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Answer of Q.N.1.(a)
Capital Budgeting:
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
Where,
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
Year
|
Cash
Inflow (Rs. In Lakhs)
|
Discounting
Factor @ 20%
|
Present
value of cash inflow(Rs. In Lakhs)
|
1
2
3
4
5
|
50
60
55
60
75
|
0.8333
0.6944
0.5787
0.4823
0.4019
|
41.67
41.67
31.83
28.94
30.14
|
Total
of Present value of cash inflow
Less:
Present Value of cash Outflow (Investment)
|
174.25
150
|
||
Net
Present Value
|
24.25
|
Answer of Q.N.4. (a)
Economic Order Quantity Click here to Download
Answer of Q.N.4. (b)
Calculation of operating Leverage
Particulars
|
2000
Units
|
2800
Units
|
Sales
@ Rs. 400 per unit
Less:
Variable Cost @ Rs. 75
|
800000
150000
|
1120000
210000
|
Contribution
Less:
Fixed Costs
|
650000
400000
|
910000
400000
|
Earnings
Before Interest and Tax (EBIT)
|
250000
|
510000
|
Operating
Leverage (Contribution / EBIT)
|
=650000/250000
=
2.60
|
=
910000/510000
=
1.784
|
Answer of Q.N. 5(a).
Capital Structure
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.