IDOL SELF LEARNING MATERIAL (SLM)

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. Under this method average profit after tax and depreciation is calculated and then it is divided by the total capital outlay or total investment in the project. In other words, it establishes the relationship between average annual profits to total investments. Illustration 3 A project requires an investment of Rs 5, 00,000 and has a scrap value of Rs 20,000 after five years. It is expected to yield profits after depreciation and taxes during the five years amounting to Rs 40,000, Rs 60,000, Rs 70,000, Rs 50,000 and Rs 20,000. Calculate the average rate of return on the investment. (b) Return per unit of Investment Method: This method is small variation of the average rate of return method. In this method the total profit after tax and depreciation is dividend by the total invest 82 CU IDOL SELF LEARNING MATERIAL (SLM)

The traditional method relies on the non-discounting criteria that do not consider the time value of money, whereas the modern method includes the discounting criteria where the time value of money is taken into the consideration (c) Return on Average Investment Method: In this method the return on average investment is calculated. Using of average investment for the purpose of return on investment is preferred because the original investment is recovered over the life of the asset on account of depreciation charges. For example: A machine costs Rs 1, 00,000 and has no scrap value after five years. It is depreciated on straight line method. The common thing about both these methods (Traditional and Modern) is that these are based on the cash inflows and the outflows of the project. Illustration 4: 83 Taking the same information above, the return on average investment: CU IDOL SELF LEARNING MATERIAL (SLM)

Illustration 5: Taking the same figures given, the average return on average investments 84 CU IDOL SELF LEARNING MATERIAL (SLM)

The average return on average investment is higher in case of project A and is also higher than the required rate of return of 12% and hence Project A is suggested to be undertaken. Illustration 6: X Ltd. is considering the purchase of a machine. Two machines are available E and F. The cost of each machine is Rs 60,000. Each machine has an expected life of 5 years. Net Profits before tax and after depreciation during the expected life of the machines are given below: Advantages of Rate of Return Method: 85 CU IDOL SELF LEARNING MATERIAL (SLM)

(1) It is very simple to understand and easy to operate. (2) It uses the entire earnings of a project in calculating rate of return and not only the earnings up to pay-back period and hence gives a better view of profitability as compared to pay-back period method. (3) As this method is based upon accounting concept of profits, it can be readily calculated from the financial data. Disadvantages of Rate of Return Method: (1) This method also like pay-back period method ignores the time value of money as the profits earned at different points of time are given equal weight by averaging the profits. It ignores the fact that a rupee earned today is of more value than a rupee earned a year after, or so. (2) It does not take into consideration the cash flows which are more important than the accounting profits. (3) It ignores the period in which the profits are earned as a 20% rate of return in 2V2 years may be considered to be better than 18% rate of return for 12 years. This is not proper because longer the term of the project, greater is the risk involved. (4) This method cannot be applied to a situation where investment in a project is to be made in parts. Figure 7.1 Capital Budgeting Methods 4. N et Present Value Net present value (NPV) is used for the same purpose as the internal rate of return, analyzing the projected returns for a potential investment or project. The net present value represents the difference between the current value of money flowing into the project and the current value of money being spent. The value can be calculated as positive or negative, with a positive net present value implying that the earnings generated by a project or investment will 86 CU IDOL SELF LEARNING MATERIAL (SLM)

exceed the expected costs of the venture and should be pursued. Also, unlike other capital P budgeting methods, like the profitability index and payback period metrics, NPV accounts for the time value of money, so opportunity costs and inflation are not ignored in the calculation. To achieve this, the net present value formula identifies a discount rate based on the costs of financing an investment or calculates the rates of return expected for similar investment options. Unlike some capital budgeting methods, NPV also factors in the risk of making long-term investments. Therefore, the formula for net present value is longstanding and effective, but professionals in the industry must still recognize the potential room for error that arises when relying on calculations like investment costs, rates of discount, and projected returns, all of which rely heavily on assumptions and estimates. As accounting for unexpected expenses can be difficult when budgeting for capital investments, it is important to consider using payback period metrics and the internal rate of return as possible alternatives to net present value calculations when evaluating a project or investment. 5. rofitability Index The profitability index is a capital budgeting tool designed to identify the relationship between the cost of a proposed investment and the benefits that could be produced if the venture was successful. The profitability index employs a ratio that consists of the present value of future cash flows over the initial investment. As this ratio increases beyond 1.0, the proposed investment becomes more desirable to companies. When this ratio does not exceed 1.0, the investment should be deferred, as the project’s present value is less than the initial investment. The caveat to using the profitability index for capital budgeting is that the technique does not account for the size of a project; therefore, sizable projects with significantly large cash flow figures often claim lower profitability indexes because of their slimmer profit margins. The upside of using the profitability index is that the index does account for the time value of investments in the calculation. It also identifies the exact rate of return for a project or investment, which makes understanding the cost-benefit ratio of projects easier. 7. Accounting Rate of Return The accounting rate of return is the projected return that an organization can expect from a proposed capital investment. To discover the accounting rate of return, finance professionals must divide the average profit by the initial investment. The accounting rate of return is a useful metric for quickly calculating the profitability of a company, and it is widely used for analyzing the success rates of investments that feature multiple projects. However, the accounting rate of return metric also has some minor drawbacks when used as the sole method for capital budgeting. The first drawback is that it does not account for the 87 CU IDOL SELF LEARNING MATERIAL (SLM)

time value of the money involved—meaning that future returns may be worth significantly less than the returns currently being taken in. A second issue with relying solely on the accounting rate of return in capital budgeting is the lack of acknowledgement of cash flows. In contrast to these drawbacks, the accounting rate of return is quite useful for providing a clear picture of a project’s potential profitability, satisfying a firm’s desire to have a clear idea of the expected return on investment. This method also acknowledges earnings after tax and depreciation, making it effective for benchmarking a firm’s current level of performance. TRADITIONAL AND MODERN TECHNIQUES 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. Definition: The Capital Budgeting Techniques are employed to evaluate the viability of long-term investments. The capital budgeting decisions are one of the critical financial decisions that relate to the selection of investment proposal or the course of action that will yield benefits in the future over the lifetime of the project. Since the capital budgeting is related to the long-term investments whose returns will be fetched in the future, certain traditional and modern capital budgeting techniques are employed by the firm to judge the feasibility of these projects. Traditional methods The traditional methods comprise of the following evaluation techniques: P A • ayback Period Method N • M verage Rate of Return or Accounting Rate of Return Method P Modern Methods The modern methods comprise of the following evaluation techniques: • et Present Value Method •I nternal Rate of Return • odified Internal Rate of Return • 88 CU IDOL SELF LEARNING MATERIAL (SLM)

rofitability Index The traditional method relies on the non-discounting criteria that do not consider the time value of money, whereas the modern method includes the discounting criteria where the time value of money is taken into the consideration. Capital Budgeting Techniques Figure 7.2 Capital Budgeting Techniques P Traditional methods A The traditional methods comprise of the following evaluation techniques: N • 89 ayback Period Method • verage Rate of Return or Accounting Rate of Return Method Modern Methods The modern methods comprise of the following evaluation techniques: • et Present Value Method •I CU IDOL SELF LEARNING MATERIAL (SLM)

nternal Rate of Return M • P odified Internal Rate of Return “ • C M rofitability Index T Traditional and modern method of capital budgeting Explanation: The traditional or non-discounting methods include the Payback period and the Accounting rate of return method. The payback method is also called a payout period method and represents a period in which the total payment is made. Under this method, various investments ranked according to the length of the period. The average rate of return takes into accounts the earrings taken form he investments over the life terms and in this various projects are ranked according to their rate of earnings of return. The modern method is the NPV IRR and Profitability index. These are time adjusted or discounted cash flow methods. The NPV is a modern method of evaluating modern proposals were the cash flows are considered with the TMV. The internal rate return is an interest rate that equates to the present values of the future and takes into account the total cash in and outflow. NPV is calculated in terms of currency and IRR is expressed in terms of percentage. SUMMARY • Capital Budgeting is a long-term planning for making and financing proposed capital outlays.” • apital 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. • ajor methods for capital budgeting include Net present value, Internal rate of return, Payback period, Profitability index, Equivalent annuity and Real options analysis. • he IRR method will result in the same decision as the NPV method for non- 90 CU IDOL SELF LEARNING MATERIAL (SLM)

mutually exclusive projects in an unconstrained environment; Never the less, for M mutually exclusive projects, the decision rule of taking the project with the highest IRR may select a project with a lower NPV. C • odified Internal Rate of Return: The modified internal rate of return (MIRR) is a M financial measure of an investment’s attractiveness. It is used in capital budgeting N to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and, as such, aims to resolve some P problems with the IRR. P • E apital Budgeting R N Capital budgeting, which is also called “investment appraisal,” is the planning process used to determine which of an organization’s long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is to budget for major capital investments or expenditures. • ajor Methods Many formal methods are used in capital budgeting, including the techniques as followed: • et present value •I nternal rate of return • ayback period • rofitability index • quivalent annuity • eal options analysis • et 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 91 CU IDOL SELF LEARNING MATERIAL (SLM)

discount rate, so selecting the proper rate–sometimes called the hurdle rate–is critical to P making the right decision. P This should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. Managers may use models, such as the CAPM or the APT, to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC 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. •I nternal 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. One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. Accordingly, a measure called “Modified Internal Rate of Return (MIRR)” is often used. • ayback 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. • rofitability Index Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), 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 92 CU IDOL SELF LEARNING MATERIAL (SLM)

investment. E • T quivalent Annuity T The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it T by the present value of the annuity factor. It is often used when comparing investment P projects of unequal lifespans. For example, if project A has an expected lifetime of seven N years, and project B has an expected lifetime of 11 years, it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated. • he discounted cash flow methods essentially value projects as if they were risky bonds, with the promised cash flows known. But managers will have many choices of how to increase future cash inflows or to decrease future cash outflows. In other words, managers get to manage the projects, not simply accept or reject them. Real options analysis tries to value the choices–the option value–that the managers will have in the future and adds these values to the NPV. • hese methods use the incremental cash flows from each potential investment or project. Techniques based on accounting earnings and accounting rules are sometimes used. Simplified and hybrid methods are used as well, such as payback period and discounted payback period. • he main goals of capital budgeting are not only to control resources and provide visibility, but also to rank projects and raise funds. KEYWORDS/ ABBREVIATIONS • ayback Period Method: The payback period refers to the amount of time it takes to recover the cost of an investment. • et Present Value Method: Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project. •I nternal Rate of return Method: The internal rate of return is a metric used in financial analysis to estimate the profitability of potential investments. The 93 CU IDOL SELF LEARNING MATERIAL (SLM)

internal rate of return is a discount rate that makes the net present value (NPV) of A all cash flows equal to zero in a discounted cash flow analysis. A P • ccounting Rate of Return: Accounting rate of return (ARR) is a formula that reflects the percentage rate of return expected on an investment, or asset, compared to the initial investment's cost. • cceptance / Rejection criterion: Those projects will be accepted whose ARR, is higher than the minimum established rate/standard rate and those projects will be rejected whose ARR is less than the said minimum established rate/standard rate. • rofitability index: The profitability index rule is a decision-making exercise that helps evaluate whether to proceed with a project. LEARNING ACTIVITY 1. Analyze any two methods to be used by any company for capital budgeting decision. 2. For a particular company using certain imaginary values with years starting from 1 to 5, analyze the real pay-back period, stating how it can be useful for a company in the process of capital budgeting. UNIT END QUESTIONS (MCQ AND DESCRIPTIVE) A. Descriptive Types Questions: 1. The cost of a project is $50,000 and it generates cash inflows of $20,000, $15,000, $25,000 and $10,000 in four years. Using present value index method, appraise profitability of the proposed investment assuming a 10% rate of discount. 2. A company is considered the purchase of a machine. the machines A and B are available for $80,000 each. Earnings after taxation are as: Year Machine A Machine B $ $ 94 CU IDOL SELF LEARNING MATERIAL (SLM)

1 24,000 8,000 2 32,000 24,000 3 40,000 32,000 4 24,000 48,000 5 16,000 32,000 Evaluate the two alternatives according to (a). Payback Method, (b). Rate of Return Method and (c). Net Present Value Method (A discount rate of 10% is to be used). 3. Ginger Manufacturers wants to invest in a new machine costing $60,000. The company expects a regular annual net cash flow of $10,000 per year for 8 years after which, they expect to sell the machine for $20,000. Calculate; a. Payback period b. Return on investment 4. Kimco LLC is tossing the idea of investing in a given project, Kimco wants to invest in a P project worthy $250,000 and wants its money back within five years and nothing more than 5 P years. What is the expected annual cash flow that Kimco will get in order to accept the S project? N 5. Explain briefly how to make a decision of a given investment based on its positive or negative NPV? B. Multiple Choice Questions 1. The span of time within which the investment made for the project will be recovered by the net returns of the project is known as a. eriod of return b. ayback period c. pan of return d. one of the above 95 CU IDOL SELF LEARNING MATERIAL (SLM)

2. Projects with are preferred a. L ower payback period N H b. A ormal payback period T c. B igher payback period N d. N ny of the above T 3. Under Net present value criterion, a project is approved if a.I ts net present value is positive b. he funds are unlimited c. oth (A) and (B) d. one of the above 4. The internal Rate of Return (IRR) criterion for project acceptance, under theoretically infinite funds is: accept all projects which have a.I RR equal to the cost of capital b.I RR greater than the cost of capital c.I RR less than the cost of capital d. one of the above 5. The project is accepted of 96 a.i f the profitability index is equal to one b. he funds are unlimited CU IDOL SELF LEARNING MATERIAL (SLM)

c.I B f the profitability index is greater than one d. oth (B) and (C) Answer 1. b) 2. a) 3.c) 4.b) 5.d) REFERENCES • Chandra, P. (2012). Financial Management. New Delhi: Tata McGraw Hill. • James, C. (2014). Financial Management. New Delhi: Prentice-Hall. • Khan, M.Y. & Jain, P.K. (2012). Financial Management. New Delhi: Tata McGraw Hill. • Pandey, I.M (2009). Financial Management. New Delhi: Vikas Publishing House. • Maheshwari S.N. (2014). Principles of Financial Management. New Delhi: Sultan Chand & Sons. • Kulkarni P.V. (2014). Financial Management. Mumbai: Himalaya Publishing House. • Pandey I M, Financial Management, Vikas Publishers, 2007. • Van Horne: Fundamentals of Financial Management, Prentice Hall, 20 97 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-8 WORKING CAPITAL MANAGEMENT AND L FINANCE M Structure C P earning Objectives F I F ntroduction S K eaning of Working Capital lassification of Working Capital Permanent working capital: rinciples of Working Capital actors Determining Working Capital inancing of Working Capital. Types of Long-Term Financing Funding the growth of a business ummary eywords Learning Activity Unit End Questions References LEARNING OBJECTIVES After studying this unit, you will be able to: • Explain the basic concepts of Working Capital Management and Finance • Assess the principles of working capital • Describe how to finance working capital • State classification of working capital 98 CU IDOL SELF LEARNING MATERIAL (SLM)