chapter-22 financial management - 117.239.72.150117.239.72.150/e3-e4/e3-e4 finance/pdf/e3-e4...
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Chapter-22
Financial Management
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Investment Analysis
Telecom Industry is highly capital intensive. After the telecom services in India were
thrown open to private players, investment in telecom projects has increased
multifold. In line with this industry trend, BSNL and the other public sector
enterprise, MTNL, have been investing very heavily in capital assets to stay ahead of
the competition. The National Telecom Policy‟99 and related government legislations
have imposed clear direction and targets for the telecom companies. Some of the
objectives in NTP‟99 are:
Create a modern & efficient Telecom Infrastructure taking into account
convergence of Information Technology, Media, telecom & consumer
electronic.
Strengthen R&D for world class Manufacturing capabilities
Enable Indian Telecom Players to become truly Global Players
These objectives and the related telecom policy, legislative and licensing initiatives of
the government have spurred capital investment in telecom Industry, by BSNL and
the other telecom sector players. A clear need also has emerged as a consequence, to
ensure that the Capital expenditure (Or CAPEX) decisions taken at various levels of
BSNL are in tune with the best practices in the industry and the return on investment
conforms to, or exceeds, the industry norms.
Nature of capital expenditure decisions:
Capital expenditure Decisions in BSNL or any telecom company are very critical for
its survival and growth because-
CAPEX decisions involve huge investment, in rupee terms and in foreign
currency terms also in many cases
The decisions are either irreversible in Nature or reversible at a huge cost
Their Consequences extend over a long period into the future
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CAPEX decisions are among the most difficult decisions to make, in industry
segments like Telecom, due to the fast changing Technologies, fast changing
customer preferences, severe competition and supply-demand dynamics.
Future costs and benefits of a CAPEX decision are very uncertain.
At present, some the important telecom services on which capital investments are
being made by telecom companies are as below:
Access provision – Fixed, Cellular Mobile, Wireless in Local loop, Cable
Service Provision
Radio paging
Public Mobile Radio Trunk Services
NLD & ILD services
Global Mobile Personal communication by satellite
V-Sat based services
Other Services (IN, WEB, digital Network etc)
These telecom projects have different components – like switching, transmission, and
value added services, apart from usual components of Land, buildings, vehicles etc.
Gestation periods and Payback periods differ from segment to segment and
technology to technology. While wired line services saw phenomenal investments and
growth in earlier decades, the 21st century has started with wireless revolution – with
GSM and CDMA technologies competing for the wireless telecom space. BSNL has
presence in both GSM and CDMA technologies and is using both for purposes for
which they are found suitable in different segments of the network from time to time.
Steps in CAPEX decisions
Every CAPEX decision involves the following fundamental steps:
Identification of Potential Investment opportunities: Potential investment
opportunities are to be identified by carefully screening the following :
New/emerging telecom Technologies; New Uses for existing
technologies/infrastructure; customer needs perceived through Market surveys
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and customer feed back; Need to spread to New locations; new opportunities
indicated by the growth path of competitors, and the regulatory framework and
policies of government.
Preliminary screening of Opportunities: This involves assembling a set of
investment opportunities as above and narrowing the list to preferred
alternatives. At this stage, the criteria typically applied are : compatibility with
the company‟s existing technology, Existing & potential skill sets,
organizational environment; easy availability of technology, equipment and
their potential sources; lead time; reasonableness of costs; associated Risks
(like obsolescence), competition in the segment etc. After considering these
factors, the set of preferred alternatives can be assembled for conducting a
more detailed feasibility study of each.
Feasibility study: Feasibility study involves preparation of a detailed Project
report (approximating to a Project estimate in BSNL) examining the
Marketing, Technical, Financial and Economic feasibility aspects of a project.
The report contains fairly specific estimates of Costs & benefits, means of
raising funds, schedules of implementation, profitability estimates, social
benefits of the project etc. Then, all the projects are listed in the order of
priority based on (i) cost-benefit analysis (ii) company policy and (iii) funds
availability. The approval of competent authority is to be accorded now, in the
order of priority within the available funds. With the disappearance of waiting
lists of customers and emergence of on-demand provision of services and
fierce competition in most parts of the country and in every business segment,
the newer methods described herein can be used for Investment Analysis
Implementation: After approval of specific projects, implementation needs to
be planned with the Preparation of Blue prints, designs, plant engineering,
Equipment selection and procurement, construction, Training, trial run,
commissioning and equipment maintenance planning. The project report must
take into account these factors for successful implementation of the project.
Dealing with implementation Delays : This involves locating potential
causes for implementation delays and taking care of them through various
means like PERT (project evaluation research techniques), CPM(Critical path
method) and assigning specific time-bound responsibilities to the nominated
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project managers for different implementation stages in clear terms. PERT is
mainly for R&D projects though some techniques can be used in a few others.
Critical path method involves splitting of a project into its component
operations and ensuring simultaneous completion of various unlinked
operations so that the project can be implemented in the minimum possible
time. A simple example of a project consisting 4 operations, namely, buying
land and machinery, constructing building and installing machinery can be
illustrated. Here, buying land and buying machinery can be done
simultaneously as independent operations. Constructing building depends only
on buying land but not on buying machinery and hence can be planned
accordingly. But, installing machinery requires that all the preceding three
operations are completed, namely buying land and machinery and constructing
building. Standard notations and techniques are used in more formal CPM
drawings.
A Simple CPM Diagram
Performance review: After implementation, the project performance must be
reviewed to see whether it matches the revenue and performance projections
made in the project report and the reasons for variations. Appropriate remedial
action is to be taken based on performance review.
The detailed project report also must contain Market appraisal, Technical appraisal,
financial appraisal and Economic appraisal of the project.
Market appraisal deals with size of market in the area and expected share of the
project in the market. It takes into account past trends, expected future trends, results
STEP.1.B : BUY MACHINERY STEP.3:INSTAL MACHINERY
STEP.1.A.BUY
LAND STEP.2 CONSTRUCT
BLDG
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of market surveys and the assessment of specific customer requirements in the project
area. In the scenario of “on-demand-provision” of services, market appraisal assumes
great significance in the justification of each project.
Technical appraisal examines technical feasibility, required scale of operations,
existing infrastructure of power, land, buildings etc and required technology to
support anticipated customer requirements. This flows from market appraisal and
planned techno commercial choices.
Economic appraisal deals with social cost-benefit analysis especially in respect of
government supported projects and government specified targets, and indicates the
impact of the project on the society it serves in terms of government-specified targets.
For Complying with Universal service obligations and any other government targets,
it is appropriate for telecom companies to keep such details and justification in respect
of VPTs. The financial appraisal looks at risk- return, cash inflows and outflows and
their impact on the viability of the project.
Financial Appraisal:
Before making capital investments on any project, the investment analysis must
estimate the cash outflows (on Investments and working capital outflows) and the
cash inflows (Revenues) and apply standard decision rules to determine whether the
investment satisfies the requisite decision criteria. This is popularly known as
Financial Appraisal of a project. The general principles adopted by Corporate finance
managers in a standard financial appraisal are:
All costs (cash outflows) and benefits (cash Inflows) must be measured.
Net cash flows must be taken – after deducting the applicable rate of corporate
tax. This means that net cash returns must be measured and not the accounting
profit on the project.
Cash flows must be determined in incremental terms. In other words, the
actual additional outflows and inflows resulting from the implementation of
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the project in question must be taken into account and not the average of all
earlier investments plus current investment.
Sunk costs like cost of land already purchased for many other purposes but is
now additionally used for the current project under appraisal must be ignored .
Opportunity costs associated with the resources of the firm must be considered
even though such utilization does not entail explicit cash outflows:
Existing overhead costs need not be shared by the new project in projecting
the cash outflows
In BSNL, the profitability is presently determined with reference to “Annual
Recurring Expenditure (ARE)” and “Anticipated Receipts &Savings (ARS)” of the
project. The other methods of project evaluation (also called investment appraisal)
currently in use in corporate finance are discussed hereunder.
The terms used in these project evaluation / appraisal techniques are explained briefly
hereunder.
Initial Investment = Cost of all new assets procured Minus sale value of old
assets, if any
Cash Flow After Taxes (CFAT) = Profit After Tax + Depreciations and
other amortizations which do not involve cash outgo
Project Life = Period during which the project generates positive Cash Flow
After Taxes
Time value of Money = We know that a rupee we get in future after a few
years is worth much less than a rupee we get today. The Present value (PV) of
a rupee that we get in future depends on (a) an agreed discount rate which in
turn, depends on factors like depreciation, interest on capital, inflation rates etc
and(b) the time lag that the future period involves. The choice of the discount
rate needs to be done by company managements with caution, taking into
account the type of capital used, the quality of assets proposed to be created
and other factors. Standard tables are available now giving the present value of
a rupee, given the discount rate and the future period of accrual of the rupee.
PV can be calculated for outflows of cash (investments) and inflows
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(revenues) and the net present value (NPV) can be found by deducting the PV
of all outflows from the PV of all inflows. Discount factor can also be
computed without use of tables by using the formula 1/ (1+ k) n where k = cost
of capital; n = year in which the in/outflow takes place. This formula takes
into account only the cost of capital.
Future Value (FV) factor : This is the opposite of the present value factor.
Given the discount rate and the future period, we can calculate the future
worth of today‟s one rupee by using standard tables.
Pay-back method(Pay out or Pay off period): Under this method we calculate the
period taken by the project to recover the investment amount from its future earnings.
Formula: - Pay back period = amount invested
Constant annual earnings
For instance, a project costs Rs.12000 and it is estimated to earn annually Rs.4000net,
then we understand that our investment is recovered over a period of 3 years. The
earnings after this period will constitute profits. This method ascertains the period of
time required for annual earnings of the project to equate with the initial investment.
Here the term „earnings‟ refers to the profits earned by the project (e.g. machine)
before charging the depreciation thereon but after deducting the tax and other
operating expenses. The recovery period is called the pay-back period. The project
which gives the invested capital in the shortest time is the best.
Illustration
ABC Company considers the mechanization of a particular process now carried on by
labour. Two methods are available. The following estimates are made by the experts:
Machine X Machine Y
Working life 5 years 5 years
Cost of machine Rs. 25000 25000
Annual incomes:
I year 7500 3000
II year 10000 6000
III year 15000 11000
IV year 6000 15000
V year 4000 10000
Total 42500 45000
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Calculate the period of time taken by each project to repay the investment amount out
of its earnings
Working
Here the earning of the machine is unevenly spread over the years. So, the general
formula (investment ÷ Constant annual earnings) cannot be used here. We have to
prepare a table as given below:-
Machine X Machine Y
Investment (cost of the machine) 25000 250000
Earnings:
I year 7500 3000
II year 10000 6000
First six months in the III year 7500 -
III year - 11000
First four months in the IV year - 5000
Total 25000 25000
Pay Back period 2 ½ years 3 ½ years
From the above results, we understand that machine „X‟ is preferable to machine „Y‟,
because the former repays the capital earlier.
The pay-back method does not consider the earnings of the post pay-back period.
Decision Rule: - Projects with shorter Payback Period or, those which meet a
management-prescribed Benchmark are to be preferred.
Advantages of the concept:
Simple to understand and Easy to use
Profit or surplus comes only after Payback period.
Used where techno obsolescence is High
Focuses on need for initial higher cash flows
Eliminates / minimizes risk
Comparable to break-even point
Disadvantages of the method are –
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• Stresses only capital recovery (Not profit)
• Nothing about cash flows after PBP
• Non-Comparability of Projects with uneven CFAT
• Ignores Time Value of Money
Discounted Pay Back Period (DPBP)
Determine all Cash outflows (Investment)
Determine all cash Inflows after taxes (revenues) for each year
For each year, the inflows must be netted against outflows. For the net
amount, apply the PV factor from the tables and Compute “Discounted Cash
Flows After Taxes (DCFAT)” by applying the formula: Net CFAT x PV
factor of the year..
Compute the Cumulative DCFAT (CDCFAT)at the end of each year i.e.,
DCFAT till last year + DCFAT of current year
Determine the year in which CDCFAT = INITIAL INVESTMENT
This is the Discounted Pay Back Period (DPBP)
Decision Rule: Accept the Project: If DPBP < Bench mark period fixed by the
company. Else, reject the project. Fixing a proper bench mark in terms of number of
years/months by management for recovery of the initial investment is the essential
first step for applying this method.
EX:- For a particular product “A”, Investment is Rs.36 lakhs. The cash inflows after
taxes for 5 years(in lakhs of Rs) are given. Determine the payback period if the cash
flows are discounted at 12% p.a.
Year 1 2 3 4 5 Total
CFAT(RS) 11.40 11.40 11.40 11.40 11.40 11.40
PV Factor .8929 .7972 .7118 .6355 .5674 3.6048
DCFAT 10.18 9.08 8.11 7.24 6.47 41.08
CUM.DCFAT 10.18 19.26 27.37 34.61 41.08
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So, DPBP = 4 YEARS +[Initial Investment – 4TH YEAR CDFAT] X 100 5TH YEAR DCFAT
= 4 YEARS + [(36 –34.61)/6.47] x 12= 4 yrs 2m
Pay Back Reciprocal (PBR)
Pay back reciprocal (PBR) is computed by the formula: (CFAT P.A. / INITIAL
INVESTMENT) x 100; the formula gives us the approximate internal rate of return
Ex:
(1) Initial investment = Rs.50 Lakhs;
(2) Life of project = 10 years
(3) CFAT = Rs.10 lakhs P.A
(4) PBR = (10 / 50) x 100 = 20%
PBR is generally used if (1) Life of project is at least twice the Payback Period and (2)
Project generates equal amount of annual cash flows
Decision Rule: Accept Projects with highest PBR or those above a Bench mark fixed
Average rate of return method (Accounting rate of return method): Under this
method an attempt is made to calculate the profits of a particular project earned over
its whole working life.
Rate of return = Average annual net profit x 100
Investment
Average annual net profit = all earnings after depreciation
Project‟s economic life
Thus the average rate of return method is an accounting method which represents the
ratio of average annual profits after depreciation and taxes to the investment in
project. A rate of return is fixed keeping in view the cost of capital of the business for
all capital investment projects, and projects which do not give the desired minimum
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rate of return are rejected. Accepted projects are then ranked according to their
respective rates of return.
Illustration
Calculate the average return for projects „X‟ and „Y‟ from the following data:
Project ‘X’ Project ‘Y’
Investment Rs. 20000 30000
Expected life 4 years 5 years
Projected Net income (after depreciation &
taxes)
Year 1 2000 3000
Year 2 1500 3000
Year 3 1500 2000
Year 4 1000 1000
Year 5 1000
6000 10000
If we required rate of return is 6%, which project should be undertaken?
Project ‘X’ Project ‘Y’
Investment
20000 30000
Average annual net profit X =6000 Y =10000
4 5
1500 2000
Average rate of return
X = 1500 x 100 Y =2000 x 100 20000 30000
7.5% 6.67%
Since the rate of return for both the projects is higher than the required rate of return
of 6%, both the projects will be undertaken provided that the two projects are not
mutually exclusive, and that enough financial resources are available. However, if the
two projects are mutually exclusive or enough financial resources are not available,
then Project „X‟ will be preferred, since the rate of return on Project „X‟ is higher than
the rate on Project „Y‟.
Decision Rule: Accept projects with highest ARR or above Benchmark
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Advantages:
• Simple to understand
• Easy to compute
• Income throughout Project Life is considered
Disadvantages:
• Does Not consider CFAT which is more crucial
• Takes rough average of profits of future years & ignores fluctuations in profits
year after year
• Ignores time value of money , which is very important in capital Budgeting
Present value method (Net Present value Method or Net Gain Method): This
method is based upon the concept that a rupee received today is not the same as a
rupee received at the end of the year, because a rupee received today can be invested
so as to earn more money during the year. Under this method, we calculate the present
values of the future earnings spread over a number of years either evenly or
unevenly(using present value table). Then the sum total of these discounted earnings
will be compared with the actual investment to find out the surplus (or otherwise).
But, the problem is what should be discounting rate at which the earnings are brought
down to the present values? This rate is known as he cut-off rate. The rate is based on
the average cost of capital which should be adjusted to allow for the risk element in
each investment project. All cash flows are discounted to present value using the
required rate of return. According to this criterion, the project is accepted if the
present value of cash inflow exceeds the present value of cash outflows. The net
present value method is superior to other methods above, as it takes into account both
the magnitude and the timing of cash flows over the effective life of the asset.
According to this method, the capital project which is quick earning and gives the
returns during early years is considered better than the capital project with the same
total of returns but with longer gestation periods.
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Illustration
Calculate the net present values of Machine „X‟ and machine „Y‟ from the following
data:
Machine ‘X’ Machine ‘Y’
Initial investment Rs. 20000 30000
Expected life 5 years 5 years
Salvage value Rs. 1000 2000
Cash flows
Year
1 5000 20000
2 10000 10000
3 10000 5000
4 3000 3000
5 2000 2000
6 30000 40000
Required Rate of Return
The management determines 10% as the cut-off rate over the proposed investment
project. Discount factors at this rate are given below:
Year 1 2 3 4 5
P.V. .909 .826 .751 .683 .621
Solution:
Machine
„X‟
Machine „Y‟
Value Discount factor
@10%
Presen
t value of
cash
flow
Valu
e
Discou
nt factor
@10%
Present
value of cash
flow
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Cash outflow
Initial
investment
20000
1
20000
3000
0
1
30000
Cash
inflows:
Year
1 5000 .909 4545 2000
0
.909 18180
2 10000 .826 8260 1000
0
.826 8260
3 10000 .751 7510 5000 .751 3755
4 3000 .683 2049 3000 .683 2049
5 2000 .621 1242 2000 .621 1242
5 (salvage) 1000 .621 621 2000 .621 1242
Present
value
24227 34728
Net present
values
(cash inflow-
cash outflow)
4227
4728
The NPV of project „X‟ is Rs.4227 and that of project „Y‟ is Rs.4728. Since the net
cash inflows exceed the net cash outflows for both the projects, both the projects are
acceptable. When the two projects are mutually exclusive so that only one project can
be undertaken, the NPV fails to establish which is a better project, since NPV is
expressed in absolute rather than in relative terms. For making a comparison between
the two projects we will have to calculate the profitability index.
Profitability index = Present value of cash inflows
Present value of cash outflows
Machine „X‟ Machine „Y‟
24227 34728
20000 30000
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=1211 =1157
Irrespective of the fact that the net present value of machine „Y‟ is greater than that of
Machine „X‟, Machine „X‟ is better than machine „Y‟ since the profitability index of
Machine „X‟ is greater than the profitability index of machine „Y‟.
Decision Rule:-Accept if NPV is Positive
Example: - A Firm‟s Investment on a machine = Rs.2 lakhs; Cash Flow after tax &
depreciation = 35,000 p.a. Cost of capital =10%; Its life = 10 years; salvage value
=nil; Calculate Present value, net present value and also profitability Index:
Annuity factor from the tables for 10 years at 10% = 6.1446
So, Discounted cash flows after taxes = present value of 35,000 p.a. paid for 10 years
= 6.1446 x 35,000 = Rs.2,15, 061 (PV)
NPV = DCFAT( - )Initial Investment= Rs.15,061
Formula for Profitability Index (PI) = DCFAT /Initial Investment = 215061 / 200000
=1.075; (see technique.6 below)
Decision: As NPV >0 and PI > 1 the firm should purchase the machinery
Merits of NPV/DCF
Considers Time value, a very important factor
All cash Flows are taken (Unlike Pay Back Period)
Focuses on the basic objective of adding to the Shareholder wealth
Different Projects can be evaluated independently but compared on NPV basis
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Disadvantages
Involves complex calculations
Forecasting Flows & discount rate is difficult
NPV & Ranking of projects differ at different rates, leading to inconsistency in
decision making
Ignores difference in (a) size of investments & (b) the benefits of earlier
inflows enabling the undertaking of more projects later
Discounted cash Flow method or Yield method or Internal rate of return method
or Time adjusted rate of return or Project rate of return: This is used to analyse
cash flows when the approximate cost of capital is not pre-determined, so we do not
know the appropriate discount rate for discounting cash flows to their present value.
The aim of this method is to find out percentage rate of discount that will reduce all
future cash inflows to the same value as the cash invested in the project. The higher
the percentage rate of discounting that is used, the lower will be the present value of
the cash flows. The lower the percentage used, the higher will be the sum of the
present values. By a process of trail and error (using present value table) a percentage
rate can be ascertained that will equate the present value of the future cash flows from
the project with the value of the cash investment. When the rate is found, it will be the
rate of return earned on the funds invested in the project. It allows ranking of
investments according to their internal return.
Illustration
Calculate the internal rates of return for projects A and B from the following data:-
A B
Initial investment Rs. 15000 15000
Effective life (no salvage value) 4 years 4 years
Cash inflow:
Year 1 6000
Year 2 6000
Year 3 6000
Year 4 6000 30000
Solution
Project - A
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There is an annuity of Rs.6000 per year for Project A. So for calculating the internal
rate of return we will use the annuity table. The proportion of annuity of Rs.6000 and
initial investment of Rs.15000 is 6000: 15000 or 1:2.5 So in the annuity table, we
will need the discount rate that will reduce an annuity of Re.1 for 4 years to a present
value factor 2.5 A perusal of the table shows that 2.5 factor lies between the 21% and
22% discount rates.
The approximate internal rate between 21% and 22% shall be determined by
extrapolation as under:
Annuity
(1)
Discount rate
(2)
Discount factor
(3)
Present value
(4) [1 x 3]
6000 21% 2.5404 15,242
22% 2.4936 14,961
1% 281
Internal rate of return = 2 +{15242 minus 15000}
15242 minus 14961
= 21+ 242 =21.89%
281
Project B
For project „B‟ there is a lump sum of Rs.30000 that will be received after the end of
4th year. So, for calculating the internal rate of return, we will use the table that gives
the present value of a rupee due at the end of „n‟ years. The proportion between the
lump sum cash inflow and the initial investment is 30000 : 15000 or 1: .5 So in the
table we will read the discount rate that will reduce a rupee receivable after the end of
4th year to a present value factor of .5 A perusal of the Table shows that .5 factor lies
between 18% and 19% discount rates.
The approximate internal rate between 18% and 19% shall be determined by
extrapolation as under:-
Ump sum
(1)
Discount rate
(2)
Discount factor
(3)
Present value
(4) [1 x 3]
30000 18% .5157 15,471
19% .4286 14,958
1% 513
Internal rate of return = 2 +{15471 minus 15000}
15471 minus 14958
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= 18+ 471 =18.92% 513
Establishing capital priorities
It is essential to establish a system of priorities when the available capital is limited,
so that best use is made of it. The following is a list of such priorities.
1. Projects already in hand: They refer to the projects which are incomplete but
requires additional expenditure for completion They will receive normally
top priority since they are in mid stream.
2. Projects necessitated by law: They refer to the projects which are necessary
to comply with certain legal requirements. Expenditure is necessary, since it
cannot be avoided.
3. Projects to maintain capacity: are meant to keep the productive capacity of
the business intact (e.g.) expenditure on the replacement of a machine.
4. Projects to increase earnings: These are undertaken to reduce costs or to
increase sales of the existing products and are, therefore, naturally looked
upon with favour.
5. Projects to develop New Projects: They refer to the schemes which are
required to improve the profitability of business.
Cost of Financing a Project
In making investment decisions, it is appropriate to have in view the cost of financing
project. This is known as the cost of capital. Common sense tell us that it would be
uneconomical for an individual to borrow money for investment purposes, if he could
not invest these funds at a higher rate. Thus in selecting from among potential
investments, a company should accept only those proposals whose accepted return
would at least exceed the cost of capital to the firm.
Capital expenditure control will have the following features:
1. Constant search: There must be a complete awareness on the part of all
management personnel that long-term expenditure constitutes the basis of
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profits over long periods. This creates constant search for new methods,
processes and products.
2. Comprehensive planning: Budget of an organization incorporates all the
ideas for the future expansion programme. The capital expenditure budget
should be so planned as to ensure balanced development of each part of the
business as well as of the company as a whole.
3. Justification: Having framed the capital budget, it is vital to see that each
project is justified by its forecast profitability. This can be done by using one
or more of the systematic rational methods of ranking investment proposals
such as Pay Back Method, Average Rate of Return Method discounted Cash
Flow Method etc.
4. Authorization: There has to be some routine at every stage request,
authorization, progress and audit. Requests for capital allocation should be
made periodically and they should be reviewed as they pass upward through
managerial level until they reach a committee which shifts these projects and
submits its recommendations to the Board of Directors for final
recommendation.
5. Authentication: As a project is carried out, all expenditure should be
authenticated as being within the previously authorized budget for the
project of the company.
6. Progress: Major capital expenditure projects cannot be accomplished
overnight. They require the preparation of detailed plans and instructions.
The next step consists of issuance of reports during the period in which
project is performed. These reports are aimed at observing that overall
programme remains within limits set by the policy of the company.
Moreover, many unexpected delays may have to be faced. Therefore control
of progress is essential.
7. Post completion audits: This is important phase of the capital expenditure
control. Post-completion audits of projects determine whether their actual
value is in accordance with the one determined at the time of authorization.
It is also possible to detect those areas where action can be taken to improve
future results which may be very valuable n the consideration of future
projects.
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Decision Rule:
If IRR off rate (generally, Cost of capital), ACCEPT
If IRR < Cost of Capital, REJECT
If IRR = Cost of > cut- capital, INDIFFERENT
Ex.: - Calculate IRR of an investment of Rs.2.5 lakhs if CFATs = Rs.45,000 p.a. for
10 years
Annual CFAT for 10 years = 45,000 p.a.
PV interest Annuity Factor DCFAT
10% 6.1446 2,76,507
14% 5.2161 2,34,725
For 4%, difference = 41,782
So, IRR = 10% + [(2,76,507 - 2,50,000) / 41,782] x 4% = 12.54%
Decision Rule: If 12.54% is above cost of capital, Accept; Else Reject;
IRR Advantages:
Takes time Value into account
Takes into account all cash outflows and inflows & time periods
Immediate decision by comparing IRR with cost of capital
Helps to maximize shareholder wealth
Projects with heavy initial years CFAT will have higher IRR. But NPV takes
the timing difference at a suitable discount rate
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Disadvantages:
Tedious to compute for multiple outflows and inflows in each year.
Multiple IRRs leads to difficult interpretation
Conflict with NPV, if in/outflows patterns are different for different proposals
Presumes that all cash inflows are reinvested immediately at the IRR – which
is not practically possible.
Working Capital Management
To create a commercial entity and carrying out commercial activity an investment
called capital is required. This investment may be in the form of cash or other assets.
These assets are used by the company for generating benefits to the company. These
assets are two types: Fixed and Current.
Fixed assets are those assets which are permanent in nature and facilitate business
activity. Examples of fixed assets are land, buildings, machinery, furniture, and long-
term investments. They are not converted as revenue in short term but facilitate
generation of revenue.
Current assets on the other hand are those assets of the entity which are either held in
the form of cash or can be easily converted into cash within a short period, say usually
within a year or an accounting period. Examples of current assets are cash, short-term
investments, sundry debtors or accounts receivable, stock, loans and advances etc.
Liabilities are economic obligations of the company to pay cash or provide goods or
services to outsiders including shareholders. Liabilities may be long-term or current.
Long-term liabilities are those which are repayable over a period greater than the
accounting period like share capital, debentures, long-term loans etc. Current
liabilities on the other hand have to be paid within the accounting period like sundry
debtors or accounts payable, bills payable, outstanding expenses, short-term loans etc.
Working Capital Management means management of current asset and current
liabilities. Traditionally the term working capital is defined in two ways, Gross
Working Capital and Net Working Capital. Gross Working Capital is equal to the
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total of all current assts. Net Working Capital is defined as the difference between
Gross Working Capital and Current liabilities. The basic objective of working capital
is to provide adequate support for the smooth functioning of normal business
operations of a company. The total amount of financial resources at the disposal of a
company is limited. These resources can be put to alternative uses, the larger the
amount of investment in current assets, the smaller will be the amount available for
investment in other profitable avenues available to a company.
Working capital traditionally comprises of cash and bank balances, goods or
inventories, cash equivalents like bills receivables and sundry debtors, etc. As the
business is generally run on credit basis there is a time gap between the transaction
and actual realization of revenue. Similarly there is a lead-time from procurement to
consumption of materials. Hence the balances of sundry debtors and inventories
invariably remain in the books of a business entity. Similarly a business enterprise
takes some time to meet its obligations of payments for services or purchases. But at a
given point of time the business concern must be able to meet its liabilities when
called upon, by converting its current assets into cash. So the working capital
management is basically an issue of liquidity. Thus some part of investment of the
owners is always blocked in holding these current assets and at times the concern is
forced to bring in additional funds from by way of borrowings. The business
concerns have different methods of meeting this working capital requirement; some of
the important methods of raising working capital are discussed below.
Working Capital Management
The problems of Working Capital Management are either not able to assess the actual
requirements of working capital and thereby holding excess current assets like cash
and inventories, or not able to realize the sundry debtors or bill receivable thus
resulting in blocking of funds in working capital. While holding a reasonable level of
working capital is advisable in liquidity point of view and for maintaining optimum
levels of production, sale of goods or services, holding excess working capital in
anyway results in losses to the concern. Let us discuss how the various components
of working capital have an impact on profitability of the business concern.
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The main components of working capital management include
1. Cash management,
2. Receivable management
3. Inventory management.
Cash Management
There is a general tendency to confuse profits with cash. But there is a difference
between profits and cash. Profits can be said to be the excess of income over the
expenditure of the business entity, for a particular accounting period. It includes both
cash incomes (cash sales, interest on investment, etc.) and non-cash incomes (credit
sales, discounts received etc. Similarly both expenses in cash/check (payment of
salaries, wages, interest on term loans, etc.) and non-cash expenses (depreciation,
preliminary expenses incurred during in corporation which are write-off every year,
outstanding expenses like unpaid salaries or rent or insurance) where there is no actual
outflow of cash at the time of accounting are included. „Cash‟ refers to the cash as
well as the bank balances of the company at the end of the accounting period, as
reflected in the Balance Sheet of the company. While profits reflect the earning
capacity of a company, cash reflects its liquidity position.
Why Companies hold cash?
The need for holding cash arises from a variety of reasons which are briefly
summarized below.
Transaction Motive
A company is always entering into transactions with other entities. While some of
these transactions may not result in an immediate inflow/outflow of cash (eg: credit
purchases and sales) other transactions cause immediate cash inflows and outflows.
So firms always keep a certain amount as cash to deal with routine transactions where
immediate cash payments are required.
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Precautions Motive
Contingencies have a habit of cropping up when least expected. A sudden fire may
break out, accidents may happen, employees may go on strike, creditors may present
bills earlier than expected or debtors may make payments later than warranted. The
company has to be prepared to meet these contingencies to minimize its losses. For
this purpose companies generally maintain some amount in the form of cash.
Speculative Motive
Firms also maintain cash balances in order to take advantage of opportunities that do
not take place in the course of routine business activities. For example, there may be
a sudden decrease in the price of raw materials which is not expected to last long or
the firm may want to invest in securities of other companies when the price is just
right. These transactions are of a purely speculative nature for which the firms need
cash.
Objectives of Cash Management
The objective of cash management can be regarded as one of making short-term
forecasts of cash position, finding avenues for financing during periods when cash
deficits are anticipated and arranging for repayment/investment during periods when
cash surpluses are anticipated with a view to minimizing idle cash as far as possible.
Towards this end short-term forecasts of cash receipts and payments are made in the
structured form of cash budgets, information is monitored at appropriate intervals for
the purpose of control and taking suitable measures as warranted by the situation.
Cash Forecasting and Budget
The principal tool of cash management is cash budgeting or short-term cash
forecasting. Usually, the time chosen for making short-term forecast for preparing
cash budgets is taken to one year. For the purpose of better monitoring and control,
however, the year is divided into quarters, quarters into months and months into
weeks. Under critical conditions a week is further divided into days. The efficiency
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of cash management can be enhanced considerably by keeping a close watch and
controlling a few important factors mentioned below:
Prompt Billing and Mailing
A time lag occurs from the date of dispatching goods or providing services to the date
of preparing invoice or bill and mailing the same to the customer. If this time gap can
be minimized, early collections can be expected, otherwise collections get delayed.
Collection of Cheques and Remittances of Cash
Delay in the receipt of cheques and depositing the same in the bank will inevitably
result in delayed cash realization. This delay can be reduced by taking measures for
hastening the process of collection and depositing cheques/cash from customers.
Receivables Management
Introduction
Business firms generally sell goods on credit, to facilitate sales especially from those
customers who cannot borrow from other sources, or find it very expensive or
difficult to do so. Goods or services sold on credit get converted (from the point of
view of the selling firm) into receivables (book debts) which when realized, generate
cash. The average balance in the receivables account would approximately be:
average daily credit sales multiplied by average collection period. For example, if the
average daily credit sales of a firm are Rs. 3,00,000 and the average collection period
is 40 days, the average balance in the receivables account would be Rs. 1,20, 00,000.
Since receivables often account for a significant proportion of the total assets,
management of receivables take up a lot of the Finance Manager‟s time.
Purpose of Receivables Management
The object of receivables management is to promote sales and profits until that point
is reached where the returns that the company get from funding of receivables is less
than the cost that the company has to incur in order to fund these receivables. Hence,
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the purpose of receivables is directly connected with the company‟s objectives of
making credit sales which are:
Increasing total sales as if a company sells goods on credit, it will be in a
position to sell more goods than if it insists on immediate cash payment.
Increasing profits as a result of increase in sales not only in volume, but also
because companies charge a higher margin of profit on credit sales as
compared to cash sales.
In order to meet the increasing competition, the company may have to grant
better credit facilities than those offered by its competitors.
Cost of Maintaining Receivables
Additional fund requirement for the company
When a firm maintains receivables, some of the firm‟s resources remain
blocked in them because there is a time lag between the credit sale to
customer and receipt of cash from them as repayment. To the extent that the
firm‟s resources are blocked in its receivables, it has to arrange additional
finance to meet its own obligations towards its creditors and employee, like
payments for purchases, salaries and other production and administrative
expenses. Whether this additional finance is met from its own resources or
from outside, it involves a cost to the firm in terms of interest (if financed
from outside) or opportunity costs (if internal resources which could have
been put to some other use are taken).
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Administrative costs
When a company maintains receivables, it has to incur additional
administrative expenses in the form of salaries to clerks who maintain
records of debtors, expenses on investigating the creditworthiness of debtors
etc.
Collection costs
These are costs which the firm, has to incur for collection of the amounts at
the appropriate time from the customers.
Defaulting costs
When customers make default in payments, not only is the collection effort to be
increased but the firm may also have to incur losses from bad debts.
Financial Management
1. What is the significance of Investment Analysis in Financial Management ?
2. Discuss about the various steps involved in CAPEX Decisions ?
3. What is meant by Critical Path Method ?
4. Discuss about the various project appraisal techniques ?
5. What is meant by Financial appraisal of a Project ? How it is carried out ?
6. What are the advantages and disadvantages of payback period Method ?
7. What are the merits and demerits of Discounted Cash Flow Methods ?
8. Brief about the working Capital management ?
9. What are the main components of working capital ?
10. What are the motives of holding the cash under cash management system ?