UNIT 3: Capital Budgeting: Analytical Overview

1. Capital Budgeting Process

 Definition:
o A systematic process to evaluate and select long-term investment projects that
maximize shareholder wealth.
 Steps:
1. Project Identification:
 Identify potential investment opportunities aligned with strategic
objectives.
2. Cash Flow Estimation:
 Forecast future cash inflows and outflows for each project.
3. Evaluation and Analysis:
 Apply capital budgeting techniques (e.g., NPV, IRR) to assess
profitability.
4. Decision Making:
 Select projects based on financial and strategic criteria.
5. Implementation:
 Allocate resources and execute the approved project.
6. Monitoring and Review:
 Compare actual performance with projections for continuous
improvement.

2. Cash Flow Estimation

 Components:
o Initial Investment: Cost of acquiring and implementing the project.
o Operating Cash Flows: Net cash flows from operations (revenue minus
expenses).
o Terminal Cash Flow: Salvage value and recovery of working capital at the
project's end.
 Importance:
o Accurate cash flow estimates are critical for reliable decision-making.

3. Payback Period Method

 Definition:
o Measures the time required to recover the initial investment from project cash
flows.
 Decision Rule:
o Accept projects with payback periods shorter than a predetermined threshold.
 Limitations:
o Ignores the time value of money and post-payback cash flows.
4. Discounted Payback Period Method

 Definition:
o Similar to the payback method but considers the time value of money.
 Decision Rule:
o Accept projects if the discounted payback period is within the acceptable
range.
 Advantages:
o Overcomes limitations of the standard payback method.

5. Accounting Rate of Return (ARR)

 Definition:
o Evaluates the return on investment based on accounting profits.
 Formula:
o ARR = (Average Annual Accounting Profit / Initial Investment) × 100
 Decision Rule:
o Accept projects with ARR exceeding the required rate of return.
 Limitations:
o Ignores cash flows and the time value of money.

6. Net Present Value (NPV)

 Definition:
o The difference between the present value of cash inflows and outflows over
the project's life.
 Decision Rule:
o Accept projects with NPV > 0 as they add value to the firm.
 Significance:
o Widely regarded as the most reliable capital budgeting method.

7. Net Terminal Value

 Definition:
o The future value of net cash inflows compounded to the end of the project.
 Purpose:
o Useful in evaluating investments with a focus on future financial impact.

8. Internal Rate of Return (IRR)

 Definition:
o The discount rate at which the NPV of a project becomes zero.
 Decision Rule:
o Accept projects with IRR exceeding the required rate of return.
 Limitations:
o May lead to conflicting decisions compared to NPV in mutually exclusive
projects.
9. Profitability Index (PI)

 Definition:
o A ratio of the present value of cash inflows to the initial investment.
 Formula:
o PI = Present Value of Inflows / Initial Investment
 Decision Rule:
o Accept projects with PI > 1, indicating a profitable investment.

10. Capital Budgeting under Risk

a. Certainty Equivalent Approach:

 Adjust cash flows to reflect risk by converting them into risk-free equivalents.
 Decision Rule:
o Use risk-free discount rates for evaluation.

b. Risk-Adjusted Discount Rate:

 Adjust the discount rate to account for project risk.

 Decision Rule:
o Use higher discount rates for riskier projects.
 LEO SIRS NOTES

Capital Budgeting: Analytical Overview

1. Capital Budgeting Process

 Definition:
o A systematic process to evaluate and select long-term investment projects that
align with an organization's strategic goals.
 Steps:
1. Identification of Investment Opportunities:
 Recognizing potential projects that fit the company's objectives.
2. Evaluating Investment Opportunities:
 Estimating expected cash inflows and outflows while considering
factors like time value of money and risk.
3. Project Selection:
 Choosing the most promising projects based on financial and strategic
criteria.
4. Implementation:
 Allocating resources, securing funding, and executing the project.
5. Performance Review:
 Comparing actual performance with projected outcomes for future
improvements.

2. Cash Flow Estimation

 Components:
o Initial investment, operating cash flows, and terminal cash flows (e.g., salvage
value).
 Importance:
o Accurate cash flow estimation is crucial for evaluating project feasibility and
profitability.

3. Traditional vs. Modern Project Appraisal Methods

 Traditional (Non-Discounted):
o Payback Period.
o Accounting Rate of Return (ARR).
 Modern (Discounted):
o Discounted Payback Period.
o Net Present Value (NPV).
o Profitability Index (PI).
o Internal Rate of Return (IRR).
4. Common Techniques

Payback Period

 Measures the time needed to recover the initial investment.

 Limitations:
o Ignores the time value of money and cash flows beyond the payback period.

Discounted Payback Period

 Accounts for the time value of money.

 Evaluates how long it takes to recover the initial investment in present value terms.

Accounting Rate of Return (ARR)

 Based on accounting profits rather than cash flows.

 Acceptance Rule:
o Accept if ARR exceeds the required rate of return.

Net Present Value (NPV)

 Difference between the present value of cash inflows and outflows.

 Acceptance Rule:
o Accept if NPV > 0; choose the project with the highest NPV for mutually
exclusive projects.

Internal Rate of Return (IRR)

 The discount rate at which NPV equals zero.

 Limitations:
o May lead to conflicts with NPV in ranking projects.

Profitability Index (PI)

 Ratio of the present value of cash inflows to the initial investment.

 Acceptance Rule:
o Accept projects with PI > 1.

5. Capital Budgeting Under Risk and Uncertainty

 Risk Considerations:
o Future cash flows are estimates and involve uncertainty.
 Techniques to Incorporate Risk:
o Conventional Techniques:
 Payback Period.
 Risk-Adjusted Discount Rate (RADR).
o Statistical Techniques:
 Probability distribution, simulation analysis, decision tree approach,
scenario analysis, sensitivity analysis.
6. Incorporating Risk in Capital Budgeting

Risk-Adjusted Discount Rate (RADR):

 Adjusts the discount rate upward for riskier projects.

Certainty Equivalents (CE):

 Converts risky cash flows into equivalent risk-free cash flows by applying a certainty
equivalent factor.
UNIT 4: Dividend Decisions: Conceptual Overview

1. Introduction to Dividend Decisions

 Definition:
o Dividend decisions involve determining the portion of profits distributed to
shareholders versus retained for reinvestment.
 Objective:
o To maximize shareholder value while ensuring adequate funds for growth and
sustainability.
 Types of Dividends:
o Cash Dividend: Distribution in cash to shareholders.
o Stock Dividend: Additional shares issued to shareholders without cash
payment.

2. Theories of Dividend Decisions

A. Relevance of Dividend Decisions

1. Walter’s Model:
o Suggests that dividend decisions affect a firm's valuation.
o Key Assumptions:
 No external financing; investments are funded through retained
earnings.
 Constant internal rate of return (r) and cost of capital (k).
o Implication:
 If r>kr > k: Retain earnings (growth firms).
 If r<kr < k: Distribute dividends (income firms).
2. Gordon’s Model (Bird-in-Hand Theory):
o Proposes that investors prefer certain dividends over uncertain future capital
gains.
o Suggests a positive relationship between dividend payouts and firm value.
o Assumptions:
 No external financing, constant return, and cost of capital.

B. Irrelevance of Dividend Decisions

1. Modigliani and Miller (MM) Theory:

o Argues that dividend policy has no effect on a firm’s valuation in perfect
capital markets.
o Key Assumptions:
 No taxes, transaction costs, or market imperfections.
 Investment decisions are independent of dividend policy.
3. Dividend Policies in Practice

 Stable Dividend Policy:

o Maintain consistent dividend payouts irrespective of earnings fluctuations.
 Residual Dividend Policy:
o Dividends are paid only after meeting all investment requirements.
 Hybrid Dividend Policy:
o Combines elements of stable and residual policies to balance predictability and
flexibility.

4. Determinants of Dividend Policy

1. Profitability:
o Firms with stable and high earnings tend to pay higher dividends.
2. Liquidity:
o Availability of cash impacts the firm's ability to pay dividends.
3. Growth Opportunities:
o Firms with high growth prospects retain more earnings for reinvestment.
4. Market Expectations:
o Consistent dividend policies align with investor expectations, reducing market
volatility.
5. Tax Considerations:
o Dividend policies may be influenced by tax implications for both the company
and shareholders.
6. Legal and Contractual Constraints:
o Debt covenants and legal restrictions may limit dividend payments.

5. Practical Considerations

 Cash Dividends:
o Preferred by shareholders seeking immediate income.
 Stock Dividends:
o Retain cash within the company while rewarding shareholders with additional
equity.
 LEO SIRS NOTES
Dividend Decisions: Conceptual Overview

1. Introduction to Dividend Decisions

 Definition:
o Decisions concerning the distribution of a company’s profits to shareholders
versus retaining them for reinvestment.
 Key Questions:
o Should profits be retained or distributed?
o If distributed, how much and in what form (cash or stock dividends)?
o Timing of dividends (interim or final)?
 Importance:
o Balances shareholder expectations with the firm’s growth and liquidity needs.

2. Theories of Dividend Decisions

A. Relevance of Dividend Policy

1. Walter’s Model:
o Suggests dividend policy impacts the firm’s market value.
o Key Points:
 Firms should retain profits if return on investment (r) > cost of equity
(k).
 Distribute profits as dividends if r<kr < k.
 Shareholders are indifferent if r=kr = k.
2. Gordon’s Model (Bird-in-Hand Theory):
o Proposes that investors prefer certain dividends over uncertain capital gains.
o Assumptions:
 All-equity firms with investments financed via retained earnings.
 The firm’s growth rate is determined by its retention ratio and return
on investment.

B. Irrelevance of Dividend Policy

1. Modigliani and Miller (MM) Theory:

o Argues that dividend policy does not affect firm value in a perfect market.
o Key Assumptions:
 No taxes, transaction costs, or information asymmetry.
 Investors can sell shares for cash (homemade dividends).

3. Types of Dividends

 Cash Dividends:
o Direct payment to shareholders, representing a portion of profits.
 Stock Dividends:
o Additional shares distributed to shareholders, retaining cash within the
company.
4. Dividend Policies in Practice

 Stable Dividend Policy:

o Regular dividend payments irrespective of fluctuations in profits.
 Residual Dividend Policy:
o Dividends are paid after funding all acceptable investment opportunities.
 Hybrid Dividend Policy:
o A mix of stable and residual policies to maintain flexibility.

5. Determinants of Dividend Policy

1. Profitability:
o Profitable firms are more likely to pay higher dividends.
2. Liquidity:
o Adequate cash flow is essential for dividend payouts.
3. Growth Opportunities:
o High-growth firms prefer retaining earnings for reinvestment.
4. Market Expectations:
o Consistent dividend policies align with investor expectations.
5. Tax Considerations:
o Dividend decisions may consider tax implications for shareholders.
6. Legal and Contractual Constraints:
o Debt covenants and regulatory restrictions may limit dividend payments.

6. Practical Applications

 Balancing Retention and Distribution:

o Striking a balance between satisfying shareholders and retaining funds for
growth.
 Signaling Effect:
o Dividend changes may signal a firm’s financial health to the market.
 Investor Preferences:
o Income-oriented investors may prefer cash dividends, while growth-oriented
investors favor retained earnings.
UNIT 5: Working Capital Management: Conceptual Overview

1. Concepts of Working Capital

 Definition:
o The capital required for day-to-day operations of a business, calculated as the
difference between current assets and current liabilities.
 Types:
o Gross Working Capital: Total current assets.
o Net Working Capital: Current assets minus current liabilities.
 Significance:
o Ensures smooth business operations.
o Balances liquidity and profitability.

2. Operating and Cash Cycles

 Operating Cycle:
o The time taken to convert raw materials into cash through sales.
o Components:
1. Inventory Conversion Period: Time to produce and sell goods.
2. Receivables Collection Period: Time to collect cash from customers.
3. Payables Deferral Period: Time taken to pay suppliers.
o Formula:
Operating Cycle=Inventory Conversion Period+Receivables Collection Period
−Payables Deferral Period\text{Operating Cycle} = \text{Inventory
Conversion Period} + \text{Receivables Collection Period} - \text{Payables
Deferral Period}
 Cash Cycle:
o The time during which funds are tied up in operations.
o Formula: Cash Cycle=Operating Cycle−Payables Deferral Period\text{Cash
Cycle} = \text{Operating Cycle} - \text{Payables Deferral Period}

3. Risk-Return Trade-off in Working Capital

 High Working Capital:

o Reduces liquidity risk.
o Increases costs due to excess funds in current assets.
 Low Working Capital:
o Enhances profitability.
o Increases liquidity risk and potential for operational disruptions.
 Optimal Trade-off:
o Balances liquidity and profitability to maximize firm value.
4. Sources of Short-Term Finance

1. Trade Credit:
o Credit extended by suppliers; often interest-free.
2. Bank Credit:
o Includes overdrafts, cash credit, and short-term loans.
3. Commercial Paper:
o Unsecured promissory notes issued by corporations.
4. Factoring:
o Selling receivables to a third party for immediate cash.
5. Accruals:
o Expenses incurred but not yet paid (e.g., wages, taxes).

5. Working Capital Estimation

 Factors Influencing Estimation:

o Nature of business: Manufacturing firms require more working capital than
service firms.
o Business cycle: Seasonal businesses need higher working capital during peak
periods.
o Credit terms: Longer credit periods increase receivables and working capital
needs.
o Growth prospects: Rapidly growing firms require additional working capital.
 Techniques:
o Percentage of Sales Method: Working capital estimated as a percentage of
projected sales.
o Operating Cycle Method: Focuses on the time required to convert resources
into cash.

6. Cash Management

 Objectives:
o Ensure liquidity for operations.
o Minimize idle cash while maintaining sufficient reserves.
 Techniques:
o Cash budgeting and forecasting.
o Managing cash inflows and outflows.
o Using tools like lockbox systems and electronic fund transfers.

7. Receivables Management

 Objective:
o Optimize credit terms to maximize sales without compromising cash flow.
 Key Activities:
o Credit Policy: Establishing guidelines for granting credit.
o Credit Analysis: Assessing customers' creditworthiness.
o Collection Policy: Timely collection of outstanding dues.
 Importance:
o Reduces bad debts and improves liquidity.
8. Inventory Management

 Objective:
o Maintain optimal inventory levels to meet demand without excess holding
costs.
 Techniques:
o Economic Order Quantity (EOQ): Determines the ideal order quantity to
minimize total costs.
o Just-in-Time (JIT): Minimizes inventory by aligning production schedules
with demand.
o ABC Analysis: Classifies inventory based on value and importance.
 Significance:
o Reduces storage costs and obsolescence risk while ensuring timely availability
of inputs.
 LEO SIRS NOTES
Working Capital Management: Conceptual Overview

1. Concepts of Working Capital

 Definition:
o Refers to the funds required for daily operations, calculated as the difference
between current assets and current liabilities.
 Types:
o Gross Working Capital: Total current assets.
o Net Working Capital: Current assets minus current liabilities.
 Significance:
o Essential for maintaining business liquidity and operational efficiency.
o Balances profitability and risk.

2. Operating and Cash Cycles

 Operating Cycle:
o Time taken to convert raw materials into cash via sales.
o Components:
 Inventory Conversion Period: Time to produce and sell goods.
 Receivables Collection Period: Time to collect receivables.
 Payables Deferral Period: Time taken to pay suppliers.
o Formula:
 Operating Cycle=Inventory Period+Receivables Period−Payables Peri
od\text{Operating Cycle} = \text{Inventory Period} +
\text{Receivables Period} - \text{Payables Period}
 Cash Cycle:
o Duration for which funds are tied up in operations.
o Formula:
 Cash Cycle=Operating Cycle−Payables Deferral Period\text{Cash
Cycle} = \text{Operating Cycle} - \text{Payables Deferral Period}

3. Risk-Return Trade-off

 High Working Capital:

o Ensures liquidity but increases carrying costs (e.g., holding inventory).
 Low Working Capital:
o Improves profitability but increases risk of operational disruption.
 Optimal Trade-Off:
o Balances liquidity and profitability for sustainable operations.
4. Sources of Short-Term Finance

 Internal Sources:
o Retained earnings, internal accruals.
 External Sources:
o Trade Credit: Credit extended by suppliers.
o Bank Credit: Overdrafts, cash credits, and short-term loans.
o Commercial Paper: Unsecured promissory notes.
o Factoring: Selling receivables for immediate cash.
o Accruals: Delayed payments for wages or expenses.

5. Working Capital Estimation

 Factors Influencing Estimation:

o Nature of business (manufacturing vs. service-oriented).
o Business cycle and seasonality.
o Credit terms for receivables and payables.
o Inventory turnover and operating cycle.
 Estimation Methods:
o Operating Cycle Method:
 Identifies funds blocked in inventory, receivables, and cash.
o Percentage of Sales Method:
 Estimates working capital as a percentage of forecasted sales.

6. Cash Management

 Definition:
o Managing cash flows to ensure liquidity while minimizing idle cash.
 Objectives:
o Maintain sufficient cash to meet obligations.
o Optimize cash usage to maximize returns.
 Key Activities:
o Cash budgeting and forecasting.
o Aligning inflows and outflows.
o Techniques like lockbox systems and electronic transfers.

7. Receivables Management

 Objective:
o Minimize collection period and bad debts while maximizing sales.
 Activities:
o Credit Policy: Guidelines for granting credit.
o Credit Analysis: Assessing customers' creditworthiness.
o Collection Policy: Ensuring timely receivables collection.
 Importance:
o Enhances liquidity and reduces default risk.
8. Inventory Management

 Objective:
o Ensure availability of inventory while minimizing holding costs.
 Key Techniques:
o Economic Order Quantity (EOQ):
 Determines the optimal order quantity to minimize costs.
o Just-in-Time (JIT):
 Reduces inventory by producing goods only when needed.
o ABC Analysis:
 Categorizes inventory based on value and importance.
 Benefits:
o Reduces wastage and storage costs while meeting demand.