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Answer of Q.N.1.(a)
The term capital budgeting means planning for capital assets. Capital budgeting decision means the decision as to whether or not to invest in long-term projects such as setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside and so on. It includes the financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company for the purpose to choose the best out of the various alternatives. The finance manager has various tools and techniques by means of which he assists the management in taking a proper capital budgeting decision. Capital budgeting decision is thus, evaluation of expenditure decisions that involve current outlays but are likely to produce benefits over a period of time longer than one year. The benefit that arises from capital budgeting decision may be either in the form of increased revenues or reduced costs. Such decision requires evaluation of the proposed project to forecast likely or expected return from the project and determine whether return from the project is adequate. Also as business is a part of society, it is its moral responsibility to undertake only those projects that are socially desirable.
At each point of time, business manager, has to evaluate a number of proposals as regards various projects where he can invest money. He compares and evaluates projects and decides which one to take up and which to reject. Apart from financial considerations, there are many other factors considered while taking a capital budgeting decision. At times a project may be undertaken only to establish foothold in the market or for better welfare of the society as a whole or of the business or for increasing the safety and security of workers, or due to requirements of law or because of emotional reasons for instance, many industrial sector projects are taken up at home towns even if better locations are available. The major consideration in taking a capital budgeting decision is to evaluate its returns as compared to its investments. Evaluation of capital budgeting proposals have two dimensions i.e. profitability and risk, which are directly related. Higher the profitability, higher would be the risk and vice versa. Thus, the finance manager has to strike a balance between profitability and risk.
Following are some of the techniques used to evaluate financial aspects of a project :
(1)UNADJUSTED RATE OF RETURN OR ACCOUNTING RATE OF RETURN:
(a) On the basis of own funds invested:
Profit after depreciation and after interest on borrowed funds
Own funds invested
This approach assumes that borrowed funds are not key factors. We can raise any amount of borrowed funds that we need. Hence, the return should be maximized on the basis of own funds invested. Return is available to own funds (owners or shareholders of the business) only after paying interest. Hence, we take the profit after interest. If tax is considered, the profit (considered in the above formula) should be taken as post- tax.
(b) On the basis of total funds invested:
Profit after depreciation but before interest
Total funds invested
This approach assumes that borrowed funds are key factors. We can raise only limited amount of borrowed funds. Hence, the return should be maximized on the basis of own as well borrowed funds invested i.e. on the basis of total funds.
Total return available on total funds (“owners or shareholders” as well as 4 “suppliers of borrowed funds”) means EBIT i.e. before paying interest. Hence, we take the profit before interest. If tax is considered, the profit (considered in the above formula) should be taken as “before interest post- tax.” This is calculated as follows: [EBIT – Interest] – Tax rate [EBIT – Interest] + interest. There is an alternative approach under which, instead of total funds, we take Average total funds invested.
Generally we calculate rates of return for capital expenditure decisions on the basis of own funds assuming that borrowed funds are available as per requirements. If borrowed funds are available in limited amount only, we calculate rate of return on the basis of total funds invested.
(2) PAY BACK PERIOD (PBP) METHOD / APPROACH
It is one of the simplest method to calculate period within which entire cost of project would be completely recovered. It is the period within which total cash inflows from project would be equal to total cash outflow of project, cash inflow means profit after tax but before depreciation.This method of evaluating proposals for capital budgeting is simple and easy to understand, it has an advantage of making clear that it has no profit on any project until the payback period is over i.e. until capital invested is recovered. When funds are limited, they may be made to do more by selecting projects having shorter payback periods. This method is particularly suitable in the case of industries where risk of technological services is very high. In such industries, only those projects having a shorter payback period should be financed since changing technology would make the projects totally obsolete, before all costs are recovered. Pay Back period is calculated with the help of the following formula:
Payback Period = Initial Investments / Annual cash inflow
(3) NET PRESENT VALUE METHOD
The best method for evaluation of investment proposal is net present value method or discounted cash flow technique. This method takes into account the time value of money. The net present value of investment proposal may be defined as sum of the present values of all cash inflows as reduced by the present values of all cash outflows associated with the proposal. Each project involves certain investments and commitment of cash at certain point of time. This is known as cash outflows. Cash inflows can be calculated by adding depreciation to profit after tax arising out of that particular project.
NPV = CF0/(1+K)0 + CF1/(1+K)1.............................+ CFn/(1+K)n
= (t=0 to n) CFt/(1+K)t
NPV = Net present value of a project
CF0 = Cash outflows at the time 0(zero).
CFt = Cash flows at the end of year t(t = 0 to n) i.e. the difference between cash inflow and outflow).
K = Discount rate
n = Life of the project
If NPV is positive the project may be taken up. If NPV is zero, project may be taken up only if non-financial benefits are there. If NPV is negative project may not be taken up.
(4) PROFITABLITY METHOD:
Present value of inflow
Profitability index (PI) = —————————-----
PV of outflow
If PI is more than one the project may be taken. If PI is one project may be taken up only on the basis of non-financial considerations. If PI is less than one the project may not be taken up. It is also called benefit cost ratio or desirability Factor.
(5) INTERNAL RATE OF RETURN:
IRR is the rate of return on funds employed; it is calculated on the basis of discounted cash flow approach. It is inclusive of cost of capital. For example, cost of capital is 10% and IRR is 15%, it means the total return on the funds employed is 15%; out of which 10% is to meet the cost of capital and the balance it is extra profit over and above cost of capital. IRR is that discounting rate at which NPV of a project is Zero. Hence,
i. If NPV = 0 or PI = 1, than IRR is equal to discounting.
ii. If NPV is greater than zero or if PI is greater than one, IRR is greater than discounting rate.
iii. If NPV is less than zero or PI is less than one, than IRR is less than discounting rate.
Answer of Q.N.1.(b)
Calulation of Net Present Value of the Project
Cash Inflow (Rs. In Lakhs)
Discounting Factor @ 20%
Present value of cash inflow(Rs. In Lakhs)
Total of Present value of cash inflow
Less: Present Value of cash Outflow (Investment)
Net Present Value
Answer of Q.N.4. (a)
Economic Order Quantity Click here to Download
Answer of Q.N.4. (b)
Calculation of operating Leverage
Sales @ Rs. 400 per unit
Less: Variable Cost @ Rs. 75
Less: Fixed Costs
Earnings Before Interest and Tax (EBIT)
Operating Leverage (Contribution / EBIT)
Answer of Q.N. 5(a).
Financing and investment are two major decision areas in a firm. In the financing decision the manager is concerned with determining the best financing mix or capital structure for his firm. Capital structure could have two effects. First, firms of the same risk class could possibly have higher cost of capital with higher leverage. Second, capital structure may affect the valuation of the firm, with more leveraged firms, being riskier, being valued lower than less leveraged firms. If we consider that the manager of a firm has the shareholders' wealth maximisation as his objective, then capital structure is an important decision, for it could lead to an optimal financing mix which maximises the market price per share of the firm.
A finance manager for procurement of funds, is required to select such a finance mix or capital structure that maximises shareholders wealth. For designing optimum capital structure he is required to select such a mix of sources of finance, so that the overall cost of capital is minimum. Capital structure refers to the mix of sources from where long term funds required by a business may be raised i.e. what should be the proportion of equity share capital, preference share capital, internal sources, debentures and other sources of funds in total amount of capital which an undertaking may raise for establishing its business.
The 3 major considerations evident in capital structure planning are risk, cost and control, they assist the management in determining the proportion of funds to be raised from various sources. The finance manager attempts to design the capital structure in a manner, that his risk and cost are least and there is least dilution of control from the existing management. There are also subsidiary factors as, marketability of the issue, maneuverability and flexibility of capital structure and timing of raising funds. Structuring capital, is a shrewd financial management decision and is something that makes or mars the fortunes of the company. The factors involved in it are as follows :
1) Risk : Risks are of 2 kinds viz. financial and business risk. Financial risk is of 2 kinds as below :
i) Risk of cash insolvency : As a business raises more debt, its risk of cash insolvency increases, as the higher proportion of debt in capital structure increases the commitments of the company with regard to fixed charges. i.e. a company stands committed to pay a higher amount of interest irrespective of the fact whether or not it has cash. And the possibility that the supplier of funds may withdraw funds at any point of time.
Thus, long term creditors may have to be paid back in installments, even if sufficient cash to do so does not exist. Such risk is absent in case of equity shares.
ii) Risk of variation in the expected earnings available to equity share-holders : In case a firm has a higher debt content in capital structure, the risk of variations in expected earnings available to equity shareholders would be higher; due to trading on equity. There is a lower probability that equity shareholders get a stable dividend if, the debt content is high in capital structure as the financial leverage works both ways i.e. it enhances shareholders' returns by a high magnitude or reduces it depending on whether the return on investment is higher or lower than the interest rate. In other words, there is relative dispersion of expected earnings available to equity shareholders, that would be greater if capital structure of a firm has a higher debt content.
The financial risk involved in various sources of funds may be understood with the help of debentures. A company has to pay interest charges on debentures even in case of absence of profits. Even the principal sum has to be repaid under the stipulated agreement. The debenture holders have a charge against the company's assets and thus, they can enforce a sale of assets in case of company's failure to meet its contractual obligations. Debentures also increase the risk of variation in expected earnings available to equity shareholders through leverage effect i.e. if return on investment remains higher than interest rate, shareholders get a high return and vice versa. As compared to debentures, preference shares entail a slightly lower risk for the company, as the payment of dividends on such shares is contingent upon the earning of profits by the company. Even in case of cumulative preference shares, dividends are to be paid only in the year in which company earns profits. Even, their repayment is made only if they are redeemable and after a stipulated period. However, preference shares increase the variations in expected earnings available to equity shareholders. From the company's view point, equity shares are least risky, as a company does not repay equity share capital except on its liquidation and may not declare dividends for years. Thus, as seen here, financial risk encompasses the volatility of earnings available to equity shareholders as also, the probability of cash insolvency.
2) Cost of capital : Cost is an important consideration in capital structure decisions and it is obvious that a business should be atleast capable of earning enough revenue to meet its cost of capital and also finance its growth. Thus, along with risk, the finance manager has to consider the cost of capital factor for determination of the capital structure.
3) Control : Along with cost and risk factors, the control aspect is also an important factor for capital structure planning. When a company issues equity shares, it automatically dilutes the controlling interest of present owners. In the same manner, preference shareholders can have voting rights and thereby affect the composition of Board of directors, if dividends are not paid on such shares for 2 consecutive years. Financial institutions normally stipulate that they shall have one or more directors on the board. Thus, when management agrees to raise loans from financial institutions, by implication it agrees to forego a part of its control over the company. It is thus, obvious that decisions concerning capital structure are taken after keeping the control factor in view.
4) Trading on equity : A company may raise funds by issue of shares or by borrowings, carrying a fixed rate of interest that is payable irrespective of the fact whether or not there is a profit. In case of ROI the total capital employed i.e. shareholders' funds plus long term borrowings, is more than the rate of interest on borrowed funds or rate of dividend on preference shares, the company is said to trade on equity. It is the finance manager's main objective to see that the return and overall wealth of the company both are maximised, and it is to be kept in view while deciding on the sources of finance. Thus, the effect of each proposed method of new finance on EPS is to be carefully analysed. This, thus, helps in deciding whether funds should be raised by internal equity or by borrowings.
5) Corporate taxation : Under the Income tax laws, dividend on shares is not deductible while interest paid on borrowed capital is allowed as deduction. Cost of raising finance through borrowings is deductible in the year in which it is incurred. If it is incurred during the pre-commencement period, it is to be capitalised. Cost of share issue is allowed as deduction. Owing to such provisions, corporate taxation, plays an important role in determination of the choice between different sources of financing.
6) Government Policies : Government policies is a major factor in determining capital structure. For instance, a change in the lending policies of financial institutions would mean a complete change in the financial pattern followed by companies.
7) Legal requirements : The finance manager has to keep in view the legal requirements at the time of deciding as regards the capital structure of the company.
8) Marketability : To obtain a balanced capital structure, it is necessary to consider the company's ability to market corporate securities.
9) Flexibility : It refers to the capacity of the business and its management to adjust to expected and unexpected changes in circumstances. In other words, the management would like to have a capital structure providing maximum freedom to changes at all times.
10) Size of the company : Small companies rely heavily on owner's funds while large companies are usually considered, to be less risky by investors and thus, they can issue different types of securities.
Answer of Q.N. 5(b)
Buy-Back of Shares
Buy-back means the repurchase of its own shares by the company. When a company has substantial cash resources, it may like to buy its own shares from the market, particularly when the prevailing rate of its shares in the market is much lower that the book or what the company perceives to be its true value. This is known as buy back of shares. Buy back procedure thus enables a company to go back to the holders of its shares and offers to purchase from them the shares they hold. The shares thus bought back have to be cancelled.
There are several reasons why a company would opt for repurchase of its own shares:
1. Tax efficient way to return investor's money: Healthy companies make profits and they must find an efficient way to give the profits to the shareholders if they they don't have a good way to use them. For instance, companies such as Apple have billions in their treasury sitting and earning 2% in interest. There are two main ways to return the money. 1) Dividends. 2) Buy back shares. Many companies try to keep dividends at a constant rate so as to not hit their shareholders with an unexpected tax event. When you get a dividend you have to pay a tax for that in that year.
2. Signal to the market that the board thinks the company is strong: When a company is buying back shares, it sends a message to the market. Since the company board knows the best about the company, the markets often think that the company is getting healthier and puts lesser pressure on the board from activist investors.
3. Compensate for stock options & bonuses: Companies give out stocks to their employees in the form of options & grants. This increases the number of outstanding shares. Many companies want to keep their outstanding shares stable. So, they compensate from the issue of new shares by buying back some of the old shares from public.
4. The buy back facility enables the companies to manage their surplus cash: Although the surplus cash can be distributed in the form of more dividends yet the two, that is, ‘buy back’ and more dividends are viewed differently. If the companies distribute cash as dividends, they have to pay corporate dividends tax too, while the investors are saved from the tax liability. So, the companies would prefer buy back in order to avoid corporate dividend tax.
5. Push up the stock price: The stock repurchase reduces the float (number of stocks held by the public) thereby causing a scarcity of the company's shares in the market. The company could then use a favorable market condition to reissue these stocks to public and make a gain (these gains will not be reflected in the profits, as a trading gain on one's own shares is not allowed to be reported in income statement).
6. Support the price: When a company is pummeled by the market, key institutional shareholders would press the company to "support a price". This is because the poor performance of the company would reflect bad on the institutions (portfolio managers, pension funds) when they send out their periodic statements to their investors.
7. Buy back improves many of the financial metrics: ROE (Retrun on Equity) and EPS (Earnings per Share). Both of these core metrics have denominator as number of shares and by reducing number of shares, you increase them.
8. The buy back decision expresses clearly the management’s view that the future prospects are good and investing in its own shares is the best option and it also signals that the market is undervaluing the company’s shares in relation to their intrinsic worth or book value. The basic objective is to facilitate capital restructuring of companies through the mechanism of buy back, of courses, in accordance with SEBI guidelines. Buy back is likely to benefit not only the shareholders and the companies but also the economy as a whole.