will help in calculating the monthly amount need to be saved in order to gather a specific amount at the time of retirement, keeping in consideration the effect of time on the value of money. Time value of money is utilized in calculating EMIs of long duration loans as well. A single amount is disbursed today and the recovery is made in equated monthly instalments. Thus, in case of creation of sinking fund and in case of capital recovery, the concept of time value of money is utilized. This concept is also useful in calculating the implicit rate of return of a project. This is the rate which a project is going to earn for itself. This rate of return is than compared with the required rate of return, in order to analyse the project further. In business and economics, the concept of time value of money has much more utility as there are n number of projects available for investment and the firm has difficulty in deciding upon the ones on which it can put its stakes. Here, various capital budgeting techniques are used by the organizations in order to finalize promising projects. Yet another utility of the concept of time value of money is in the valuation of firm or business. This is useful at the time of sale and purchase of the firm or business. In such cases, the present value of future stream of profits to be generated from the business needs to be calculated and to be compared with the price being asked for the firm or business. Similar analysis needs to be done in the case of mergers and acquisitions. When two organizations merge or when one organization acquires another, the number of shares, the proportion in profits etc. are decided on the basis of generating profit in future. These expected flow of profits in future and the present terms and conditions are then analysed to arrive at various decisions regarding share in new business etc. the concept of time value of money is useful in cases of mortgages. It helps in the calculation of monthly mortgage payment. Time value of money concept is useful in all situations where cash flows at different point of time need to be brought at one point of time for decision making. Time value of money is an important concept in financial management. This concept says that the money has different value at different points of time. Traditionally, the money was assumed to have the same value at all points of time meaning that a Rs 100 note was assumed to be always having purchasing power of Rs 100. With knowledge development, it is understood that the purchasing power of currency is affected and in most of the economies, it is reduced basically due to the effect of inflation along with other reasons as well. The change in purchasing power of the currency with the passage of time is known as the time value of money. Time value of money concept is useful for individuals as well as for corporate. An individual utilizes the concept of time value of money for analysing investment opportunities, to calculate sinking funds and to study capital 51 CU IDOL SELF LEARNING MATERIAL (SLM)
recovery options. Corporate entities utilize the concept of time value of money to analyse various projects available for capital investment. Capital budgeting techniques are utilized by the firms to short list and select various capital investment projects. Time value of money concept is also utilized for the purpose of valuation of firms at the time of buying and selling of businesses. The calculation of present and future value of goodwill of any business can be improvised using time value of money concept. This concept is also useful in case of valuation of firms at the time of mergers and acquisitions in order to decide upon the share of old firms in new firm, share in profits, decision making power etc. The organizations also use this concept for the purpose of calculation of sinking fund, monthly pay-outs in the cases of mortgage, lease or rental agreements etc. In the American colonies coins of almost every European country circulated, with the Spanish dollar predominating. Because of the scarcity of coins, the colonists also used various primitive media / mediums of exchange, such as bullets, tobacco, and animal skins / hides; many of the colonies issued paper money that circulated at varying rates of discount. The first unified currency consisted of the notes issued by the Continental Congress to finance the American Revolution. These notes were originally declared redeemable in gold or silver coins, but redemption was found impossible after the Revolution because of the excess of printing notes over metal reserves. Thus, the notes depreciated and became nearly worthless. 3.5 KEYWORDS Arbitrage: With respect to the issuance of municipal bonds, arbitrage usually refers to the difference between the interest paid on the bonds issued and the interested earned by investing the bond proceeds in other securities. Arbitrage profits are permitted on bond proceeds for various temporary periods after issuance of municipal bonds. Internal Revenue Service regulations govern arbitrage of municipal bond proceeds. Assessable Base: The value of all real and personal property in the county used as a basis for levying taxes. Tax-exempt property is excluded from the assessable base. Assessed Value: The value a jurisdiction assigns to a property for tax purposes. Assessed value is less than market value. Assessment Bonds: Bonds secured by a direct fixed lien(s) on assessed properties to finance the acquisition and construction of local improvements. Audit: An examination of evidence, including records, facilities, inventories, systems, etc., to discover or verify desired information. A written report of findings will 52 CU IDOL SELF LEARNING MATERIAL (SLM)
normally result, and findings will generally be based on investigation of a sample of agency operations. 3.6 LEARNING ACTIVITY 1. Create a session on compounding. ___________________________________________________________________________ ___________________________________________________________________________ 2. Create a survey on discounting. ___________________________________________________________________________ ___________________________________________________________________________ 3.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Define the termdiscounting? 2. Define the term compounding? 3. What is money? 4. Write the main aim of value of money? 5. Write the main aim of compounding? Long Questions 1. Explain the disadvantages of compounding. 2. Elaborate the advantages of compounding. 3. Illustrate the advantages of discounting. 4. Discuss on the disadvantages of discounting. 5. Explain the scope of time value of money. B. Multiple Choice Questions 1. What does risk-return trade off imply? a. Increasing the portfolio of the firm through increased production b. Not taking any loans which increase the risk. c. Not granting credit to risky customers d. Taking decision in such a way which optimizes the balance between risk and return 53 CU IDOL SELF LEARNING MATERIAL (SLM)
2. What is a specific risk factor? a. Market risk b. Financial risk c. Inflation risk d. Interest rate risk. 3. What is not a diversifiable or specific risk factor? a. Company strike b. Bankruptcy of a major supplier c. Death of a key company officer d. Industrial recession. 4. What is Anil’s holding period return ifMr.Anil purchased 100 stocks of future informatics ltd, for Rs.21 on March 15, sold for Rs.35 on March 14 next year. In the company paid a dividend of Rs.2.50 per sharethem a. 78.60%. b. 45.40%. c. 66.70% d. 76.60%. 5. What is the required rate of return from investment in stock B is if 182-day annualized T bills rate is 9%p.a., the return on market is 15% p.a., and the beta of stock B is1.5? a. 17% p.a. b. 18% p.a. c. 19% p.a d. .20% p.a Answers 54 1-c, 2-b, 3-d, 4-a, 5-d 3.8 REFERENCES References CU IDOL SELF LEARNING MATERIAL (SLM)
Bai,J. Lumsdaine, R, L. & Stock, J, H. (1998). Testing for and dating common breaks in multivariate time series. Review of Economic Studies. Baker, M. & Wurgler, J. (2002). Market timing and capital structure. The Journal of Finance. Bandiera, O. Caprio, G. Honohan, P & Schiantarelli, F. (2000). Does financial reform raise or reduce saving? The Review of Economics and Statistics. Textbooks Banerjee, S. Heshmati, A & Wihlborg, C. (2004). The dynamics of capital structure. Research in Banking and Finance. Barclay, M, J. & Smith, C, W. (1996). On financial architecture: leverage, maturity and priority. Journal of Applied Corporate Finance. Barclay, M, J. & Smith, C, W. (1999). The capital structure puzzle. Journal of Applied Corporate Finance. Website https://www.researchgate.net/publication/337464889 https://www.researchgate.net/publication File:///C:/Users/Sony/Downloads/TIMEVALUEOFMONEYTHECONCEPTANDITS UTILITY.Pdf 55 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT-4 CAPITAL BUDGETING STRUCTURE 4.0 Learning Objective 4.1 Introduction 4.2 LongTerm InvestmentDecisions 4.3CapitalBudgetingPrinciples 4.4 Process of Capital Budgeting 4.5 Summary 4.6 Keywords 4.7 Learning Activity 4.8 Unit End Questions 4.9 References 4.0 LEARNING OBJECTIVE After studying this unit, you will be able to Explain the concept of longterm investmentdecisions. Illustrate the concept of capital. Explain the process of capital budgeting. 4.1 INTRODUCTION A budget is a quantitative expression of a plan for a defined period of time. It may include planned sales volumes and revenues, resource quantities, costs and expenses, assets, liabilities and cash flows. It expresses strategic plans of business units, organizations, activities or events in measurable terms. Budgeting lies at the foundation of every financial plan. It doesn’t matter if you’re living pay check to pay check or earning six-figures a year, you need to know where your money is going if you want to have a handle on your finances. Unlike what you might believe, budgeting isn’t all about restricting what you spend money on and cutting out all the fun in your life. It’s really about understanding how much money you have, where it goes, and then planning how to best allocate those funds. Here’s everything you need to help you create and maintain a budget. Do you know why a budget is so important? On the surface it seems like creating a budget is just a tedious financial exercise, especially if you feel your finances are already in good order. But you might be surprised at just how valuable a budget can be. A good budget can help keep your spending 56 CU IDOL SELF LEARNING MATERIAL (SLM)
on track and even uncover some hidden cash flow problems that might free up even more money to put toward your other financial goals. Swiping plastic has become incredibly easy. With both credit cards and debit cards, we can be in and out with a purchase in a matter of seconds. Unfortunately, this convenience comes at a cost. By using plastic we can begin to lose track of how much money is actually being spent. Sure, two dollars here, 4 dollars there, it doesn’t seem like much at the time of purchase, but if you aren’t careful they can really add up and bust your budget. One trick to help keep your daily spending under control is to use cash instead of your credit or debit cards. It might not be as fast, but it helps you visualize just how much money you’re actually spending. Figure 4.1: Budgeting A budget is a document that translates plans into money - money that will need to be spent to get your planned activities done (expenditure) and money that will need to be generated to cover the costs of getting the work done (income). It is an estimate, or informed guess, about what you will need in monetary terms to do your work. A budget is not: Written in stone – where necessary, a budget can be changed, so long as you take steps to deal with the implications of the changes. So, for example, if you have budgeted for ten new computers but discover that you really need a generator, you could buy fewer computers and purchase the generator. Simply a record of last year’s expenditure, with an extra 15% added on to cover inflation. Every year is different. Organisations need to use the budgeting process to explore 57 CU IDOL SELF LEARNING MATERIAL (SLM)
what is really needed to implement their plans. Just an administrative and financial requirement of donors. The budget should not be prepared as part of a funding proposal and then taken out and dusted when it is time to do a financial report for the donor. It is a living tool that must be consulted in day to day work, checked monthly, monitored constantly and used creatively. An optimistic and unrealistic picture of what things actually cost – don’t underestimate what things really cost in the hopes that this will help you raise the money you need. It is better to return unspent money to donors than to beg for a “bit more” so you can complete the work. All throughout the activity, regardless of how perfect the unit’s strategy is, controlling the predictions is necessary to track down the causes that lead to certain deviations, to assign responsibilities and to anticipate some corrective measures for them. This prediction control system that contributes to achieving the time-targeted objectives, of one year deadline usually, is called budgeting. Budgeting represents the accounting instrument used by companies on a regular basis to plan and control their actions in order to satisfy their clients and secure their success on the market. The budget can be defined as afinancial plan that includes calculating the revenues and expenses of the state, a social or economic organization for a determined period of time”. The budget is the quantitative expression of the plan framed by the administration for a specified period and a support for the coordination of the necessary activities in implementing that plan. A budget may reflect both financial and non- financial issues concerning the plan and represents aschedule” regarding the forthcoming period. A budget that includes financial aspects quantifies the administration’s predictions regarding the profit, treasury’s cash flows and financial statement of the entity. The financial statements for the forthcoming period can be drawn up the same way as those for the former periods. Non-financial budgets can be drawn up in addition to these financial budgets such as those regarding the number of products, the number of employees or the number of new products introduced on the market. The budget may become an instrument for the amortization and optimization of the relation between revenues and expenses within an entity whereas the costs budgeting may become a systematic economical practice that demands carrying out a formal process by which financial resources are distributed in order to achieve the time-objectives for the forthcoming periods. Practically, the budget can be viewed as a list, a document that includes the predictable revenues and expenses of an entity, regardless of its size, within a certain period of time. The budget represents the underlying activity of the economical agents. The budget reflects the economical unit’s revenues and expenses, financial results, proper funds including the employees’ contribution to the profit, bank loans and their reimbursement, payments to the treasury and information regarding the main indicators of its activity. The budget contributes to maintaining a permanent balance between receivables and payments and also ensures a continuous capacity of payment. The budget of an enterprise reflects the potential of achieving its revenues, the expenses’ limit as well as its final results. The unit’s financial 58 CU IDOL SELF LEARNING MATERIAL (SLM)
balance must permanently reflect the match between the monetary resources and the actual needs, according to the requirements of a lucrative economical-financial activity. In the context of economic competition, where the companies’ activity must be lucrative, the budget contributes in increasing the profit and decreasing expenses, therefore the budget represents a leading instrument. The budget is an instrument used by any entity, financially ensuring the dimension of the objectives, revenues, expenses and results at the management level and finally evaluating the economic efficiency through comparing the results with those budgeted for. The elaboration, monitoring and controlling the budgets is mandatory for the purpose of acknowledging the results and delivering private information necessary for the decision making. If the budget is designed to present all the predictable figures of the enterprise, it is questioned whether autonomous subsystems called expenses centres (places) aimed at optimizing the use of resources and making profit should be created within. Figure 4.2: Capital Budgeting 4.2 LONG TERM INVESTMENT DECISIONS A long-term investment is an account on the asset side of a company's balance sheet that represents the company's investments, including stocks, bonds, real estate, and cash. Long- term investments are assets that a company intends to hold for more than a year. The long- term investment account differs largely from the short-term investment account in that short- term investments will most likely be sold, whereas the long-term investments will not be sold for years and, in some cases, may never be sold. 59 CU IDOL SELF LEARNING MATERIAL (SLM)
Being a long-term investor means that you are willing to accept a certain amount of risk in pursuit of potentially higher rewards and that you can afford to be patient for a longer period of time. It also suggests that you have enough capital available to afford to tie up a set amount for a long period of time Figure 4.3: Capital Budgeting A common form of long-term investing occurs when company A invests largely in company B and gains significant influence over company B without having a majority of the voting shares. In this case, the purchase price would be shown as a long-term investment. When a holding company or other firm purchases bonds or shares of common stock as investments, the decision about whether to classify it as short-term or long-term has some fairly important implications for the way those assets are valued on the balance sheet. Short- term investments are marked to market, and any declines in value are recognized as a loss. However, increases in value are not recognized until the item is sold. Therefore, the balance sheet classification of investment – whether it is long-term or short-term – has a direct impact on the net income that is reported on the income statement. 60 CU IDOL SELF LEARNING MATERIAL (SLM)
Figure 4.4: Short & Long Term If an entity intends to keep an investment until it has matured and the company can demonstrate the ability to do so, the investment is noted as being \"held to maturity.\" The investment is recorded at cost, although any premiums or discounts are amortized over the life of the investment. For example, a classic held to maturity investment was the purchase of PayPal by eBay in 2002. Once PayPal had significantly grown its infrastructure and user base, it was then spun out as its own company in 2015 with a five-year agreement to continue processing payments for eBay. This investment helped PayPal grow and at the same time allowed eBay the benefit of owning a world-class payment processing solution for nearly two decades. The long-term investment may be written down to properly reflect an impaired value. However, there may not be any adjustment for temporary market fluctuations. Since investments must have an end date, equity securities may be not be classified as held to maturity. Investments held with the intention of resale within a year, for the purpose of garnering a short-term profit, are classified as current investments. A trading investment may not be a long-term investment. However, a company may hold an investment with the intention to sell in the future. 61 CU IDOL SELF LEARNING MATERIAL (SLM)
Figure 4.5: Long term investment These investments are classified as \"available for sale\" as long as the anticipated sale date is not within the next 12 months. Available for sale long-term investments are recorded at cost when purchased and subsequently adjusted to reflect their fair values at the end of the reporting period. Unrealized holding gains or losses are kept as \"other comprehensive income\" until the long-term investment has been sold. Role and responsibilities of a finance manager have under gone a remarkable transformation during the last four decades. Unlike the past, finance manager plays pivotal role in planning the quantum and pattern of fund requirements, procuring the desired amount of funds on reasonable terms, allocating funds so pooled among profitable outlets and controlling the uses of funds. Since all business activities involve planning for and utilization of funds, finance manager must have clear conception of the financial objectives of his firm and cardinal principles of financial decisions. Against this back drop, we shall discuss the basics of financial decisions; nature of long term financing and investment decisions; NPV Rule; time value of money; determination of implied interest rates, implied principal amount and annuities and basic factors influencing long term financial decisions. There are many other objectives which are assumed to compete with Value maximisation Objective (VMO). In fact there are a whole lot of researchers who interview practicing managers and ‘show’ that the managers often have a whole lot of other ‘legitimate’ objectives other than the VMO. These are often enumerated as maximizing return on investment, 62 CU IDOL SELF LEARNING MATERIAL (SLM)
maximizing profit after taxes, maximizing sales, maximizing the market share of their products and so on. It is often held that very few managers in fact agree to pursue value maximisation of their firms as an explicit objective. A little reflection reveals the intrinsic weakness of such studies. For example, one researcher asked a manager who held maximization of market share as the corporate objective, as to whether he would like his company to capture 100% market share by pricing below costs. Clearly if market share maximization is the prime objective, he should have no objection to such a proposition. And yet it would be a poor manager indeed who goes for such an opinion. Clearly, his desire to maximize market share even at cost of profits in the short terms, must have been triggered off by the possibility of attaining a monopolistic position so that profits in the long term can be maximized. Similarly, a manager who maximizes sales may be operating under the assumption, that such a course of action would eventually lead to enhanced profits in the long run, if not immediately. Other objectives such as maximization of return on investment or profit before taxes etc. are at any rate linked to the wealth maximization criteria directly or indirectly. We can see that what are constructed as objective as other than VMO are in fact merely short term operational strategies for maximizing wealth of the shareholders in the long run. 4.3CAPITALBUDGETINGPRINCIPLES PFS has started its comprehensive classes for CFA Level I candidates targeting the Dec 2020 CFA Level I Exam. The class schedules and plans are already shared to our clients and via our blog. Because of COVID-19, we are having classes via zoom. We will go back to our offline classes soon after the lockdown periods are over. We are also opening another batch targeting Feb 2021 CFA Level I Exam. This will be the first computer-based exam to be organized by CFA Institute. We have started our first class today, and we have covered two chapters from corporate finance, capital budgeting, and cost of capital. We have discussed all the learning outcomes of the chapters and a practice exam will take place next week. I will share the basic principles of capital budgeting in this section. One can also watch an excerpt from our class to know about the principles. The capital budgeting decisions are based on the cash flow forecasts instead of relying on the accounting income. These are the incremental cash flows, that is, the additional cash flow that will occur if the project is undertaken compared to if the project is not undertaken. While estimating these cash flows certain costs such as the sunk cost will be ignored. This is because sunk cost is the cost that is already incurred whether the project is undertaken or not. Similarly any intangible costs and benefits are ignored. The investment analysis should also account for any externalities. An externality refers to the effect of the project/investment on other things than the project itself. A common externality is cannibalization, where a new project reduces the cash flow of another project. This is a 63 CU IDOL SELF LEARNING MATERIAL (SLM)
negative externality. A project can also have a positive externality where a new project has positive effect on the revenue from another project. Another important aspect of the analysis is to estimate the timing of cash flow as accurately as possible. As the capital budgeting analysis uses the concept of time value of money, the time at which the cash flow occurs significantly impacts the present value of the project. The earlier the cash flow occurs the more valuable it is. Financing costs should not be included in the cash flow. Analysts will take the after-tax operating cash flows and will discount them using the required rate of return to arrive at the net present value. The financing costs are already reflected in the required rate of return and the cash flow should not be adjusted for the same, irrespective of whether the project is financed sing equity, debt or a combination of both. A project may have conventional or unconventional cash flow pattern. In case of a conventional cash flow pattern, there is an initial outflow of cash followed by one or more cash inflows. In case of unconventional cash flows, there could be a series of cash inflows and outflows at different times. Decisions are based on cash flows, not based on accounting net income: Capital budgeting decisions focus on analysing cash flows, not the accounting net income. Timing of cash flows is important: The timing of the cash flows is important. The earlier a project receives the bigger cash flows the better. Cash flows are compared relative to opportunity costs: Cash flows are compared based on the opportunity costs of other projects. In case of discounting the cash flows opportunity cost of capital is used. After-tax cash flows are considered, not before tax cash flows: After-tax cash flows are the cash flows that belong to the suppliers of capital. Focus is on after-tax operating cash flows by ignoring the financing costs: Financing costs are captured in the required rate of return. After-tax operating cash flows belong to all the suppliers of capital. That is why after-tax cash flows are discounted using a weighted average cost of capital (WACC). Financing costs are already incorporated in WACC. To avoid double-counting, the numerator uses after-tax operating cash flows. Capital budgeting cash flows don’t consider accrual income or expenses: Non-cash charges, for example, depreciation, amortizations are ignored since we only focus on cash flows, not the accrual income/expenses. Sunk costs should be ignored: Sunk costs are costs that are already incurred and cannot be recouped whether or not we enter into a project. Since the costs are already incurred and cannot be altered, they should not be considered in capital budgeting decision making. 64 CU IDOL SELF LEARNING MATERIAL (SLM)
Incremental cash flows are considered: Incremental cash flows should be considered in capital budgeting decision making. For example, for replacement projects, the cash flows from the new equipment minus the cash flows from the old equipment should be considered. When evaluating costs again, we should consider the incremental costs. Externalities are considered in investment decision making: An externality is the effect of an investment on other things besides the investment itself. There are two types of externalities. Positive externalities and Negative externalities. Cannibalization is one type of externality. Cannibalization occurs when an investment takes customers and sales away from another part of the company. If possible, we should consider externalities in investment decision making. 4.4 PROCESS 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. A company’s manager has to plan for the expenditure and benefits an entity would derive from investing in an underlying project. These investment decisions are typically pertaining to the long term assets that are expected to produce benefits over more than one year. All such evaluation forms part of the capital budgeting process. In this article, you will learn what is capital budgeting, capital budgeting process and techniques of capital budgeting. 65 CU IDOL SELF LEARNING MATERIAL (SLM)
Figure 4.6: Capital Budgeting Process 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. 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 66 CU IDOL SELF LEARNING MATERIAL (SLM)
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. 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 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. 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 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 67 CU IDOL SELF LEARNING MATERIAL (SLM)
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. 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. Figure 4.7: Process of Capital Budgeting 4.5 SUMMARY Capital is anything that increases one’s ability to generate value. It can be used to increase value across a wide range of categories, such as financial, social, physical, intellectual, etc. In business and economics, the two most common types of capital are financial and human. This guide will explore all the above categories in more detail. Debt is a loan or financial obligation that must be repaid in the future. It has an interest expense attached to it, which is the cost of borrowing money. The cash received from borrowing money is then used to purchase an asset and fund the operations of a business, which in turn generates revenues for a company. Equity is an ownership stake in a company, and equity investors will receive the residual value of the company in the event it is sold or wound-down. Unlike debt, it does not have to be repaid and doesn’t have an interest expense associated with it. Equity is used to fund the business and purchase assets to generate revenue. 68 CU IDOL SELF LEARNING MATERIAL (SLM)
Human capital is used by businesses to create products and perform services that can be used to generate revenue for the company. Companies don’t “own” people they way they do other assets. The most common types of human capital are intellectual and skills/talents. Intellectual refers to the intelligence of people, which can be used to successfully run a company, think creatively, solve problems, form strategies, and outperform competitors. Skills and talents are used in much the same way as intelligence to help a business operate and generate revenues. Skills do not necessarily require mental capacity and can include manual labour, physical exertion, social influence, etc. Natural capital can also be used by businesses to generate income and increase production. Many businesses use natural resources such as water, wind, solar, animals, trees, plants, and crops to operate their company and increase value over time. Since the interest expense is tax-deductible, the after-tax cost of debt is equal to the interest rate multiplied by one minus the tax rate. Continuing with the example above, if the company’s tax rate is 25%, the after-tax cost of debt would be 10% x (1 – 25%) = 7.5%. The cost of equity is an implied cost that is calculated using the Capital Asset Pricing Model (CAPM), which uses the riskiness of an investment (the volatility of its returns) as a means of determining how much it should cost per year. The cost of equity is always higher than the cost of debt because it carries more risk (in the event of insolvency, debt is repaid before equity). In business, a company’s capital base is absolutely essential to its operation. Without adequate funding, a company may not be able to afford the assets it needs to operate and survive, nor be able to outperform its competitors. Financial analysts perform extensive analysis to assess how well funded a business is, how efficient its operation is, and how good a job it does of generating a return for the investors who fund the business. Managers and operators of a business are typically very focused on being efficient in operations and generating the highest possible returns for their investors. While money (currency) and capital may seem like the same thing, they are not. Capital is a much broader term that includes all aspects of a business that can be used to generate revenue and income, i.e., the company’s people, investments, patents, trademarks, and other resources. 69 CU IDOL SELF LEARNING MATERIAL (SLM)
4.6 KEYWORDS Balance Sheet: A statement of the financial position of an entity that presents the value of its assets, liabilities, and equities on a specified date. Balloon Maturity: A bond issue with substantially more late maturities than early maturities. Some or all of the late maturities are often callable to allow for early redemption. Bid: A formal, binding document used to obtain pricing from vendors for a specific period of time. It contains complete specifications of the goods or services requested by the county. A bid also includes payment terms, delivery requirements, and other conditions that define the scope of the purchase. Bids are used to establish county contracts for products or services or for one-time purchases of high dollar items (usually over $1,000). Block Grant: A type of grant given primarily to a general-purpose government unit in accordance with a statutory formula. Such grants can be used for a variety of activities within a broad functional area. Bond: A bond is a written promise to repay borrowed money on a definite schedule and usually at a fixed rate of interest for the life of the bond. State and local governments repay this debt with taxes, fees, or other sources of governmental revenue. 4.7 LEARNING ACTIVITY 1. Create a session on long term investment decisions. ___________________________________________________________________________ ___________________________________________________________________________ 2. Create a survey on capital budgeting principles. ___________________________________________________________________________ ___________________________________________________________________________ 4.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What is capital? 2. What is capital gain? 70 CU IDOL SELF LEARNING MATERIAL (SLM)
3. Define capital loss? 4. How do you determine budgeting? 5. Define the term budget? Long Questions 1. Explain the advantages of capital budgeting. 2. Elaborate the disadvantages of capital budgeting. 3. Illustrate the features of capital budgeting. 4. Discuss on the process of capital budgeting. 5. Examine the long-terminvestment decisions. B. Multiple Choice Questions 1. Which of the following statements is correct regarding profit maximization as the primary goal of the firm? a. Profit maximization considers the firm's risk level. b. Profit maximization will not lead to increasing short-term profits at the expense of lowering expected future profits. c. Profit maximization does consider the impact on individual shareholder's EPS. d. Profit maximization is concerned more with maximizing net income than the stock price. 2. What if a company issues bonus shares the debt equity ratio? a. Remain unaffected b. Will be affected c. Will improve d. None of these 3. Which of the following is not normally a responsibility of the treasurer of the modern corporation but rather the controller? a. Budgets and forecasts b. Asset management c. Investment management d. Financial management 4. Which decision involves determining the appropriate make-up of the right-hand side of the balance sheet? 71 CU IDOL SELF LEARNING MATERIAL (SLM)
a. Asset management b. Financing c. Investment d. Investment 5. What does Treasurer should report to a. Chief Financial Officer b. Vice President of Operations. c. chief Executive Officer d. Board of Directors. Answers 1-a, 2-d, 3-c, 4-a, 5-b 4.9 REFERENCES References Bauer, P. 2004. Determinants of capital structure. Empirical evidence from the Czech Republic. Czech Journal of Economics and Finance. Baumol, W, J. & Malkiel, B, G. (1967). The firm's optimal debt-equity combination and the cost of capital. The Quarterly Journal of Economics. Baxter, N, D. (1967). Leverage, risk of ruins and the cost of capital. The Journal of Finance. Textbooks Bekaert, G. (1995). Market integration and investment barriers in emerging equity markets. The World Bank Economic Review. Bekaert, G. & Harvey, C, R. (2000). Foreign speculators and emerging equity markets. The Journal of Finance. Bekaert, G. & Harvey, C, R. (2003). Emerging markets finance. Journal of Empirical Finance. Website https://www.researchgate.net/publication https://courses.aiu.edu http://www.gpcet.ac.in/wp-content/uploads/2017/07/UNIT-IV.pdf 72 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT-5 INVESTMENT EVALUATION CRITERIA STRUCTURE 5.0 Learning Objective 5.1 Introduction 5.2 PaybackPeriod 5.3 AccountingRateofReturn 5.4NetPresentValue 5.5 InternalRate of Return 5.6 Profitability Index 5.7 Project Evaluation 5.7.1 Independent 5.7.2 Replacement 5.7.3 Mutually Exclusive Projects 5.8 Capital Budgeting UnderConstraints(Capital Rationing) 5.9 Summary 5.10 Keywords 5.11 Learning Activity 5.12 Unit End Questions 5.13 References 5.0 LEARNING OBJECTIVE After studying this unit, you will be able to Explain the notion of paybackperiod. Illustrate the concept of accountingrateofreturn. Explain the impression of internalrate of return. 5.1 INTRODUCTION To invest is to allocate money with the expectation of a positive benefit/return in the future. In other words, to invest means owning an asset or an item with the goal of generating income from the investment or the appreciation of your investmentis an increase in the value 73 CU IDOL SELF LEARNING MATERIAL (SLM)
of the asset. When a person invests, it always requires a sacrifice of some present asset that they own, such as time, money, or effort. In finance, the benefit from investing is when you receive a return on your investment. The return may consist of a gain or a loss realized from the sale of a property or an investment, unrealized capital appreciation (or depreciation), or investment income such as dividends, interest, rental income etc., or a combination of capital gain and income. In finance, the benefit from investing is when you receive a return on your investment.The return may consist of a gain or a loss realized from the sale of a property or an investment, unrealized capital appreciation (or depreciation), or investment income such as dividends, interest, rental income etc., or a combination of capital gain and income. The return may also include currency gains or losses due to changes in the foreign currency exchange rates. Investors generally expect higher returns from riskier investments. When a low-risk investment is made, the return is also generally low. Similarly, high risk comes with high returns. Investors, particularly novices, are often advised to adopt a particular investment strategy and diversify their portfolio. Diversification has the statistical effect of reducing overall risk n investor may bear a risk of loss of some or all of their capital invested. Investment differs from arbitrage, in which profit is generated without investing capital or bearing risk. Savings bear the (normally remote) risk that the financial provider may default.Foreign currency savings also bear foreign exchange risk: if the currency of a savings account differs from the account holder's home currency, then there is the risk that the exchange rate between the two currencies will move unfavourably so that the value of the savings account decreases, measured in the account holder's home currency. Even investing in tangible assets property has its risk. And just like with most risk, property buyers can seek to mitigate any potential risk by taking out mortgage insurance and by borrowing at a lower loan to security ratio. In contrast with savings, investments tend to carry more risk, in the form of both a wider variety of risk factors and a greater level of uncertainty. Industry to industry volatility is more or less of a risk depending. In biotechnology for example, investors look for big profits on companies that have small market capitalizations but can be worth hundreds of millions quite quickly. The risk is approximately 90% of the products researched do not make it to market due to regulations and the complex demands within pharmacology as the average prescription drug takes 10 years and $2.5 billion USD worth of capital. The Code of Hammurabi (around 1700 BC) provided a legal framework for investment, establishing a means for the pledge of collateral by codifying debtor and creditor rights in regard to pledged land. Punishments for breaking financial obligations were not as severe as those for crimes involving injury or death. In the medieval Islamic world, the qirad was a major financial instrument. This was an arrangement between one or more investors and an agent where the investors entrusted capital to an agent who then traded with it in hopes of making a profit. Both parties then received a previously settled portion of the profit, though the agent was not liable for any losses. Many will notice that the qirad is similar to the institution of the commend later used in western Europe, though whether the qirad transformed into the commend or the two institutions evolved independently cannot be stated 74 CU IDOL SELF LEARNING MATERIAL (SLM)
with certainty.Amsterdam Stock Exchange is considered to be the world's oldest stock exchange. Established in 1602 by Dutch East India Company, the company issued the first shares on the Amsterdam Stock Exchange. In the early 1900s, purchasers of stocks, bonds, and other securities were described in media, academia, and commerce as speculators. Since the Wall Street crash of 1929, and particularly by the 1950s, the term investment had come to denote the more conservative end of the securities spectrum, while speculation was applied by financial brokers and their advertising agencies to higher risk securities much in vogue at that time.Since the last half of the 20th century, the terms speculation and speculator have specifically referred to higher risk ventures. A value investor buys assets that they believe to be undervalued (and sells overvalued ones). To identify undervalued securities, a value investor uses analysis of the financial reports of the issuer to evaluate the security. Value investors employ accounting ratios, such as earnings per share and sales growth, to identify securities trading at prices below their worth. Warren Buffett and Benjamin Graham are notable examples of value investors. Graham and Dodd's seminal work, Security Analysis, was written in the wake of the Wall Street Crash of 1929. The price to earnings ratio (P/E), or earnings multiple, is a particularly significant and recognized fundamental ratio, with a function of dividing the share price of the stock, by its earnings per share. This will provide the value representing the sum investors are prepared to expend for each dollar of company earnings. This ratio is an important aspect, due to its capacity as measurement for the comparison of valuations of various companies. A stock with a lower P/E ratio will cost less per share than one with a higher P/E, taking into account the same level of financial performance; therefore, it essentially means a low P/E is the preferred option. An instance in which the price to earnings ratio has a lesser significance is when companies in different industries are compared. For example, although it is reasonable for a telecommunications stock to show a P/E in the low teens, in the case of hi-tech stock, a P/E in the 40s range is not unusual. When making comparisons, the P/E ratio can give you a refined view of a particular stock valuation. For investors paying for each dollar of a company's earnings, the P/E ratio is a significant indicator, but the price-to-book ratio (P/B) is also a reliable indication of how much investors are willing to spend on each dollar of company assets. In the process of the P/B ratio, the share price of a stock is divided by its net assets; any intangibles, such as goodwill, are not taken into account. It is a crucial factor of the price- to-book ratio, due to it indicating the actual payment for tangible assets and not the more difficult valuation of intangibles. Accordingly, the P/B could be considered a comparatively conservative metric. This revised and fully expanded edition of Understanding Investments continues to incorporate the elements of traditional textbooks on investments, but goes further in that the material is presented from an intuitive, practical point of view, and the supplementary material included in each chapter lends itself to both class discussion and further reading by students. It provides the essential tools to navigate complex, global financial markets and instruments including relevant (and classic) academic research and market perspectives. The author has developed a number of key innovative features. One 75 CU IDOL SELF LEARNING MATERIAL (SLM)
unique feature is its economic angle, whereby each chapter includes a section dedicated to the economic analysis of that chapter's material. Additionally, all chapters contain sections on strategies that investors can apply in specific situations and the pros and cons of each are also discussed.The book provides further clarification of some of the concepts discussed in the previous edition, thereby offering a more detailed analysis and discussion, with more real- world examples. The author has added new, shorter text boxes, labelled \"Market Flash\" to highlight the use of, or changes in current practices in the field; updates on strategies as applied by professionals; provision of useful information for an investor; updates on regulations; and anything else that might be relevant in discussing and applying a concept. This second edition also includes new sections on core issues in the field of investments, such as alternative investments, disruptive technologies, and future trends in investment management. This textbook is intended for undergraduate students majoring or minoring in finance and also for students in economics and related disciplines who wish to take an elective course in finance or investments. What is an investment and why do people invest? Investment is the sacrifice of your resources (time, money, and effort) today for the expectation of earning more resources tomorrow. What can you do with your money? Spend it, save some of it, or invest it? If you choose the latter, where are you going to invest it? There are many investment alternatives (like stocks and bonds), and the amount of information on each one of them is staggering. What is your goal in investing? What are your constraints and risks? Once you have defined these, what is the next step? Are you going to do the investing on your own or are you going to hire a professional money manager? These are some of the questions that you need to address as a (novice) investor, and we will deal with them in this part of this textbook. In the remaining chapters, we will have more to say about the field of investments in general, the strategies that you can apply to achieve your goals, and the risks involved in investing. It examines the general investment framework by defining investments and the various investment alternatives available in the market. It also presents the objectives and constraints of individual and institutional investors, and the roles of the various financial intermediaries that assist you in investing. Lays out the investment process (that is, the two main steps that you need to take before investing) and presents some very basic and simple investment strategies. Finallydiscusses in detail the basic elements of investments: risk and return. This chapter also addresses the objective of investing, which is the maximization of your expected return, and its constraint, which is (subject to) risk. We end with a cautionary word. This textbook cannot make investment decisions for you! It can only assist you in making informed decisions by providing you with valuable information so that you can apply it to your particular investment situation. 5.2 PAYBACKPERIOD Corporate finance is all about capital budgeting. One of the most important concepts every corporate financial analyst must learn is how to value different investments or operational 76 CU IDOL SELF LEARNING MATERIAL (SLM)
projects. The analyst must find a reliable way to determine the most profitable project or investment to undertake. One way corporate financial analysts do this is with the payback period. The desirability of an investment is directly related to its payback period. Shorter paybacks mean more attractive investments. Investors and managers use the payback period to make quick judgments on their investments. The concept of the payback period is generally used in financial and capital budgeting. But it has also been used to determine the cost savings of energy efficiency technology. As an example it can be used by homeowners and businesses to calculate the return on the energy efficient technologies such as solar panels and insulation, as well as maintenance and upgrades. The payback period, though, disregards the time value of money. It is determined by counting the number of years it takes to recover the funds invested. For example, if it takes five years to recover the cost of the investment, the payback period is five years. While payback periods are useful in financial and capital budgeting, it has applications in other industries. Some analysts favour the payback method for its simplicity. Others like to use it as an additional point of reference in a capital budgeting decision framework. The payback period does not account for what happens after payback, ignoring the overall profitability of an investment. The payback period is useful from a risk analysis perspective, since it gives a quick picture of the length of time that the initial investment will be at risk. If you were to analyse a prospective investment using the payback method, you would tend to accept those investments having rapid payback periods and reject those having longer ones. It tends to be more useful in industries where investments become obsolete very quickly, and where a full return of the initial investment is therefore a serious concern. An investment project with a short payback period promises the quick inflow of cash. It is therefore, a useful capital budgeting method for cash poor firms. A project with short payback period can improve the liquidity position of the business quickly. The payback period is important for the firms for which liquidity is very important. 77 CU IDOL SELF LEARNING MATERIAL (SLM)
Figure 5.1: Payback Period It does not consider the useful life of the assets and inflow of cash after payback period. For example, If two projects, project A and project B require an initial investment of $5,000. Project A generates an annual cash inflow of $1,000 for 5 years whereas project B generates a cash inflow of $1,000 for 7 years. It is clear that the project B is more profitable than project A. But according to payback method, both the projects are equally desirable because both have a payback period of 5 years ($5,000/$1,000). If an asset’s useful life expires immediately after it pays back the initial investment, then there is no opportunity to generate additional cash flows. The payback method does not incorporate any assumption regarding asset life span. Additional cash flows. The concept does not consider the presence of any additional cash flows that may arise from an investment in the periods after full payback has been achieved. Cash flow complexity. The formula is too simplistic to account for the multitude of cash flows that actually arise with a capital investment. For example, cash investments may be required at several stages, such as cash outlays for periodic upgrades. 78 CU IDOL SELF LEARNING MATERIAL (SLM)
Also, cash outflows may change significantly over time, varying with customer demand and the amount of competition.Profitability. The payback method focuses solely upon the time required to pay back the initial investment; it does not track the ultimate profitability of a project at all. Thus, the method may indicate that a project having a short payback but with no overall profitability is a better investment than a project requiring a long-term payback but having substantial long-term profitability. Time value of money. The method does not take into account the time value of money, where cash generated in later periods is worth less than cash earned in the current period. A variation on the payback period formula, known as the discounted payback formula, eliminates this concern by incorporating the time value of money into the calculation. Other capital budgeting analysis methods that include the time value of money are the net present value method and the internal rate of return. Individual asset orientation. Many fixed asset purchases are designed to improve the efficiency of a single operation, which is completely useless if there is a process bottleneck located downstream from that operation that restricts the ability of the business to generate more output. The payback period formula does not account for the output of the entire system, only a specific operation. Thus, its use is more at the tactical level than at the strategic level. 5.3 ACCOUNTINGRATEOFRETURN The ARR method of capital investment appraisal appears to go under a number of guises, with a multitude of definitions used as the basis for its calculation. There is no single accepted formula for the accounting rate of return (ARR), and there is considerable confusion in the academic and the professional literature as to which method of calculation should be adopted. As a result, management may select whichever formula suits them best. Reference is made to the ARR without giving a precise definition to its calculation or meaning. Comparisons are made on the basic assumption that one is comparing like with like. This, in many cases, is a false assumption. Although, in some cases, a distinction is made between the ARR based on initial investment and average investment, there is no generally accepted basis of calculating the figures to be used for either investment in or the return arriving from a project. 79 CU IDOL SELF LEARNING MATERIAL (SLM)
The accounting rate of return (ARR) is also commonly referred to as average rate of return (ARR), return on investment (ROI), and return on capital employed (ROCE). It is also known as average book rate of return, return on book value, book rate of return, unadjusted rate of return, and simple rate of return. In many cases the terms are used synonymously, while in others, they imply subtle differences in calculation. Although the ARR, in whatever format, suffers from serious deficiencies (it is based on an accrual and not a cashflow concept; it does not take fully into account the fact that profits may vary year by year and therefore show an uneven pattern; it ignores the time value of the flow of funds and is not suitable for comparing projects with different life spans), research shows that it continues to be used in the United Kingdom and the United States for the appraisal of capital projects. Reasons for its use have been given as simplicity and ease of calculation, readily understandability, and its use of accrual accounting measures by which managers are frequently appraised and rewarded. It does, however, offer a potential for manipulation by creative accounting. Under the ‘initial’ method, the returns from a project are expressed as a percentage of the initial cost (hence the term ‘initial’). The returns are stated after depreciation, so this shows in effect, in a simplistic way, the rate of return that is expected to be achieved above that which is required to recover the initial cost of the investment. There is, however, a school of thought that advances the proposition that as the capital investment will be written-off over the useful life of the project, then the figure for investment should take this into account. In its most basic form, this would result in an ‘average’ investment figure of one-half of the original cost. The earnings from the project would remain the same under either approach. There appears to be two further areas of confusion with regard to the calculation of the ARR: how to deal with (i) scrap/salvage values and (ii) different methods of depreciation. Some textbooks show examples that do not include scrap values, thus getting round the problem of what to do with them, and with regards to depreciation, restrict the calculations to straight-line depreciation. This gives the reader of such texts a general impression of incompleteness, in that he/she is left wondering what to do if there is any scrap value from a project or if the organisation uses a different method of depreciation other than the straight-line method. We would suggest that the accounting rate of return (ARR) used in the evaluation of capital projects should be based on either the initial (with the abbreviation, ARRi) or average (ARRa) investment method. The term ‘accounting’ relates to the concept by which the determination of the actual figures for income and investment are arrived at. The figure for income should be calculated following the conventional accounting concepts for profit. In this case, income is synonymous with profit. Net income should be after depreciation. By using the following formula, it is immaterial which method of depreciation is used, as the average income will always be total gross income less total depreciation divided by the life (in years) of the project. Total depreciation will be equal to the capital cost of the project less any scrap value. Investment under the ‘initial’ method will be the capital cost of the project less any scrap value, while under the ‘average’ method, it will be the capital cost of the project plus any scrap value divided by 2. 80 CU IDOL SELF LEARNING MATERIAL (SLM)
In our opinion, it seems unnecessary to refine the calculations any further. After all, the figures for both investment and income are based on management estimates and are therefore susceptible to errors. Much of the confusion would also disappear if the term ‘ARR’ (ARRi and ARRa) was restricted to capital investment appraisal, and ROI and ROCE are treated as post-investment ‘performance measures. ROI, which appears to be more widely used in the United States than in the United Kingdom, should be applied to the appraisal of ‘performance’ and calculated on an annual basis, based on the net book value of the investment at the beginning of each year. Because of the difficulty and information cost in determining the actual ‘profit’ from each individual investment made by an organisation, it may be more appropriate to calculate the ROI on a profit centre basis. The ROCE is more appropriate in measuring divisional performance, rather than as a tool for the initial evaluation of capital projects. It differs from both the ARR and ROI, in that it includes ‘working capital’ as part of the investment figure, and from the ARR in that it is calculated on an annual basis and does not therefore show, as a single figure, the overall return from a project. The ROCE is the ratio of accounting profit to capital employed expressed as a percentage. Accounting profit is arrived at after taking into account depreciation, while capital employed is the capital cost of the investment plus additional working capital required as a result of the project less accumulated depreciation. Although the ROI and ROCE are post-investment performance measures, it is understandable that managers may wish to know how these measures will be influenced by accepting a particular investment project. After all, their own performance will, in many cases, be judged using one of these performance measurements, and they will, invariably, be rewarded accordingly. It is therefore not surprising that managers may wish to calculate such figures when appraising capital projects. What must be remembered, however, is that the ROI and ROCE calculate the annual return from an investment or group of investments, and it is the returns ‘profile’ that will be of interest to management. Selecting projects with different profit profiles will influence the total annual profit from all investments. The profit profile will not only be influenced by the pattern of gross income from investments but also by the method of depreciation adopted by the organisation. It can be seen that by adopting the reducing-balance method of depreciation, this has the effect of showing lower profits in the early years and higher profits in later years, while the straight-line method of depreciation charges the same amount to costs in each year. The ROI and ROCE should not be the driving force behind project selection, as such techniques may be biased towards managerial benefits and short-termism rather than corporate long-term profitability. All other ‘terms’ for ARR should be ignored and left out of future textbooks, as they only breed confusion in the minds of both students and practitioners. This is, perhaps, a ‘back to basics’ approach, but one which, in our opinion, would eliminate much of the mystique and confusion over the ARR. It must be remembered that the ARR is a basic, simplistic investment appraisal tool. So why try and make it into something that it will never be – a substitute for the more sophisticated DCF methods? 81 CU IDOL SELF LEARNING MATERIAL (SLM)
Figure 5.2: Rate of return 5.4NETPRESENTVALUE 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 analyse the profitability of a projected investment or project. NPV is the result of calculations used to find today’s value of a future stream of payments. It accounts for the time value of money and can be used to compare similar investment alternatives. The NPV relies on a discount rate that may be derived from the cost of the capital required to make the investment, and any project or investment with a negative NPV should be avoided. One important drawback of NPV analysis is that it makes assumptions about future events that may not be reliable. 82 CU IDOL SELF LEARNING MATERIAL (SLM)
Figure 5.3: Net Present Value NPV looks to assess the profitability of a given investment on the basis that a dollar in the future is not worth the same as a dollar today. Money loses value over time due to inflation. However, a dollar today can be invested and earn a return, making its future value possibly higher than a dollar received at the same point in the future. NPV seeks to determine the present value of an investment's future cash flows above the investment's initial cost. The discount rate element of the NPV formula discounts the future cash flows to the present- day value. If subtracting the initial cost of the investment from the sum of the cash flows in the present-day is positive, then the investment is worthwhile. For example, an investor could receive $100 today or a year from now. Most investors would not be willing to postpone receiving $100 today. However, what if an investor could choose to receive $100 today or $105 in one year? The 5% rate of return (RoR) for waiting one year might be worthwhile for an investor unless another investment could yield a rate greater than 5% over the same period. If an investor knew they could earn 8% from a relatively safe investment over the next year, they would choose to receive $100 today and not the $105 in a year, with the 5% rate of return. In this case, 8% would be the discount rate. Money in the present is worth more than the same amount in the future due to inflation and to earnings from alternative investments that could be made during the intervening time. In other words, a dollar earned in the future won’t be worth as much as one earned in the present. The discount rate element of the NPV formula is a way to account for this. For example, assume that an investor could choose a $100 payment today or in a year. A rational investor would not be willing to postpone payment. However, what if an investor could choose to receive $100 today or $105 in a year? If the payer was reliable, that extra 5% 83 CU IDOL SELF LEARNING MATERIAL (SLM)
may be worth the wait, but only if there wasn’t anything else the investors could do with the $100 that would earn more than 5%. An investor might be willing to wait a year to earn an extra 5%, but that may not be acceptable for all investors. In this case, the 5% is the discount rate, which will vary depending on the investor. If an investor knew they could earn 8% from a relatively safe investment over the next year, they would not be willing to postpone payment for 5%. In this case, the investor’s discount rate is 8%. Figure 5.4: Present value vs Net Present value A company may determine the discount rate using the expected return of other projects with a similar level of risk or the cost of borrowing the money needed to finance the project. For example, a company may avoid a project that is expected to return 10% per year if it costs 12% to finance the project or an alternative project is expected to return 14% per year. Imagine a company can invest in equipment that will cost $1,000,000 and is expected to generate $25,000 a month in revenue for five years. The company has the capital available for the equipment and could alternatively invest it in the stock market for an expected return of 8% per year. The managers feel that buying the equipment or investing in the stock market are similar risks. In finance, the net present value (NPV) or net present worth (NPW)applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount rate. NPV accounts for the time value of money. It provides a method for evaluating and comparing capital projects or financial products with cash flows spread over time, as in loans, investments, pay-outs from insurance contracts plus many other applications. Time value of money dictates that time affects the value of cash flows. For example, a lender may offer 99 cents for the promise of receiving $1.00 a month from now, but the promise to 84 CU IDOL SELF LEARNING MATERIAL (SLM)
receive that same dollar 20 years in the future would be worth much less today to that same person (lender), even if the payback in both cases was equally certain. This decrease in the current value of future cash flows is based on a chosen rate of return (or discount rate). If for example there exists a time series of identical cash flows, the cash flow in the present is the most valuable, with each future cash flow becoming less valuable than the previous cash flow. A cash flow today is more valuable than an identical cash flow in the futurebecause a present flow can be invested immediately and begin earning returns, while a future flow cannot. NPV is determined by calculating the costs (negative cash flows) and benefits (positive cash flows) for each period of an investment. After the cash flow for each period is calculated, the present value (PV) of each one is achieved by discounting its future valueat a periodic rate of return (the rate of return dictated by the market). NPV is the sum of all the discounted future cash flows. Because of its simplicity, NPV is a useful tool to determine whether a project or investment will result in a net profit or a loss. A positive NPV results in profit, while a negative NPV results in a loss. The NPV measures the excess or shortfall of cash flows, in present value terms, above the cost of funds. In a theoretical situation of unlimited capital budgeting a company should pursue every investment with a positive NPV. However, in practical terms a company's capital constraints limit investments to projects with the highest NPV whose cost cash flows, or initial cash investment, do not exceed the company's capital. NPV is a central tool in discounted cash flow (DCF) analysis and is a standard method for using the time value of money to appraise long-term projects. It is widely used throughout economics, finance, and accounting. In the case when all future cash flows are positive, or incoming (such as the principal and coupon payment of a bond) the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV). NPV can be described as the \"difference amount\" between the sums of discounted cash inflows and cash outflows. It compares the present value of money today to the present value of money in the future, taking inflation and returns into account. The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or discount curve and outputs a present value, which is the current fair price. The converse process in discounted cash flow (DCF) analysis takes a sequence of cash flows and a price as input and as output the discount rate, or internal rate of return (IRR) which would yield the given price as NPV. This rate, called the yield, is widely used in bond trading. Many computer-based spreadsheet programs have built-in formulae for PV and NPV. A firm's weighted average cost of capital (after tax) is often used, but many people believe that it is appropriate to use higher discount rates to adjust for risk, opportunity cost, or other 85 CU IDOL SELF LEARNING MATERIAL (SLM)
factors. A variable discount rate with higher rates applied to cash flows occurring further along the time span might be used to reflect the yield curve premium for long-term debt. Another approach to choosing the discount rate factor is to decide the rate which the capital needed for the project could return if invested in an alternative venture. If, for example, the capital required for Project A can earn 5% elsewhere, use this discount rate in the NPV calculation to allow a direct comparison to be made between Project A and the alternative. Related to this concept is to use the firm's reinvestment rate. Re-investment rate can be defined as the rate of return for the firm's investments on average. When analysing projects in a capital constrained environment, it may be appropriate to use the reinvestment rate rather than the firm's weighted average cost of capital as the discount factor. It reflects opportunity cost of investment, rather than the possibly lower cost of capital. An NPV calculated using variable discount rates (if they are known for the duration of the investment) may better reflect the situation than one calculated from a constant discount rate for the entire investment duration. Refer to the tutorial article written by Samuel Bakerfor more detailed relationship between the NPV and the discount rate. For some professional investors, their investment funds are committed to target a specified rate of return. In such cases, that rate of return should be selected as the discount rate for the NPV calculation. In this way, a direct comparison can be made between the profitability of the project and the desired rate of return. To some extent, the selection of the discount rate is dependent on the use to which it will be put. If the intent is simply to determine whether a project will add value to the company, using the firm's weighted average cost of capital may be appropriate. If trying to decide between alternative investments in order to maximize the value of the firm, the corporate reinvestment rate would probably be a better choice. Using variable rates over time, or discounting \"guaranteed\" cash flows differently from \"at risk\" cash flows, may be a superior methodology but is seldom used in practice. Using the discount rate to adjust for risk is often difficult to do in practiceand is difficult to do well. An alternative to using discount factor to adjust for risk is to explicitly correct the cash flows for the risk elements using rNPV or a similar method, then discount at the firm's rate. 5.5 INTERNALRATE OF RETURN Internal rate of return (IRR) is a method of calculating an investment’s rate of return. The term internal refers to the fact that the calculation excludes external factors, such as the risk- free rate, inflation, the cost of capital, or financial risk. The method may be applied either ex-post or ex-ante. Applied ex-ante, the IRR is an estimate of a future annual rate of return. Applied ex-post, it measures the actual achieved investment return of a historical investment. 86 CU IDOL SELF LEARNING MATERIAL (SLM)
It is also called the discounted cash flow rate of return. The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a project zero. In other words, it is the expected compound annual rate of return that will be earned on a project or investment. In the example below, an initial investment of $50 has a 22% IRR. That is equal to earning a 22% compound annual growth rate. When calculating IRR, expected cash flows for a project or investment are given and the NPV equals zero. Put another way, the initial cash investment for the beginning period will be equal to the present value of the future cash flows of that investment. (Cost paid = present value of future cash flows, and hence, the net present value = 0). Once the internal rate of return is determined, it is typically compared to a company’s hurdle rate or cost of capital. If the IRR is greater than or equal to the cost of capital, the company would accept the project as a good investment. (That is, of course, assuming this is the sole basis for the decision. Figure 5.5: IRR In reality, there are many other quantitative and qualitative factors that are considered in an investment decision.) If the IRR is lower than the hurdle rate, then it would be rejected. The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments. IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis. IRR calculations rely on the same formula as NPV does. Keep in mind that IRR is not the actual dollar value of the project. It is the annual return that makes the NPV equal to zero. 87 CU IDOL SELF LEARNING MATERIAL (SLM)
Generally speaking, the higher an internal rate of return, the more desirable an investment is to undertake. IRR is uniform for investments of varying types and, as such, can be used to rank multiple prospective investments or projects on a relatively even basis. In general, when comparing investment options with other similar characteristics, the investment with the highest IRR probably would be considered the best. In capital planning, one popular scenario for IRR is comparing the profitability of establishing new operations with that of expanding existing operations. For example, an energy company may use IRR in deciding whether to open a new power plant or to renovate and expand an existing power plant. While both projects could add value to the company, it is likely that one will be the more logical decision as prescribed by IRR. Note that because IRR does not account for changing discount rates, it’s often not adequate for longer-term projects with discount rates that are expected to vary. IRR is also useful for corporations in evaluating stock buyback programs. Clearly, if a company allocates substantial funding to repurchasing its shares, then the analysis must show that the company’s own stock is a better investment—that is, has a higher IRR—than any other use of the funds, such as creating new outlets or acquiring other companies. Individuals can also use IRR when making financial decisions—for instance, when evaluating different insurance policies using their premiums and death benefits. The general consensus is that policies that have the same premiums and a high IRR are much more desirable. Note that life insurance has a very high IRR in the early years of policy—often more than 1,000%. It then decreases over time. This IRR is very high during the early days of the policy because if you made only one monthly premium payment and then suddenly died, your beneficiaries would still get a lump sum benefit. Another common use of IRR is in analysing investment returns. In most cases, the advertised return will assume that any interest payments or cash dividends are reinvested back into the investment. What if you don’t want to reinvest dividends but need them as income when paid? And if dividends are not assumed to be reinvested, are they paid out or are they left in cash? What is the assumed return on the cash? IRR and other assumptions are particularly important on instruments like annuities, where the cash flows can become complex. Finally, IRR is calculation used for an investment’s money-weighted rate of return (MWRR). The MWRR helps determine the rate of return needed to start with the initial investment amount factoring all of the changes to cash flows during the investment period, including sales proceeds. 5.6 PROFITABILITY INDEX The profitability index (PI), alternatively referred to as value investment ratio (VIR) or profit investment ratio (PIR), describes an index that represents the relationship between the costs and benefits of a proposed project. It is calculated as the ratio between the present value of 88 CU IDOL SELF LEARNING MATERIAL (SLM)
future expected cash flows and the initial amount invested in the project. A higher PI means that a project will be considered more attractive. The PI is helpful in ranking various projects because it lets investors quantify the value created per each investment unit. A profitability index of 1.0 is logically the lowest acceptable measure on the index, as any value lower than that number would indicate that the project's present value (PV) is less than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project. The profitability index is an appraisal technique applied to potential capital outlays. The method divides the projected capital inflow by the projected capital outflow to determine the profitability of a project. As indicated by the aforementioned formula, the profitability index uses the present value of future cash flows and the initial investment to represent the aforementioned variables. The present value of future cash flows requires the implementation of time value of money calculations. Cash flows are discounted the appropriate number of periods to equate future cash flows to current monetary levels. Discounting accounts for the idea that the value of $1 today does not equal the value of $1 received in one year because money in the present offers more earning potential via interest-bearing savings accounts, than money yet unavailable. Cash flows received further in the future are therefore considered to have a lower present value than money received closer to the present. The discounted projected cash outflows represent the initial capital outlay of a project. The initial investment required is only the cash flow required at the start of the project. All other outlays may occur at any point in the project's life, and these are factored into the calculation through the use of discounting in the numerator. These additional capital outlays may factor in benefits relating to taxation or depreciation. Because profitability index calculations cannot be negative, they consequently must be converted to positive figures before they are deemed useful. Calculations greater than 1.0 indicate the future anticipated discounted cash inflows of the project are greater than the anticipated discounted cash outflows. Calculations less than 1.0 indicate the deficit of the outflows is greater than the discounted inflows, and the project should not be accepted. Calculations that equal 1.0 bring about situations of indifference where any gains or losses from a project are minimal. When using the profitability index exclusively, calculations greater than 1.0 are ranked based on the highest calculation. When limited capital is available, and projects are mutually exclusive, the project with the highest profitability index is to be accepted as it indicates the project with the most productive use of limited capital. The profitability index is also called the benefit-cost ratio for this reason. Although some projects result in higher net present values, those projects may be passed over because they do not have the highest profitability index and do not represent the most beneficial usage of company assets.The Profitability 89 CU IDOL SELF LEARNING MATERIAL (SLM)
Index (PI), also known as Value Investment Ratio (VIR), expresses the relationship between the discounted inflows and invested amounts, or costs, for a given project. We can think of PI as the discounted value a project returns for one unit of currency invested. Where “PV of future cash flows” is the present value of cash flows, starting from period 1 until the end of the project, and NPV denotes the Net Present Value. Note that PI results are based on estimates rather than precise numbers taken from a firm’s major financial statements. Discounted cash flows may unexpectedly differ in the future, which immediately makes us question the predictive accuracy of both PI and NPV figures as stand-alone metrics. To build solid decision-making criteria for investments, we often combine it with other ratios. 5.7 PROJECT EVALUATION Common rationales for conducting an evaluation are Response to demands for accountability. Demonstration of effective, efficient and equitable use of financial and other resources. Recognition of actual changes and progress made. Identification of success factors, need for improvement or where expected outcomes are unrealistic. Validation for project staff and partners that desired outcomes are being achieved. The project planning stage is the best time to identify desired outcomes and how they will be measured. This will guide future planning, as well as ensure that the data required to measure success is available when the time comes to evaluate the project. Project evaluation assumes a comprehensive point of view looking at the project as a package. Success or failure is determined by the achievements of the whole project measured against its objectives. The evaluation process results in the refinement of policy and implementation. However, it is not yet institutionalized in most government planning agencies. Effective project evaluation requires that evaluation standards, criteria and indicators are established during the early stages of the project planning process. The identification and collection of baseline data should entail a preliminary evaluation framework with the following specifications: 1. Identification of evaluation criteria: these are key result areas (e.g. cost and budget limits, productivity output targets, time schedule) specified in measurable terms; 2. Selection of evaluation techniques: apart from the cost benefit analysis, the use of control groups for comparative analysis, baseline measures, sampling and various data gathering methods such as field surveys, FGD, questionnaires and interviews may be chosen. 3. Time Schedule: in the case where the project results are not evident immediately after project completion, project evaluation should be scheduled; 4. budget for evaluation: the acquisition and efficient utilization of needed resources for evaluation must be planned for; 5. Organization and staff 90 CU IDOL SELF LEARNING MATERIAL (SLM)
requirements: the size of the evaluation team, its qualifications, the reporting relationships and access to project information and staff should be outlined; 6. Participation of beneficiaries: the evaluation process should be designed in such a 217 7. Way that it allows the intended beneficiaries to assume a vital role in it. Cost benefit analysis, as main evaluation technique, attempts to determine what success the country will have towards achieving national objectives by pursuing a particular strategy against opportunities lost because it has committed its measure if the computations made for societal/ macroeconomic costs and benefits done in the feasibility and appraisal process reflect what actually occurred. This could require a recompilation or remodification of societal / macroeconomic costs and benefits in the light of changing government priorities. Design, monitoring and evaluation are all part of results-based project management. The key idea underlying project cycle management, and specifically monitoring and evaluation, is to help those responsible for managing the resources and activities of a project to enhance development results along a continuum, from short-term to long-term. Managing for impact means steering project intervention towards sustainable, longer-term impact along a plausibly linked chain of results: inputs produce outputs that engender outcomes that contribute to impact. The prime reason why the ILO engages in technical cooperation projects and why it receives funding from donors is to have a positive impact in relation to policies, processes, regulations, behaviour, and, ultimately, on individual lives. Outcomes are defined as medium-term effects of project outputs. Outcomes are observable changes that can be linked to project interventions. Usually, they are the achievements of the project partners. They are logically linked to the intended impact. Outcomes are the results that link to the immediate objectives as described in the project document. Impact is defined as the positive and negative, primary and secondary long-term effects produced by a development intervention, directly or indirectly, intended or unintended. Impact is the result that links to the development objective as described in the project document. It is often only detectable after several years and usually not attained during the life cycle of one project. For this reason, there is a need to plan for impact, recognizing that the project will likely achieve outcomes. A project is accountable for achieving outcomes and contributing to development impact. Since the achievement of broad, long-term development changes depends on many factors, it is usually not possible to attribute impact to one project. All outcomes of a project should contribute to the intended impact. Along the chain of results of a project, the relative influence of the project decreases while the relative influence of the project partners increases as they develop capacity and take over ownership of the project. Only when the project is gradually handed over to the local partners can it achieve broader, longterm, sustainable impact. This process also implies a shift in responsibilities during the course of the project. Golden rule During the course of the project, the local partners should ideally take on increasing responsibility for converting the project’s Evaluation assesses how well planning and managing for future outputs into outcomes. impact is being done during the project cycle. 91 CU IDOL SELF LEARNING MATERIAL (SLM)
Because projects are collaborative efforts, partners have co-responsibility for achieving outcomes and, ultimately, impact. During the course of the project, the local partners ideally take on increasing responsibility for converting the project’s outputs into outcomes and, often after the project itself has ended, for making the outcomes contribute to broader, long-term impacts (for example, passing and implementing a new legislation frequently takes much longer than the life of a project and is left in the hands of the national partners). Project management is accountable for facilitating this transition process. It is therefore important that an exit strategy is negotiated at project start-up. 5.7.1 Independent A project can only achieve sustainability if the local partners take ownership for the project during the design and implementation processes and after completion of the project. They should also take an active part in the accompanying learning process, including evaluation. A participatory evaluation involving the local partners and the beneficiaries strengthens their capacities and ownership of the project and thereby increases a project’s sustainability. It also assesses how a project is motivating and supporting national constituents and other partners to meet the decent work-related needs of the intended beneficiaries. Participatory learning is central to good project management (design, implementation, monitoring and evaluation). Information on project activities, including personal accounts of people’s experiences, should be collected to facilitate focused management. The project management team and the evaluation manager should ask. 5.7.2 Replacement The Replacements were an American rock band formed in Minneapolis, Minnesota, in 1979. Initially a punk rock band, they are considered one of the pioneers of alternative rock. The band was composed of the guitarist and vocalist Paul Westerberg, guitarist Bob Stinson, bass guitarist Tommy Stinson and drummer Chris Mars for most of its career. Following several acclaimed albums, including Let It Be and Tim, Bob Stinson was kicked out of the band in 1986, and Slim Dunlap joined as lead guitarist. Steve Foley replaced Mars in 1990. Towards the end of the band's career, Westerberg exerted more control over the creative output. The group disbanded in 1991, with the members eventually pursuing various projects. A reunion was announced on October 3, 2012. The band is referred to by their nickname \"The 'Mats\" by fans, which originated as a truncation of \"The Placemats,\" a mispronunciation of their name. The Replacements' music was influenced by rock artists such as the Rolling Stones, the Beatles, Faces, Big Star, Slade, Bad finger, Creedence Clearwater Revival, and Bob Dylan as well as punk rock bands such as the Ramones, the New York Dolls, the Bouzouks, the Damned, and the Sex Pistols. Unlike many of their underground contemporaries, the Replacements played \"heart-on-the-sleeve\"rock songs that combined Westerberg's \"raw- throated adolescent howl\"with self-deprecating lyrics. The Replacements were a notoriously 92 CU IDOL SELF LEARNING MATERIAL (SLM)
wayward live act, often performing under the influence of alcohol and playing fragments of covers instead of their own material. The Replacements' history began in Minneapolis in 1978, when nineteen-year-old Bob Stinson gave his eleven-year-old brother Tommy Stinson a bass guitar to keep him off the streets. That year Bob met Mars, a high school dropout. With Mars playing guitar and then switching to drums, the trio called themselves \"Dog breath\" and began covering songs by Aerosmith, Ted Nugent and Yeswithout a singer. One day as Westerberg, a janitor in U.S. Senator David Durenberger's officewas walking home from workhe heard a band playing in the Stinson’s' house. After being impressed by the band's performance, Westerberg regularly listened in after work. Mars knew Westerberg and invited him over to jam. Westerberg was unaware Mars drummed in Dog breath. Dog breath auditioned several vocalists, including a hippie who read lyrics off a sheet. The band eventually found a vocalist, but Westerberg wanted to be the singer and took him aside one day to say, \"The band doesn't like you.\" The vocalist soon left and Westerberg replaced him. Before Westerberg joined the band, Dog breath often drank and took various drugs during rehearsals, playing songs as an afterthought. In contrast to the rest of the band, the relatively disciplined Westerberg appeared at rehearsals in neat clothes and insisted on practicing songs until he was happy with them. \"They didn't even know what punk was. They didn't like punk. Chris had hair down to his shoulders,\" Westerberg chortled to an interviewer. But after the band members discovered first-generation English punk bands like the Clash, the Jam, the Damned and the Bouzouks, Dog breath changed its name to the Impediments and played a drunken performance without Tommy Stinson at a church hall gig in June 1980. After being banned from the venue for disorderly behaviour, they changed the name to the Replacements. In an unpublished memoir, Mars later explained the band's choice of name: \"Like maybe the main act doesn't show, and instead the crowd has to settle for an earful of us dirtbags. It seemed to sit just right with us, accurately describing our collective 'secondary' social esteem. The band soon recorded a four-song demo tape in Mars's basementand handed it to Peter Jespersen in May 1980. Jespersen was the manager of Oar Folkjokeopus, a punk rock record store in Minneapolisand had also founded Twin/Tone Records with Paul Stark (a local recording engineer) and Charley Hallman. Westerberg originally handed in the tape to see if the band could perform at Jay's Longhorn Bar, a local venue where Jespersen worked as a disc jockey. He eavesdropped as Jespersen put in the tape, only to run away as soon as the first song, \"Raised in the City\", played. Jespersen played the song again and again. \"If I've ever had a magic moment in my life, it was popping that tape in\", said Jespersen. \"I didn't even get through the first song before I thought my head was going to explode\". Jesperson called Westerberg the next day, asking, \"So do you want to do a single or an album?\"With the agreement of Stark and the rest of the band, the Replacements signed with 93 CU IDOL SELF LEARNING MATERIAL (SLM)
Twin/Tone Records in 1980. Jesperson's support of the band was welcomed, and they asked him to be their manager after their second show. Later that summer they played at the Longhorn on a Wednesday \"New Band Night\". They also played several club gigs to almost empty rooms. When they finished a song, apart from the low hum of conversation, the band would hear Jesperson's loud whistle and fast clapping. \"His enthusiasm kept us going at times, definitely,\" Mars later said. \"His vision, his faith in the band was a binding force.\"After the Replacements signed with Twin/Tone, Westerberg began to write new songs and soon had a whole album's worth of material. Mere weeks after their live debut, the band felt ready to record the album. Jesperson chose Blackberry Way, an eight-track home studio in Minneapolis. However, as the band had no clout there, time spent in the studio was intermittent, and it took about six months to record the album. Although not important at the time, Twin/Tone could not afford to release the album until August 1981. Because they were suspicious of the music business in general, the Replacements had not signed a written contract with Twin/Tone Records. When the band's first album, Sorry Ma, Forgot to Take Out the Trash, was released in August 1981, it received positive reviews in local fanzines. Option's Blake Gumprecht wrote, \"Westerberg has the ability to make you feel like you're right in the car with him, alongside him at the door, drinking from the same bottle.\"The album contained the band's first single, \"I'm in Trouble\", Westerberg's \"first truly good song\". Sorry Ma included the song, \"Somethin to Dü\", a homage to another Minneapolis punk band, Hüsker Dü. The Replacements had a friendly rivalry with the band, which started when Twin/Tone chose the Replacements over Hüsker Düand Hüsker Dü landed an opening slot at a Johnny Thunders gig that the Replacements had wanted. Hüsker Dü also influenced the band's music. The Replacements began playing faster and became more influenced by hardcore punk. Despite this, the band did not feel part of the hardcore scene. As Mars later stated, \"We were confused about what we were.\" 5.7.3 Mutually Exclusive Projects In much of our discussion so far, we have assessed projects independently of other projects that the firm already has or might have in the future. Disney, for instance, was able to look at Rio Disney standing alone and analyse whether it was a good or bad investment. In reality, projects at most firms have interdependencies with and consequences for other projects. Disney may be able to increase both movie and merchandise revenues because of the new theme park in Brazil and may face higher advertising expenditures because of its Latin American expansion. In this chapter, we examine a number of scenarios in which the consideration of one project affects other projects. We start with the most extreme case, whereby investing in one project leads to the rejection of one or more other projects; this is the case when firms have to choose between mutually exclusive investments. We then consider a less extreme scenario, in which a firm with constraints on how much capital it can raise considers a new project. Accepting this project reduces the capital available for other 94 CU IDOL SELF LEARNING MATERIAL (SLM)
projects that the firm considers later in the period and thus can affect their acceptance; this is the case of capital rationing. Projects can create costs for existing investments by using shared resources or excess capacity, and we consider these side costs next. Projects sometimes generate benefits for other projects, and we analyse how to bring these benefits into the analysis. In the third part of the chapter, we introduce the notion that projects often have options embedded in them, and ignoring these options can result in poor project decisions. In the final part of the chapter, we turn from looking at new investments to the existing investments of the company. We consider how we can extend the techniques used to analyse new investments can be used to do post-mortems of existing investments as well as analysing whether to continue or terminate an existing investment. We also look at how best to assess the portfolio of existing investments on a firm’s books, using both cash flows and accounting earnings. Finally, we step away from investment and capital budgeting techniques and ask a more fundamental question. Where do good investments come from? Put another way, what are the qualities that a company or its management possess that allow it to generate value from its investments. Projects are mutually exclusive when accepting one investment means rejecting others, even though the latter standing alone may pass muster as good investments, i.e. have a positive NPV and a high IRR. There are two reasons for the loss of project independence. In the first, the firm may face a capital rationing constraint, where not all good projects can be accepted and choices have to be made across good investments. In the second, projects may be mutually exclusive because they serve the same purpose and choosing one makes the other redundant. This is the case when the owner of a commercial building is choosing among a number of different air conditioning or heating systems for the building. This is also the case when investments provide alternative approaches to the future; a firm that has to choose between a “high-margin, low volume” strategy and a “low-margin, high-volume” strategy for a product can choose only one of the two. We will begin this section by looking at why firms may face capital rationing and how to choose between investments, when faced with this constraint. We will then move on to look at projects that are mutually exclusive because they provide alternatives to the same ends. In chapter 5, in our analysis of independent projects, we assumed that investing capital in a good project has no effect on other concurrent or subsequent projects that the firm may consider. Implicitly, we assume that firms with good investment prospects (with positive NPV) can raise capital from financial markets, at a fair price, and without paying transaction costs. In reality, however, it is possible that the capital required to finance a project can cause managers to reject other good projects because the firm has limited access to capital. Capital rationing occurs when a firm is unable to invest in projects that earn returns greater than the hurdle rates. Firms may face capital rationing constraints because they do not have either the capital on hand or the capacity and willingness to raise the capital needed to finance these 95 CU IDOL SELF LEARNING MATERIAL (SLM)
projects. This implies that the firm does not have the capital to accept the positive NPV projects available. 5.8 CAPITAL BUDGETING UNDERCONSTRAINTS(CAPITAL RATIONING) Capital rationing is the act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on specific portions of a budget. For example, suppose ABC Corp. has a cost of capital of 10% but that the company has undertaken too many projects, many of which are incomplete. This causes the company's actual return on investment to drop well below the 10% level. As a result, management decides to place a cap on the number of new projects by raising the cost of capital for these new projects to 15%. Starting fewer new projects would give the company more time and resources to complete existing projects. Capital rationing affects a company's bottom line and dictates the amount it can pay out in dividends and reward shareholders. Using a real-world example, Cummins, Inc., a publicly- traded company that provides natural gas engines and related technologies, needs to be very cognizant of its capital rationing and how it affects its share price. As of March 2016, the company's board of directors has decided to allocate its capital in such a way that it provides investors with a dividend yield near 4%. The company has rationed its capital so that its existing investments allow it to pay out increasing dividends to its shareholders over the long-term. However, shareholders have come to expect increasing dividend pay-outs, and any reduction in dividends can hurt its share price. Therefore, the company needs to ration its capital and invest in projects efficiently, so it increases its bottom line, allowing it to either increase its dividend yield or increase its actual dividend per share. Capital rationing is a situation where a constraint or budget ceiling is placed on the total size of capital expenditures during a particular period. Often firms draw up their capital budget under the assumption that the availability of financial resources is limited. Capital rationing refers to the selection of the investment proposals in a situation of constraint on availability of capital funds, to maximize the wealth of the company by selecting those projects which will maximize overall NPV of the concern. In capital rationing situation a company may have to forego some of the projects whose IRR is above the overall cost of the firm due to ceiling on budget allocation for the projects which are eligible for capital investment. Capital rationing refers to a situation where a company cannot undertake all positive NPV projects it has identified because of shortage of capital. 96 CU IDOL SELF LEARNING MATERIAL (SLM)
Under this situation, a decision maker is compelled to reject some of the viable projects having positive net present value because of shortage of funds. It is known as a situation involving capital rationing. 5.9 SUMMARY Under the profitability index ranking projects D, A and G has scored the first three ranks with a total fund’s commitment of Rs. 350 lakhs. Obviously projects C, B and E which are next in the sequence of decreasing PI, cannot be selected because they cannot be accommodated from the balance of funds i.e., Rs. 50 lakhs (Rs. 400 lakhs – Rs. 350 lakhs) available for investment. Hence project F is selected to complete the optimum set. The sum of NPVs of projects D, A, G and F amounts to Rs. 368.58 lakhs. As seem from the above illustration, the decision regarding choice of set of projects which best meets the corporate financial objective in a capital rationing situation depends upon the criterion used for selection. The present value of the returns to the enterprise is, in general, different for each of the combinations recommended by using different criteria. There is no guarantee that one particular criterion will always give a solution by which the present value of the returns will be more than that for the combination obtained by using other criteria. In some cases NPV may result in the best solution. In some others, IRR may give the best combination of projects. While in still others, the set of projects chosen by using PI as the criterion may help maximize the net returns to the enterprise. Sometimes two or even all the three criteria may result in the same solution, while at other times the solutions may be totally different, especially when the number of viable projects is large. Contrary to serial replacement, parallel replacement problems require a decision maker to evaluate a portfolio of replacement decisions in each time period because of economic interdependencies among assets. In this paper, we describe a parallel replacement problem in which the economic interdependence among assets is caused by capital rationing. The research was motivated by the experience gained from a vehicle fleet replacement study where solutions to serial replacement problems could not be implemented since they violated management's budget plan. When firms use budgets to control their expenditures, competition for the limited funds creates interdependent problems. In this paper, we formulate the problem as a zero-one integer program and develop a branch-and-bound algorithm based on Lagrangian relaxation methodology. A multiplier adjustment method is developed to solve one Lagrangian dual. Capital rationing is a technique of selecting the projects that maximize the firm’s value when the capital infusion is restricted. Two types of capital 97 CU IDOL SELF LEARNING MATERIAL (SLM)
rationing are soft and hard capital rationing. The calculation and method prescribe arranging projects in descending order of their profitability based on IRR, NPV, and PI and selecting the optimal combination. Capital rationing decisions by managers are made to attain the optimum utilization of the available capital. It is not wrong to say that all the investments with positive NPV should be accepted but at the same time, the ground reality prevails that the availability of capital is limited. The option of achieving the best is ruled out and therefore, the rational approach is to make the most out of the on-hand capital. Capital rationing implies investment in projects within limited capital resources. It is the process of allocating money among different projects, where the amount of money to be invested is limited. Companies ration their capital and investments among different opportunities as countries use rationing of food. In case of capital rationing, the company may not be able to invest in all profitable projects. Therefore, the key to decision making under capital rationing is to select those projects that maximize the total net present value given the capital budget limit. Capital rationing provides a practical approach to the capital budgeting because in real life situations, the possibility of limited financial resources is obvious. In capital rationing the most important criterion for investment decision is neither the NPV nor IRR, rather it is “percent budget utilization.” In other words, what percentage of the total money to be invested is mobilized? Money is always in short supply and it is only the available amount of money that a company has to spend in different projects. Therefore, it is important to mobilize as much money as possible in the projects on which IRR is greater than risk free rate for maximizing the return on your portfolio. It is caused by internal constraints on account of policy of the management. For example, it may be decided not to obtain additional funds by incurring debt as a part of firm’s conservative financial policy. Management may fix a limit to the amount of funds to be invested by the managers in specific projects. As a result of these restrictions, some profitable projects may have to be forgone because of the lack of funds though the NPV rule works well with shareholders here. Internal capital rationing is generally used as a means of financial controls for checking the performance of divisional managers by putting upper limits to their capital expenditures. Similarly, a growing company may put investment limits to grow at steady pace and avoid major strains and organizational problems. 5.10 KEYWORDS Callable Bonds: Bonds that are redeemable by the issuer prior to the specified maturity date at the specified price at or above par. 98 CU IDOL SELF LEARNING MATERIAL (SLM)
Capital Budget: The annual request for capital project appropriations. Project appropriations are normally only for that amount necessary to enable the implementation of the first year of the capital program expenditure plan. However, if contracted work is scheduled that will extend beyond the upcoming fiscal year, the entire contract appropriation is required, even if the work and expenditures will be spread over two or more fiscal years. Capital Gain: An increase in the value of an asset. Capitalization: The process by which a stream of tax liabilities becomes incorporated into the price of an asset. Capital Improvements Program (CIP): The comprehensive presentation of capital project expenditure estimates; funding requirements; capital budget requests; and program data for the construction of all public buildings, roads, and other facilities planned by county agencies usually over a five or six-year period. The CIP constitutes both a fiscal plan for proposed project expenditures and funding, and includes the annual capital budget for appropriations to fund project activity during the first fiscal year of the plan. Capital Lease: A long-term rental agreement that transfers substantial rights and obligations for the use of an asset to the lessee and, generally, ownership at the end of the lease. Similar to an instalment purchase, a Capital Lease may also represent the purchase of a fixed asset and the incidence of a long-term liability. 5.11 LEARNING ACTIVITY 1. Create a survey on accounting rate of return. ___________________________________________________________________________ ___________________________________________________________________________ 2. Create a session on net present value. ___________________________________________________________________________ ___________________________________________________________________________ 5.12 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Define net present value? 2. Write the full form of NPV? 3. Write the full form of ARR? 99 CU IDOL SELF LEARNING MATERIAL (SLM)
4. Define accounting rate of return? 5. What is profitability index? Long Questions 1. Explain the advantages of net present value. 2. Elaborate the disadvantages of net present value. 3. Explain the advantages of accounting rate of return. 4. Discuss on the capital budgeting under constraints (capital rationing). 5. Illustrate the concept of project evaluation. B. Multiple Choice Questions 1. Which decision involves a determination of the total amount of assets needed, the composition of the assets, and whether any assets need to be reduced, eliminated, or replaced? a. Asset management b. Financing c. Investment d. Accounting 2. What is the par value of the stocks and bonds outstanding is termed as? a. Capitalization b. Multiplication. c. Outstanding income d. Earnings before interest and taxes 3. According to the text's authors, which is the most important of the three financial management decisions? a. Asset management decision b. Financing decision c. Investment decision d. Accounting decision 4. Which decision involves efficiently managing the assets on the balance sheet on a day-to-day basis, especially current assets? a. Asset management b. Financing c. Investment 100 CU IDOL SELF LEARNING MATERIAL (SLM)
Search
Read the Text Version
- 1
- 2
- 3
- 4
- 5
- 6
- 7
- 8
- 9
- 10
- 11
- 12
- 13
- 14
- 15
- 16
- 17
- 18
- 19
- 20
- 21
- 22
- 23
- 24
- 25
- 26
- 27
- 28
- 29
- 30
- 31
- 32
- 33
- 34
- 35
- 36
- 37
- 38
- 39
- 40
- 41
- 42
- 43
- 44
- 45
- 46
- 47
- 48
- 49
- 50
- 51
- 52
- 53
- 54
- 55
- 56
- 57
- 58
- 59
- 60
- 61
- 62
- 63
- 64
- 65
- 66
- 67
- 68
- 69
- 70
- 71
- 72
- 73
- 74
- 75
- 76
- 77
- 78
- 79
- 80
- 81
- 82
- 83
- 84
- 85
- 86
- 87
- 88
- 89
- 90
- 91
- 92
- 93
- 94
- 95
- 96
- 97
- 98
- 99
- 100
- 101
- 102
- 103
- 104
- 105
- 106
- 107
- 108
- 109
- 110
- 111
- 112
- 113
- 114
- 115
- 116
- 117
- 118
- 119
- 120
- 121
- 122
- 123
- 124
- 125
- 126
- 127
- 128
- 129
- 130
- 131
- 132
- 133
- 134
- 135
- 136
- 137
- 138
- 139
- 140
- 141
- 142
- 143
- 144
- 145
- 146
- 147
- 148
- 149
- 150
- 151
- 152
- 153
- 154
- 155
- 156
- 157
- 158
- 159
- 160
- 161
- 162
- 163
- 164
- 165
- 166
- 167
- 168
- 169
- 170
- 171
- 172
- 173
- 174
- 175
- 176
- 177
- 178
- 179
- 180
- 181
- 182
- 183
- 184
- 185
- 186
- 187
- 188
- 189
- 190
- 191
- 192
- 193
- 194
- 195
- 196
- 197
- 198
- 199
- 200
- 201
- 202
- 203
- 204
- 205
- 206
- 207
- 208
- 209
- 210
- 211
- 212
- 213
- 214
- 215
- 216
- 217
- 218
- 219
- 220
- 221
- 222
- 223
- 224
- 225
- 226
- 227
- 228
- 229
- 230
- 231
- 232
- 233
- 234
