Session

Introduction to Corporate
Finance
 Origin of Corporate
Finance
• What is Finance?
Anything to do with
Money

• Types – Personal, Public,

Corporate

• Origin of Corporate
Finance
• Business Finance
• Profit Maximisation
• Complexities –
Interconnections
 Nee
Functions of Finance
d
• Financing decisions – Best mix of funding i.e. the
best capital structure, various ways of obtaining long
and short- term funds etc.
• Investment decisions – Allocation of funds to
investment activities, managing ongoing investments
efficiently and effectively etc.
• Liquidity decisions – Amount of cash & cash
equivalents to be kept
• Dividend decisions – Earnings distribution, share splits
etc.
• Reporting, Monitoring and Controlling of Funds
related decisions- Financial planning and fund
utilization
 Functions of a Finance
Manager
• Forecasting and planning

• Analysing and evaluating the investment

activities
• Coordinating and controlling

• Understanding the finance market

• Understanding risk management

• Evaluating performance measurement

 Goals of a
Firm
• FINANCIAL GOALS
• Setting achievable target market share
• Sustaining and maintaining the business
position
• Maintaining financial liquidity and solvency
• Maximising profit
• Maximising shareholders’ wealth

• NON-FINANCIAL GOALS
• Enhancing employee satisfaction and welfare
• Enhancing management satisfaction.
• Prioritising social objective
• Rendering quality service to customers
Finance and Other
Functions
 Key
Concepts
• Management vs Shareholders
– Role holders to run or manage the business
– Owners

• Agency Costs
– Costs incurred for controlling and monitoring
the Management
– Auditing
– Maintaining structures, job profile, roles etc.
 Chapter
2

Time Value of
Money

- Gayatri
Galvankar
 Meanin
g
“Money Today Is Worth More Than
Money Received Tomorrow”

As:

 Revenue generating capacity

 Inflation
 Opportunity Cost

INTEREST
 Interest Calculation
Approaches
 Simple Interest
Interest on Principal

 Compound Interest
Interest on Principal +
Interest
 Simple Interest
Approach
Mr X invests Rs 3,00,000 at 10% simple interest
per annum. The following table shows the
state of the investment, year by year for 5 years.
 Compound Interest
Approach
Mr X invests Rs 3,00,000 at 10% Compound interest
per annum. The following table shows the state
of the investment, year by year for 5 years.

Intere
st Cumulati
Year Principal Earne ve
d Amount
(@10
%)
1 3,00,000 30,000 3,30,000
2 3,30,000 33,000 3,63,000
3 3,63,000 36,300 3,99,300
4 3,99,300 39,930 4,39,230
Comparative table for Simple vs compound
interest on Rs. 1000 at an interest of
10%
 Future Value of Money

Future Value = Present Value (1 + Rate of Interest)

FV = Po (1+r)

Future Value = Present Value (1 + Rate of Interest)

^ No. of years

FV = PV (1+i)^n
 Future Value of Money
Example:

Investment - Rs
1000 Interest Rate
- 10%
What is the Future
value after 2
years?

FV = PV (1+ i ) ^
n
=1000 (1 +
0.10)^2 =
1000 * 1.21
= 1210
Relationship of Interest Rate, Time and
Future Value
1. When interest rate, i, increases, future value FV increases.
2. When number of years, n, increases, future value FV
increases.
3. When the principal, PV or P0, increases, future value FV
increases.
Year Interest Interest Interest
4.5
0 @5% @10% @15%
Future Value 0 1.00 1.00 1.00
4.0
1 1.05 1.10 1.15
0
3.5
15
% 2 1.10 1.21 1.32
0
3 1.16 1.33 1.52
3.0
FV of Re.

0 4 1.22 1.46 1.75

5 1.28 1.61 2.01
1

2.5 10
0 % 6 1.34 1.77 2.31
2.0
0 7 1.41 1.95 2.66
1.5 5
8 1.48 2.14 3.06
0
% 9 1.55 2.36 3.52
1.0
0 0 1 2 3 4 5 7 8 9
10 1.63 2.59 4.05
6 10
Years
 Present Value of Money

Present Value = Future Value / (1 + Rate of Interest)

^ No. of years

PV = FV / FV = PV *
(1+r)^n
(1+i)^n
Example:

Future Value after 2 years- Rs

1210 Interest Rate - 10%
What is the Present value?

PV = FV / (1+ i ) ^ n
= 1210 / (1 + 0.1)^2 = 1210
/ 1.21
= 1000
 Relationship of Interest Rate, Time and Present
Value
1. When interest rate, r, decreases, present value PV
increases.
2. When number of years, n, decreases, present value PV
increases.
3. When FV increases, present value of the principal PV
increases. Year Interest Interest Interest
Impact on Present @5% @10% @15%
1.0 Value
0 0 1.00 1.00 1.00
1 0.95 0.91 0.87
0.9
0 2 0.91 0.83 0.76
0.8
0.7
3 0.86 0.75 0.66
0 5
PV of Re.

4 0.82 0.68 0.57

0.6 %
0 5 0.78 0.62 0.50
0.5
1

0 10 6 0.75 0.56 0.43

0.4 % 7 0.71 0.51 0.38
0 15
0.3 % 8 0.68 0.47 0.33
0
9 0.64 0.42 0.28
0.2 0 1 2 3 4 5 6 7 8 9 10 0.61 0.39 0.25
0 10
Year
Present Value of Money

FV = PV * FVIF

(1+r)^n

PV = FV
(1+i)^
n
= FV * 1 PVIF
(1+i)^
n
 Time Value
Tables
With use of Time Value Tables

FV = PV (FVIF i,n)

PV = FV (PVIF i,n)
Time Value
Tables
Time Value
Tables
 Time Value of Money

Future Value = Present Value (1 + Rate of Interest)

^ No. of years
FV = PV (1+i)^n
Compounding

Present Value = Future Value / (1 + Rate of

Interest) ^ No. of years
PV = FV / (1+i)^n

Discounting
 Time Value
Tables
Examples:
1. Calculate the present value of INR 50,000 received
after five
years discounted at 10%.

PV = FV(PVIF10%,5)
= 50,000 × 0.621
= 31,050

2.Calculate the future value of INR 31,050 after five

years compounded at 10%.

FV = PV (FVIF 10%,5)
= 31,050 * 1.611
= 50,000
Time Value of Money using Excel
Time Value of Money using Excel
 Multiple times compounding
If compounded m no.of times in a
year

Terms:
 Nominal Interest Rate (NIR) – Quoted annual ROI
 Real / Effective rate of Interest (RI) – Actual effective ROI
considering compounding impact
RI > NIR
Higher the frequency of compounding, higher will be
the RI.

Using Excel
Multiple times compounding
 Annuities
Annuity is a series of a fixed amount of money received or
paid for a
particular period of time.
Eg: Receipt : Pensions from a pension plan / money back policies etc.
Payment: EMIs on loan, Instalments of a pension plan.

Types:

1.Ordinary annuity: Payments at the end of the

period. Eg: Receipt from money back
policies

2.Annuity due: Payments at the beginning of the

period. Eg: Lease payments, rentals
Annuity Due = Ordinary Annuity (1+
i)
 Time Value of
Annuities
R

FV = R * (FVIFA i,n) PV = R * (PVIFA

i,n)
R = Annuity

For Annuity Due multiply by (1+

i) Annuity due = Ordinary Annuity (1

+i)

Using Excel
Time Value of
Annuities
Excel Calculation
Excel Calculation
 Rule of 72

Doubling of Money
concept

r = 72 / n

n = 72 / r

Eg: Rs. 10,000/- doubles in 6 years – RoI = ?

No. of years for Rs. 12,000/- to double at
10%
 Growing
Annuities
Cash flow that grows at a specified rate for a specified period
of time.

If i = g thenPV =
nA
 Perpetuity

Annuity with infinite time period.

Series of payments that have a specified date of start but no
maturity as they continue forever.

P=A/i

P = present value of
perpetuity A = annual
receipt
i = Interest rate

Perpetuity with a growth rate

P = A / (i - g)

g= growth rate
 Amortisation
 Amortisation means paying off borrowed sum over a period of
time.
 Balance at the end of the repayment period is NIL
 Payment is a form of Annuity
 Payment towards Interest and Principal

Calculated using Average Capital Recovery / Amortisation Factor

(PVIFA)
PV = Eg:
R *Loan of Rs.
(PVIFA i,n) 1,00,000 for 5 years @ 14%. Calculate the
R
1,00,000 = R * (PVIFA
EMI.14%,5)
R = 1,00,000 / 3.433 =
29,129
EMI = 29,129 / 12 = Rs.
Using
2427
Excel
Amortisation
 Amortisation Schedule
Schedule showing the periodic repayments and its split
between Principal & Interest

0.14)
 Let’s Solve
together……
1

4
 Let’s Solve
5
together……

6
 Chapter
3

Cost of
Capital

- Prof. Gayatri
Galvankar
 Cost of Capital

What is Capital?
• Funds utilised in the
Business
Deb Equity
t

Ordinary
Bank Equity
Loans

Preferenc
e
Debenture Shares

Retained
s Bonds Earnings
 Cost of Capital
Capital Employed = Equity + Long Term
Debt Return on Capital Employed (ROCE)

Cost of Capital
 Cost of obtaining funds from
different sources
 Minimum rate of return expected by investors / lenders
of the company

Corollaries:
 ROCE should be > Wtg. Average Cost of Capital (WACC)
 Return on lent money = Cost of borrowed money
 Uses
Why learn about Cost of Capital?
 Find cheapest source of funding – Evaluate funding
decisions
 Know what should be the return on their investments
 Design their capital structure
 Strategic decisions on investments / Investment
Appraisals
 Evaluating the performance of the firm

Opportunity Cost :
Rate of return forgone on the next best alternative.
 Factors affecting Cost of Capital
 RISK – Reputation / Credit
rating
 Tenure
 Liquidity – Availability of funds
 Cost of Debt
Debt Instruments are instruments generally issued by corporates
at a
specified rate of interest for a specified time period.

Cost of Debt
 Rate of Interest
Kb = Interest / Principal
 Discount rate which equates the present value of cash flows
(interest + principal repayment) with the current market price of
the new debt.

P0 – Market Price of the I – Interest Rate

Debt Pn – Principal repayment in period
Kd – Cost of Debt n
n – no. of years
 Cost of Debt
Tax Advantage of Debt:
• Tax Deductible Expenditure
Kd = Kb (1 – Tax
Rate)
• Tax Shield = Interest * Tax Rate
 Types of Debt
 Based on Repayment
schedule:
 Redeemable
 Perpetual / Irredeemable

 Based on Issue Price

 At Par
 At Premium
 At Discount

How shall the cost of Debt differ for each

type??
 Cost of Debt
Perpetual
Debt:

Where I is the annual interest payment, SP is Sales proceeds, t is the Tax

Rate.

Redeemable Debt:

Where I is the annual interest payment, M is Maturity Value, Pb is the

purchase
price, N is no. of years to maturity.
M-Pb = Debt Premium

kb is Cost of Debt before Tax and kd is after Tax.

 Examples – Cost of Debt
Irredeemable
Debt:

Redeemable
Debt:

Redeemable in next 5
years.
 Yields of Bonds
WHAT?
Percentage of actual Interest Payment to the current Market price
of the bond

Yield to Maturity is Total Return from time of purchase until

Maturity
 Preference Shares
WHAT?
• Hybrid security between Equity and Debt
• Fixed return, no voting rights, preference over Equity in
winding up
• Preference Dividend not tax deductible

TYPES:
Irredeemabl
e
Redeemable

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s
 Cost of Preference Shares
COST:
Irredeemable:

Where D is dividend and P0 is price of

share

Redeemable:

Where M is Maturity Price, and Pb is price of share, N is no. of years to

Maturity
M-Pb = Share Premium
 Equity Shares
WHAT?
• Equity Shares – Part Owners
• No Fixed return, voting rights, Last preference in case of
winding up
• Riskiest investment
• Dividend not tax deductible
• Return on Equity is in 2 forms :
• Dividend
• Capital appreciation

Calculating the Cost of Equity:

• Riskiest so expects highest return
• Capital Gain depends on market perceptions hence
difficult to forecast.
• Widely used methods used to calculate cost are:
• Dividend Capitalisation Approach
 Cost of Equity Shares
Dividend Capitalisation Approach
• Rate of return required by Shareholder
• Discount rate which equates PV of expected Dividends to
Market
Price

Where P0 is Market Price, D is Dividend expected each year up to period t, ke is

Cost of Equity

Calculation of Cost of Equity:

• Constant Dividend

• Constant Growth Rate

• Flotation Cost
 Cost of Equity Shares
Capital Asset Pricing Model (CAPM)
• Most widely used method
• There exists a linear relationship between risk and expected
return.
• Calculates the cost of equity by considering the risk-free
rate and the risk free premium desired by the investor.
Expected Return = Risk Free Rate + Risk Premium
• Considers β – Beta Co-efficient - Risk of the Equity in relation
to the Market, Sensitivity of the security to the market

Where Rm is Market return and Rf is Risk Free

return

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 Cost of Equity Shares
Examples
1. Dividend per share of a firm is Re 1. cost of equity and is
expected to grow at 5% per annum perpetually. Calculate
the cost of equity capital, assuming the market price per
share as Rs 20.
Soln: Ke = 1/20+0.05 = 10%

2. Bharatware Corp. has equity stock with a beta of 1.35.

Estimated market return is 12%. Government Bond rate is
6.5%. Calculate cost of Equity.
Soln:
 Cost of Equity Shares
Exampl
e
 Cost of Retained Earnings
WHAT?
• Retained earnings are the earnings retained by the Business
for
reinvesting in the Business itself
• Earnings left after deducting Dividends payments from Profits
after tax and other provisions
• Shareholders forgo their current income (in the form of
dividend) by
allowing business to retain earnings for more profitable
investment.
• Helps in Capital Appreciation
• Form of Equity Funds

Cost of Retained Earnings:

Similar to required rate on Equity, adjusted for floatation costs.
Cost of Retained Earnings
 Weighted Average Cost of
Capital
• Capital is derived from various sources.
• Each source of capital has a distinct cost attached to it.
• The overall cost of capital is termed as weighted average
cost of capital (WACC).
• WACC is calculated by multiplying the cost of each capital
component
by its proportional weight and then summing it up.
 Weighted Average Cost of
Capital
Assigning Weights to the Source of
Capital:
• Book Value
• Current Market Value

Example:

Ans:
8.8%
Weighted Average Cost of
Capital
Weighted Average Cost of
Capital
 Factors affecting Cost of Capital

• Risk Free rate of Interest

• Business Risk
• Financial Risk
• Decisions of Financing
Mix
• Attitude of Management
• Requirement of the Firm
• Nature of Business
• Goodwill
 Chapter
4

Financial and Operating

Leverages

- Prof. Gayatri
Galvankar
 Leverages
WHAT??

• Origin - French word lever that means ‘to raise’ or ‘to

enhance’.

• In corporate finance the term leverage applies to the use of

certain fixed costs (that act as lever) that results in a
manifold increase (or leverage) in a firm’s profitability.

• For a business firm, the lever is the fixed operating costs

and the
fixed financing costs in the cost structure of the firm.
 Types of Leverages

Total
Leverage

Operating Financial

Sensitivity of the Sensitivity of the relationship

relationship between Sales between the EBIT and EPS
and EBIT due to its Fixed due to its Fixed financing
Operating Cost. cost.

Leverage associated with Leverage associated

asset acquisition with financing
activities activities
 Operating Leverages
WHAT??

• Operating leverage implies that by use of certain fixed

operating
costs the profitability of the business can be increased
manifold.
• In other words a small change in sales produces a large
change in the operating profits for firms having high fixed
costs in their cost structure.
• A higher proportion of fixed cost per unit or a lower
proportion of variable cost per unit in a firm’s cost
structure results in higher volatility of profits brought
about by a change in the level of output.
 Operating Leverages
Effect of Fixed Cost on EBIT - Operating Leverage
In Rs.
FIRM A B
Sales 10000 12000
Fixed Cost 8000 9000
Variable Cost 1000 1200
EBIT 1000 1800

50% increase in Sales Qty

FIRM A B
Sales 15000 18000
Fixed Cost 8000 9000
Variable Cost 1500 1800
EBIT 5500 7200

Increase in EBIT (%) 450 300

 Degree of Operating Leverage
• DOL is defined as the percentage change in operating
income (or EBIT) that results from a given percentage
change in sales.
• In effect, the DOL is an index number which measures the
effect of a
change in number of units of sales on operating income /
EBIT.

• DOL at different levels of Sales

Quantity
 DOL at various levels of Sales

Fixe Variabl Tota

Sales d e l EBIT DOL
Cos Cost Cos
t t
Units @ 15/unit @ 10/unit

5000 75000 50000 50000 100000 -25000 -1

8000 120000 50000 80000 130000 -10000 -4

10000 150000 50000 100000 150000 0 0

11000 165000 50000 110000 160000 5000 11

14000 210000 50000 140000 190000 20000 3.5

15000 225000 50000 150000 200000 25000 3

Example of DOL

= 70,000 / (70,000 –
30,000)
= 1.75
Breakeven
Sales Revenue

Total Cost

Variable
Cost

Fixed
Cost
Breakeven
 DOL and Break Even Point
• If a given business has a cost structure that involves use of
greater fixed costs—say 70 to 80 percent of total costs—
the break-even point comes at a higher level of production
and sales.

• The multiplier effect of fixed costs on operating profits

reduces as firms move further away from their break-even
point.

• A company that operates much above its break even point

reduces the degree of operating profit.

• Hence Business enterprises prefer to function sufficiently

high above their break even to avoid danger of fluctuation
in sales and profits due to DOL.
 Business Risk and DOL
• Firms having high degree of operating leverage DOL
generate good bottom line during growth phase, while
during adversities even a small amount of sales
decline leads to more than proportionate decline in
profits.
• Degree of operating leverage is a double edged sword
hence firms must aim to keep the DOL low. Generally a
high degree of operating leverage is not preferred as
leverage works in both directions positive as well as
negative thus creating a high-risk situation.
• Firms having high degree of operating leverage are prone to
large fluctuations in their operating profits anytime
sales levels fluctuate.
• This volatility in the operating profits is termed as Business
risk. Greater the degree of operating leverage of a given
firm; higher is its business risk.
 Financial Leverage
WHAT??
• Financial leverage magnifies the result of the firm by using
fixed
Financing Cost.
• Financial leverage implies that the capital structure includes
fixed cost funds like debt or preferred capital.
• In popular term financial leverage means use of debt in
firm’s capital structure. We say that financial leverage occurs
when firms use debt in their capital structure.
• Firms that have some degree of debt financing are called
‘Levered firms’.
 Degree of Financial Leverage
• Degree of Financial leverage is the change in earnings per share
caused by a change in Operating Profit.
• DFL tells us how much a given % change in EBIT will cause PAT or
EPS
to change.
DFL = % change in EPS
% change in EBIT

/
Degree of Financial Leverage
Degree of Financial Leverage
 Examples
OPERATING LEVERAGE:
Most of Microsoft’s costs are fixed, such as expenses for
upfront development and marketing - High operating
leverage.
Conversely, Walmart retail stores have low fixed costs and
large variable
costs, especially for merchandise. Because Walmart sells a huge
volume of items and pays upfront for each unit it sells, its cost of
goods sold increases as sales increase. - Low operating leverage.

FINANCIAL LEVERAGE:
Apple issued $4.7 billion of Green Bonds for the third time in
March 2022. By using debt funding, Apple is able to
expand low-carbon manufacturing, recycling opportunities,
and use of carbon-free aluminum. If the strategy results in
greater revenue than the cost of the bonds, Apple would have
successfully levered its investment.

Adani Energy – High Financial

Leverage TCS – Low Financial
 EBIT -EPS Analysis

• Financial leverage helps companies to increase their

earnings by using debt and preferred capital i.e. fixed cost
financing.
• An effective means to measure the optimum amount of
fixed cost of financing i.e. debt and preferred capital or
both is EBIT-EPS analysis.
• When fixed cost of financing will change, the equity
financing will also get affected.

EBIT –EPS analysis helps us to understand the affect on

Earning Per Share (EPS) due to the changes in Earning Before
Interest and Taxes (EBIT) under different financing alternatives.
 EBIT-EPS Analysis

EBIT – EPS Analysis helps firm to choose a capital structure (the financial
plan) that maximises EPS over a specified range of EBIT.

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 Total Leverage
WHAT??
• Combine effect of the two leverages namely Operating &
d
Financial.
• Total leverage is product of Operating and Financial
leverage to magnify profits.
• It is the use of fixed costs, both operating fixed costs and
financing costs, to magnify the impact of sales on firms’
earnings.
Total Leverage
Formulae for Degree of Leverage
Total Leverage

40% &

DTL Q (SP – VC)

= Q(SP-VC) –
FC – Int.
 Total Leverage

0
.

0
EBIT EPS Analysis
EBIT EPS Analysis
EBIT EPS Analysis
EBIT EPS Analysis
EBIT EPS Analysis
Cash, Receivables and
Inventory
Management

- Prof. Gayatri
Galvankar
 Introduction
WHY?
• Liquidity
• Reduction of Risk
• Cash is the most liquid current asset
• Efficient cash management helps the company to remain
healthy and strong. Poor cash management, may end up
pushing the company to crisis.
• Idle Cash is cost to Company (lost opportunity)

Related Concepts:
• Cost of not availing Prompt payment Discount

• Current Ratio = Current Assets / Current Liabilities

• Acid Test Ratio = (Current Assets – Inventory) / Current
Liabilities
 Motives of Holding Cash
• Transaction motive
• Speculative motive
• Precautionary motive
• Avoiding demerits of deficit
financing
• Compensating motive
 Efficient Cash Management
Involves efficient collections, efficient disbursements
and continuous and dynamic monitoring of cash movement.
 Cash Management Systems
Lock Box System:
• When a firm adopts the lock box system, it tells its
customers to mail their payments to special post office
boxes called lockboxes.
• Lock-boxes are widely dispersed because they are
usually adopted by multinationals, large and big
companies, which have their branches in many states.
• The amounts collected in various lock-boxes are
wired/mailed from each lock-box of firm’s-branch-bank
to the firm’s main office bank.
• Thus the lock box system helps to reduce the mailing
time, because Cheque are received at a nearby post office
instead of at corporate headquarters, and deposited and
cleared locally.
 Cash Management Systems
Cash Concentration System:
• When firms open up different collection centres
(banks) in different parts of the country in order to
reduce the postal delays, it is known as concentration
banking.
• Cash Concentration implies moving all cash from field
and branches to firm's head office where central cash
pool, is formed in one or two central banks known as
concentration banks.
• Cash concentration is encouraged by timely transfer of
funds to
and from concentration banks and regional branches.
 Cash Management Systems
Electronic Fund Transfer and Foreign Currency Transfer:
• Electronic fund transfer speeds up the cash receipt and
reduces the cash transit.
• In India we have the "NEFT Facility“ which means the
Electronic Funds Transfer Facility through the RBI
NEFT System.
• The transfer of foreign currency falls under the head
“international transfer”.
• International transfers are usually executed through
SWIFT (Society for World-wide Inter-bank Fund Transfer).
 Cash Management Systems
Efficient Disbursements and delaying payments:
• The companies speed up their collections and they
also slow down their disbursements.
• Companies slow down their payments by making
payments only when they fall due and not before and
centralize disbursements.
• The disbursements should be delayed as long as they
are not affecting the goodwill and credibility of the firm.
• For delaying cash payments, the firm should make
payments in
the last possible moment.
 Cash Management Systems
Playing the Float:
• The time that lags between the point when the firm
issues a Cheque and the time the payment is actually
made and is debited in the bank account is known as
float.
• Thus float is the time period between the payment and
actually receiving the cheque amount
 Tools of efficient Cash Management
• Cash Budget: is the forecasted cash needs of the firm.
Cash budget is used in cash forecasting i.e. determining
the amount of cash needed for the firm to meet out its
payments, obligations and running expenses.
• Daily Cash and Bank Report: Record of actual cash and
bank balances to monitor cash inflow and outflows.

Optimum Cash Balance:

ECM aims at maintaining an optimum level of cash (cash
pool) where there is trade-off between cost of
maintaining the cash surplus and cost of deficit financing
 Receivables Management
• Receivable Management means managing the credit sales
of the firm.
• Can improve cash available with the firm and hence
leads to
significant financial gain for the company.
• Basic objective is to collect the funds due and to
help the management in meeting their cash flow
requirements.
• An effective accounts receivable management can
help and support the management in achieving the
desired cash flow through the timely collection of
outstanding debts.

Rationale for Credit Sales:

• Improvement in Sales / Revenue

An efficient management of accounts receivable

implies less amount of outstanding account balances which
 Credit Policy
WHAT?
Terms on which Credit is extended to
customers. Credit Conditions:
• Credit Period
• Cash Discount
• Cash Discount Period

Dimensions of Credit
Policy
 Credit Sales
Categories: Cost
1. Monitoring costs: Cost of managing the receivables
(arising due to adoption of credit sales) or additional
receivable (arising due to extension of existing
credit period) if the firm adopts or relaxes its
credit standards.
2. Bad debt costs: Cost associated with the occurrence
of bad debts, i.e. losses occurring in credit sales.
3. Opportunity Cost: Opportunity cost is the cost associated
with
foregoing of the next best alternative available to the firm.
4. Collection Costs: Costs incurred in extra efforts to
monitor and recover funds blocked in receivables.
 Receivables Management
Factors affecting size of Receivables:
• Level of Sales
• Credit Policy
• Credit Terms
• Costs of Receivables
• Nature of Business
• Collection Policy
• Quality of Customers
• Age and Experience of the Management
• Length of Time the Customer has been in
Business

Types of Credit Instruments:

• Bills Payable
• Promissory Notes
• Commercial Draft
• Trade Acceptance
• Letter of Credit
 Monitoring of
3 methods: Receivables
1. Average Collection Period (ACP) = Receivables / Credit Sales *
360

2. Day’s Sale Outstanding = Average Receivales / Average

Daily Sales
3. Receivables Ageing Schedule – Age analysis of
receivables to see which has high risk of defaults.
 Inventory Management
Types of Inventory:
• Raw Material
• Work in Process
• Finishes Goods
• Stores and Spares

Significance:
• Transaction motive to avoiding loss related to the gap
between the demand and supply of goods.
• Gaining quantity discounts.
• Reduction of ordering cost.
• Efficiency and economy of production run.
• Precautionary motive.
• Creation of goodwill with customers.
 Inventory Management
Costs related to Inventory:
• Ordering costs
• Carrying costs
• Shortage or Stock-out
Cost
 Inventory Management
Ordering Cost:
• Remains fixed irrespective of the size of the order.
• It increases with increase in the frequency of orders
placed.
• Thus by increasing order size and decreasing order
frequency
ordering costs are reduced.
TOC = No. of Orders * OC per
order Or
TOC = (U * F) / Q
U = Annual Usage of Inventory, F = Fixed cost per order, Q
= Quantity per order
 Inventory Management
Carrying Cost:
• Directly influenced by the investment in inventory
• As inventory size increases so does the carrying cost
• Thus, if ordering size increases the carrying cost also
increases.
 Inventory Management
Total Inventory Cost:
TIC = TOC +
TCC

Ordering Cost + Carrying Cost

EIM is to minimise this cost
Inventory Management
 Inventory Policy
Conservative Policy : High Inventory, Low risk of
stoppage

Aggressive Policy: Low / Just in Time Inventory, High

risk of
stoppage
 Inventory Management with EOQ
• Economic Order Quantity or EOQ is the most economic
quantity of material a firm can order and hold as inventory
so that production system and distribution runs smoothly.
• It is the optimum size of inventory that yields maximum
benefit
at minimum cost.
• Total Inventory Cost TIC is the sum of Total Ordering Cost
TOC and the Total Carrying Cost TCC.
• Both T.O.C. and T.C.C. are inversely related to each other
i.e. as
order size increases T.O.C. decreases and T.C.C. increases
 Inventory Management with EOQ
Assumptions:
• Constant demand
• Purchase price remains constant
• Instant delivery
• Constant ordering costs and carrying costs

Reorder Level: Level at which a new order should be placed

Reorder Level = Consumption during lead time + Safety
Stock
= Average Daily Consumption * Lead Days +
Safety Stock
 Inventory Management with ABC
• Analysis
The total inventory of a firm may contain both valuable and
less valuable items.
• ABC system measures the value of each item of
inventories. The highest valued items are classified as 'A
inventory and would demand maximum control and
monitoring.
• The lowest valued inventory items are classified 'C' inventory
and require least control and monitoring.
• Class 'B' inventory requires control and monitoring which
falls between the above two categories. The ABC system is
also known as control by importance and selection. tems
• The ABC classification process is an analysis of a range,
of i such as finished products or customers into three
categories:
• A -Outstandingly important in value;
• B -of average importance in value;
• C -Relatively unimportant in value (as a basis for a
control scheme. )
• Also called as Control by Importance and Exception (CIE)
 Chapter
6

Capital
Structure

- Prof. Gayatri
Galvankar
Introduction
 Theories
The capital structure theories can be demarcated into two
categories depending on their view of relation between Capital
Structure and the value of the firm.
a) Relevant theories
b) Irrelevant theories.

The relevant view states that capitals structure decisions are

relevant for the firm value. They affect the value of the firm.

The irrelevance group theories state that the firm’s capitals

structure does not affect its value. The firm’s value is
independent of its capital structure. The firm’s value depends
upon its investment decision rather than its financing decisions.
 Theories
Capital Structure
Theories

Relevan Irrelevant
t

Net Operating
Income Income
Approach Approach

Traditional
Approach Modigliani Miller
Approach

Trade Off
Theory
 Relevant Theories
NET INCOME APPROACH:
• The Net Income Approach states that the capital structure
of any
given firm creates an impact on the value of the firm.
• Thus capital structure is important as a determinant of a
given
firm’s value.
• The debt-equity ratio of a firm affects its value and its
stock price. Therefore, the use of debt (leverage) creates an
impact both in the overall cost of capital (WACC) and the
value of the firm.
• In the net income approach the Net Income is
capitalized for determining the market value of the firm.
 Relevant Theories
NET INCOME APPROACH:
 Relevant Theories
NET INCOME APPROACH:
If we assume earnings are constant for the
lifetime
 Relevant Theories
NET INCOME APPROACH:
Company A has a debt of Rs. 10,000 @ 5% p.a. and equity of Rs.
45000 with cost of 10% p.a. Company B has same equity but
Debt of Rs. 20,000 @ 5% p.a.

A B
 Relevant Theories
TRADITIONAL APPROACH:
• The traditional view holds that there is an optimal capital
structure.
•
At this optimum capital structure the weighted average cost of
capital
(WACC) is minimized thereby maximizing the firm’s market value.
• The traditional theory is in continuation with the views of the
Net Income approach.
• Like Net Income Approach it argues that there exists benefit
to the firm as well as the shareholders of the firm that
employs high leverage.
 Relevant Theories
TRADITIONAL APPROACH:
 Recap
• Capital Structure
• Theories of Capital Structure
• Relevant - Net Income Approach, Traditional Approach
• Irrelevant – Operating Income Approach, Modigliani
Miller Approach, Trade-off Theory
• Modigliani Miller Approach: Arbitrage, Assumptions,
Propositions
 Recap

Capital Structure
Theories

Relevan
t

Net Income
Approach

Traditional
Approach
 Irrelevant Theories
NET OPERATING INCOME APPROACH:
• According to Net Operating Income approach, there is no optimal
capital
structure for any firm i.e. capital structure is irrelevant for a given
firm.
• The financing decisions does not affect the average cost of
capital of the company; and hence the total value of the firm
remains unchanged with changes in the debt proportion
 Irrelevant Theories
NET OPERATING INCOME APPROACH:
• Introduced by David Durand
• Value of the firm depends on Operating Revenue and Business
risk and
not on Capital Structure.
• The changes in Captial Structure realign the cost of Debt and
Equity such that the total cost of capital and hence the value of the
firm does not change.
Assumptions:
Irrelevant Theories
Irrelevant Theories
 Modigliani-Miller Theory
The Arbitrage argument
• States that firms of same risk class have similar types of
assets and firms having similar types of assets will also have
similar value.
• Their value will not be affected by their financing decisions.
• Their value will be affected by their investment decisions.
• MM in their model argued that arbitrage opportunities exist for
the investor in perfect capital markets under the assumption
that the value of a firm is a function of its financing decisions.
 Modigliani-Miller Theory
Assumptions
• Perfect Capital Markets. Perfect Information. No transaction
costs
• Investors are Rational, evaluate risk and return rationally
before
investing.
• Firms can be classified into distinct homogeneous risk
categories.
• Zero Tax environment
• Known, definite and perpetual Earnings
• Investment decisions are known and definite
• Only debt and equity is issued and debt is risk free
• No cost for financial distress and liquidation. Equity holders will
get
the market value of shares in case of liquidation.
 Modigliani-Miller Theory
Propositio
ns
Modigliani-Miller Theory
Modigliani-Miller Theory
 Modigliani-Miller Theory
MM With Tax Theory
• Total Cost of Capital decreases with increase in Debt
portion
• Optimal Capital Structure will be at 100% Debt
 Trade off Theory
• Modification of the Modigliani and Miller irrelevance
hypothesis of capital structure.
• Argues that the capital structure of any firm is a result of the
firm’s trading off i.e. the advantages arising out of increased
leverage in the form of low cost of debt and a debt-tax shield,
against the potential financial risk (financial distress) that may
arise due to increased debt.
• Basically the financial risk or financial distress relates to the
chances of the firm going bankrupt due to excessive
indebtedness.
• Apart from bankruptcy risk, the financial distress will also include
the agency cost that arises due to the probability of the
firm getting insolvent.
• The shareowners are worried over such affair as they may land
up to lose everything under the condition of firm being declared
insolvent or bankrupt.
• Thus their exists an Optimum Capital Structure for every firm at
the point where its marginal value of debt benefits are more
than the expected cost of financial distress.
 Agency Costs

• According to Jensen and Meckling, agency costs are the sum of

the monitoring expenditures by the principal, bonding costs by
the agent and a residual loss.
• Agency problems arise when the corporate managers
misuse the earnings generated by focusing on more
perquisite distribution to managers and wrong long-term
investments.
• Conflict can occur between management and shareowners
which
leads to agency cost of equity.
• Conflict can also arise between debt holders and
management and shareowners that lead to agency cost of
debt.
• At Optimal Capital Structure, agency costs are also at
Optimal
 Factors Affecting Capital Structure
• Favourable financial leverage
• Tax advantage of debt
• Flexibility to borrow
• Risk exposure restricted to reasonable limits
• Prevailing market conditions
• Retention of control
• Integration of financial policies and corporate strategies
• Raise of capital at the proper time
• Compliance with the norms of lenders and credit-rating
agencies
• Issuance of innovative securities
• Transaction costs
 Chapter
7

Capital Budgeting Methods

- Prof. Gayatri
Galvankar
 Introduction

Capital budgeting techniques help in:

• Identifying, analyzing and selecting investment
projects
• Evaluation
• Feasibility
• Valuation
 Methods

The various techniques used for evaluation of capital budgeting

decisions can be divided into two broad groups:
• Non-discounting cash flow (NDCF) techniques or
unsophisticated
techniques and

• Discounting cash flow techniques (DCF) or sophisticated

techniques
(also known as time-adjusted techniques).
 Methods
Payback period (PB)

Non-Discounting
Accounting Rate of
Return (ARR)
method
Techniques
Budgeting
Capital

Discounted Pay
Back Period
(DBP)

Profitability Index
(PI)

Net Present
Discounting
Value
(NPV)
Modified Net
Present Value
(MNPV)
Internal Rate
Of Return
(IRR)
 Methods

1.Non discounting methods

• Payback period (PB)
• Accounting Rate of Return (ARR)
method

2.Discounting methods
• Discounted Pay Back Period (DBP)
• Profitability Index (PI),
• Net Present Value (NPV),
• Modified Net Present Value (MNPV)
• Internal Rate Of Return (IRR)
 Payback Period Method

• The payback period method is tells us the number of years

required to recover the initial investment made by the firm in
the project.
• The payback period is the time period taken to recover the
initial
cost of the investment.

• The year in which your cumulative returns equals the

initial investment.
Payback Period Method
Payback Period Method
 Payback Period Method
ACCEPT OR REJECT RULE

The firm presents a standard or a target PB. The PB of the

projects is
compared with the target PB.
• If project’s PB period > target PB, then the project is rejected.
• If the project’s PB period < target PB, then the project is
accepted.
• If the project’s PB period = target PB, then one is indifferent to
the project. Acceptance or rejection will make no difference to
the value of the firm.

When n number of projects are to be appraised, then the project

with the
lowest PB is selected.
Payback Period Method
The Accounting Rate of Return (ARR)
Method
The ARR is determined by dividing average income by
average investment.

ACCEPT OR REJECT RULE

The firm fixes a target or a standard ARR or it considers its
cost of
capital (k). This is then compared with the given project(s)’s
ARR.
• If project’s ARR > target ARR or k, then the project is
accepted.
• If project’s ARR < target ARR or k , then the project is
rejected.
• If project’s ARR = target ARR or k , then one is indifferent
to the
project.
The Accounting Rate of Return (ARR)
Method
The Accounting Rate of Return (ARR)
Method
 Discounted Payback Method
Same as payback method except that the cash inflows are
adjusted with time value of money to calculate the payback.

With the following information, calculate Discounted PB.

Discounting @
10%
 Profitability Index (PI) Method
Also known as Benefit-Cost ratio analysis.
Used when firms have only a limited supply of
capital

ACCEPT OR REJECT RULE

• If PI > 1, then the project proposal is
accepted.
• If PI < 1, then the project proposal is
rejected.
Profitability Index (PI) Method
Profitability Index (PI) Method
Profitability Index (PI) Method
 Net Present Value (NPV) Method
• Involves discounting net cash flows for a project, then
subtracting net investment from the discounted net cash
flows.
• The result is called the net present value (NPV).

ACCEPT OR REJECT RULE

• If NPV > 0, then the project proposal is accepted.
• If NPV < 0, then the project proposal is rejected.
• If NPV = 0, then one is indifferent to the project
proposal
Net Present Value (NPV) Method

= INR
1,340.8
 Net Present Value (NPV) Method

Initial Cash Outflow is Rs. 60,000 for both the projects.

 Net Present Value (NPV)
Using Excel
Method
-
 NPV and PI
Points to remember:

 NPV and PI will give same results if the initial outflow is same
 NPV and PI may give contradictory results when initial outflow is
different. In
such cases, select basis NPV.
Net Present Value (NPV) Method
 Modified Net Present Value (MNPV)
• Method
Also called as the Terminal Value (TV) method
• Considers the reinvestmentof cash flows generatedduring
the project.
 Modified NPV Method

Net Present Value is 19,726 – 10,000 = Rs.

9,726
 Internal Rate of Return (IRR) Method
• Internal rate of return that a given investment generates
over its useful life.
• It is the measured as the Return yielded by the
investment.
• IRR is a popular, time-adjusted technique and
overcomes the disadvantages of the traditional
techniques.
• When evaluating an investment it takes into account
both the magnitude and timings of expected cash flows
in every time period of project’s life.
• IRR is the amount of profit you get by investing in a
certain
project.
• It is a percentage. An IRR of 10% means you make 10%
profit per year on the money invested in the project.
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 Internal Rate of Return (IRR) Method
ACCEPT OR REJECT RULE:
• IRR < Cost of Capital or Minimum Desired Rate of return –
Reject
• IRR > Cost of Capital or Minimum Desired Rate of return –
Accept
• IRR = Cost of Capital or Minimum Desired Rate of return –
Indifferent

Rationale:
• IRR, basically computes a break-even rate of return.
• At IRR, the NPV is zero.
• It shows the discount rate below which an investment
results in a positive NPV (and should be selected) and
above which an investment results in a negative NPV
(and should be rejected).
IRR is the break-even discount rate, the rate at which the
value of
Internal Rate of Return (IRR) Method
Internal Rate of Return (IRR) Method
 Internal Rate of Return (IRR) Method
Limitations:
• Projects with Unconventional Cash flows –
Contradiction between NPV and IRR

• Multiple IRRs – When CF changes signs multiple

times
 Modified Internal Rate of Return (MIRR)
• MIRR is the compound average rate of return per annum
that a project generates if its cash flows are reinvested
at a rate different than the project’s IRR.
• This rate can ideally be the opportunity cost of capital
for the
project.
Modified Internal Rate of Return (MIRR)
 Capital Rationing
WHAT?
• When firms have to take investment decisions under
the constraint of fund availability it is termed as Capital
rationing.
• Funds available with the firm are limited
• Thus lesser the funds available with the firm, lesser will be
the number of profitable investment projects accepted by
the firm.
• Under capital rationing the usual capital budgeting
decisions have to be restructured in order to maintain the
profitability and value addition of the firm.
 Capital Rationing
Types:
• Hard Capital Rationing:
• Fund Constraint due to external forces.
• The limitations are externally determined.
• Happens in imperfect markets where availability of funds
from same source varies for different firms and at
different rates.

• Soft Capital Rationing:

• Fund constraint is due to internal factors like
management- imposed limits on investment
expenditure.
• The management may limit the company's further
investments, either by setting a limit on parts of the capital
budget or by using a higher cost of capital.
 Chp.
8

Working Capital
Management

- Prof. Gayatri
Galvankar
 Introduction
• Assets and Liabilities are categorised as : Current and Non-
Current
• Current : Liquidated in short term (less than 1 year)
• Non-Current : Liquidated in long term (more than 1 year)

• Liquidity means Capacity to be converted into Cash

• The variables that determine the liquidity of a given asset are
• time taken by the asset to convert into cash,
• efforts put in to convert the asset into cash,
• the risk associated with the asset convertibility, and
• the amount of cash realized compared to the original cost
of the
asset.

• Current Assets are Liquid Assets.

 Introduction
Gross working capital (GWC)= Total Current assets (TCA)

Net Working Capital (NWC) = GWC - Total Current Liabilities

(TCL)
Also called the liquid surplus of the firm

Financing of WC:
• Fixed assets are financed by owned funds and long term
liabilities.
• Current Assets are financed by Current Liabilities and Short
term Bank Borrowings
 Objectives of Working Capital
Management
• Involves administering and controlling current assets as
well as procurement and financing of the current assets.
• Deals with funds involved in day-to-day operations of the
firm.
• Important for protecting the firm from liquidity problems.

WHY?
• Maintain Liquidity
• Ensure optimum levels

Objectives:
• To provide enough liquidity so that production process
continues smoothly during the normal course of the
business.
• Scarcity of working capital may result in interrupted
and inefficient production processes
• Scarcity of fund investment in current assets may also
imply lack of confidence of investors in the firm.
Objectives of Working Capital
Management
• Idle Funds
• Cost of Storing
and managing
• Inefficient
inventory
credit policies
Carrying
• Selling costs to
Cost
liquidate
receivables
• seasonal
Wastage/loss / of stock
in
cyclical industries

• Interruption /
Shortage inefficient production
Cost process
• Higher buying costs
• Higher borrowing
costs
• Not
Loss meeting demand
–
loss
of of reputation

Investor confidence

To maintain Optimum Level of Working Capital

 Working Capital Policies
Conservative Working Capital Policy
• Firm maintains huge investments in its current assets –
High liquidity
• Low risk and uncertainty – as funds are not invested to
produce
future benefits, but in existing current assets.
• Low Returns

Aggressive Working Capital Policy

• Firm invests scarcely in its current assets - Liquidity of the firm
will be quite low.
• Surplus funds are invested in profitable investment
opportunities
• High risk
• High returns

Trade-off (balance) between Liquidity and Risk / Return

Working Capital Policies
 Factors affecting Working Capital
• Nature of business
• Nature of raw material used – Seasonal
• Process technology used, Multi processing
• Nature of finished goods, shelf life
• Degree of competition in the market, credit sales
• Paying habits of the customers
• Degree of synchronization among cash inflows and cash
outflows
• Easy availability of working capital
• Management of the firm
 Operating and Cash Cycle
• Operating cycle signifies the time taken by the firm in
processing the raw material into finished goods for earning
sales revenue.

• Cash cycle is the time between the cash payments and the
cash collections.

• When accounts payable period is deducted from the

operating cycle
we get the cash cycle of the firm.
Cash Cycle = Operating Cycle – Accounts Payable
 Calculations – Operating Cycle
Steps:
1. Calculate the stocking period of the raw material. It is the time
taken by the firm to convert raw material into semi-finished
goods or work- in-process.

Step
1
 Calculations – Operating Cycle
Steps:
2. Calculate the conversion period of semi-finished goods into
finished goods – Time taken by the firm to convert the work-
in-process into finished goods

Step
2
 Calculations – Operating Cycle
Steps:
3. Calculate storage period of finished goods – Time taken by the
firm to convert the finished goods into sales.

Step
3
 Calculations – Operating Cycle
Steps:
4. Calculate average collection period – Time taken by the
debtors in paying the firm against credit sales.

Step
4
 Calculations – Operating / Cash Cycle
Steps:
5. Calculate average payment period – Time taken by the firm in
paying its creditors against credit purchases

Step 5
Payment
to Supplier
 Calculations – Operating / Cash Cycle
Steps:

Gross Operating Cycle Period = n1 + n2 + n3 + n4

Cash Cycle (Net Operating Cycle) = n1 + n2 + n3 +

n4 – n5
 Related Concepts
Important Ratios:

Current Ratio
Quick Ratio / Acid Test Ratio
Debtors Turnover Ratio
Inventory Turnover Ratio
Working Capital Turnover
Ratio

Reference :
Investopedia
 Hedging Approach
What?
Mitigating
Risk

• Also called
as
Matching
Approach
• Permanent assets should be financed with long-term capital
(long term liabilities + equity) and temporary assets should
be financed with short-term credit.
 Types of Working Capital Requirement
• Permanent: Part of current assets, which is fixed is
and mandatory requirement of the firm. the
• Temporary: Extra funds required to finance the that part of
working capital which is over and above fixed working
capital. Based on contingent needs of business.
 Working Capital Requirement
• Working capital requirement is usually estimated with the
help of operating cycle concept.
• Other Methods: Sales, Holding Period, Operating Cycle Concept
and
fixed investment.
 Chp.
9

Short Term Sources of Financing

- Prof. Gayatri
Galvankar
 Introduction
Short-term funds are funds borrowed for repayment within a
year.

Sources:
• Accrued expenses
• Provisions and reserves
• Trade credit
• Bank finance
• Cash credit
• Overdraft
• Note lending
• Discounting of bills
• Letter of credit
• Public deposits
• Commercial papers
• Factoring
 Accrued Expenses and Provisions
Accrued Expenses:
• Payments that are to be made by the firm, but are
delayed or are payable at some future date other than the
date of payment are known as ‘accrued expenses’.
• Accrued expenses are expenses that have occurred, but
are not paid.

Provisions and Reserves:

• Provisions may also be made in the books, against some
future liability such as tax when the amount is not
certain.
• As these provisions are not immediate cash outflows,
they
provide funds for the firm for its current use.
• Reserves are transferred profits for specific purposes.
 Trade Credit
A kind of spontaneous source of financing that arises from
day-to- day business transactions.

Cost of Trade Credit:

Whether to accept discount and make early payment or
delay payment
Credit Terms Eg: 2/15 Net 30
 Bank Finance
• Banks offer short-term funds for business enterprise in
different forms.
• Under direct financing, the bank provides finance, and it
also covers the risks such as cash credit, overdraft, note
lending and discounting of bills.
• The various forms of bank finance are as follows:
• Cash credit
• Overdraft
• Note lending
• Discounting of bills
• Letter of credit
• Commercial Papers
• Public Deposits
• Factoring
• Forfaiting
 Bank Finance
1. Cash credit –
• Rotatory Account
• Sanctioned Limits
• Hypothecated against assets / securities at a particular
margin.
2. Overdraft
• Running account
• Does not earn interest
• Business allowed to overdraw up to a fixed limit
• Security by pledge of assets
3. Note lending
• Not running account
• Sanctioned for a period
• Loan against promissory note by borrower.
• Interest on total limit charged
4. Discounting of bills
• Encashing receivables at a fee (discount)
• Bank received from the Debtors of the Business
 Bank Finance
5. Letter of credit
• Form of Credit Purchase
• Bank takes guarantee of payment to supplier

6. Commercial Papers
• Short duration
• Unsecured Promissory Notes
• Fixed Maturity max. of 270 days.
• Issued at Discount
• Money Market Instruments issued by big corporates
• ABCP – Asset Backed Commercial Papers

7. Public Deposits
• Short term funds raised from general public (6 months to 3
years)
• Non-financial institutions
• Regulated under Companies Act
• Up to 10% of Paid up Capital + Reserves
• Interest Rate maximum of 15%
 Bank Finance
8. Factoring
• Financial Innovation
• Financial and Management Support
• Convert non-productive, inactive current assets into Cash
• Sale of accounts receivable to Factor who is a
specialised
institution who manages entire receivables for a fee.
• Can be ‘with recourse’ or ‘without recourse’
• Advance and lump sum payments.

Services offered:
• Purchasing receivables
• Maintaining sales ledger administration
• Maintaining credit management
• Undertaking credit collection
• Protecting against default and bad debts
• Providing financial accommodation against assigned
book debts
• Assuming losses which may arise from bad debts
• Providing relevant advisory services to the seller
 Bank Finance
8. Factoring

Types
• Recourse factoring
• Non-recourse
factoring
• Maturity factoring
• Advance factoring
• Invoice discounting
• Undisclosed
factoring
Factoring vs Bill
Discounting
Bank Finance
 Bank Finance
9. Forfaiting
• Process of purchasing receivables from exporters.
Forfaiter assumes all risks associated with
receivables.
• Once the forfaiting instrument is issued, the exporter
cannot be denied the cash payment even if importer
does not pay. Forfaiting helps exporter’s encash
the trade credit in International trade transactions.
• Exporter approaches a forfeiter who agrees to
discount the trade transaction receivables at a quoted
rate of ‘n’ per cent plus a charge for x days grace and
fee for the deal.
• Transaction based

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Bank Finance
Capital Budgeting
Decisions

- Prof. Gayatri
Galvankar
 Introduction
WHAT?
• Capital budgeting is a process where the company
identifies, analyses and selects one or more long-term
projects
• Capital budgeting deals with the acquisition or
generation of assets that create benefits in the form of
positive returns over multiple periods in future.
• Investment decisions or capital budgeting decisions, are the
most important strategic decisions affecting a firm’s long-
term value.
• The long-term decisions of a firm emphasise the firm’s
value addition in the long run.
• Capital budgeting also deals with corporate
restructuring initiatives that streamline the business of the
firm and increase the firm’s focus on its core strengths.
 Understanding Capital Investments
• Capital budgeting is based upon identifying opportunities
and threats in the environment, as well as internal
weaknesses, setting long-term goals, formulating action
plans and strategies and implementing them with online
continuous monitoring and feedback from the systems.
• Capital budgeting is fundamentally concerned with
large investments in long-term assets.
• Capital investment decisions deal with the creation of
assets.
als
• Capital
o considered equivalentthat to
investments reducecapital investment
the investments
generate
decisions future
are that
profits for the firm and increase its growth
rate.
Understanding Capital Investments
Characteristics of Capital Budgeting
Decisions
• Long-term consequences
• Large initial investments
• High degree of risk
• Irreversibility of decisions
• Indicator of a firm’s growth
potential
 Capital Budgeting Process

• The Capital Budgeting process determines the direction

of the capital investment.
• From the time the company decides to take up
investments opportunities till the time the
investments projects are implemented, the company
looks for growth.
• The value creation will depend on the feasibility
and profitability of the capital investment decisions.
Capital Budgeting Decision
Steps in a typical Capital Budgeting
Decision
 Capital Budgeting Decision
1. IDENTIFYING PROFITABLE INVESTMENT OPPORTUNITIES

• Tap the market for available opportunities

• Analyse w.r.t. strengths, weakness, opportunities and threats
• Alignment with Company Objectives
• Choose alternatives for further evaluation.
 Capital Budgeting Process
2. PLANNING AND PREPARING THE CAPITAL BUDGET
• Capital budget is the investment proposal(s) the firm will
adopt after careful evaluation and selection.
• The firm may have various investment proposals identified
by its departments, managers, chief operating officer and
others.
• Large firms have standardized capital investment proposal
forms that are submitted to the central head.
• Good firms do not select capital investment opportunities in a
rush.
• They circulate these proposal forms amongst all the relevant
people so that they are able to evaluate the capital
investment decision from different angles.
• Such firms may also organize brainstorming and
discussion sessions to assess the feasibility of such
opportunities.
 Capital Budgeting Process
3. ESTIMATING AND EVALUATING CASH FLOWS
• The capital expenditure decisions are evaluated in
terms of their cash flows.
• Before adoption of any project the managers need to
estimate the related cash flows, i.e. the cash outflows
(investment) and the cash inflows (benefits).
• After various adjustments, (like depreciation and
taxes), of different Capital Budgeting opportunities, the
cash flows are estimated and expressed in monetary
terms.
• Hence costs and benefits of each investment
proposal are determined to ascertain the net cash
income generated from each proposal respectively.
 Capital Budgeting Process
Points to remember while estimating Cash Flows:
• Cash flow is different from accounting income
• Incremental Cash flows to be considered:
• Sunk
• Opportunity cost
• Time value of money and inflation (present
value)
• Cost of capital (discount rate)
• Inflation Rate
• Nominal vs Real Discount Rate
Real Discount rate = (1+ Nominal Discount rate)

1
(1+ Inflation Rate)
• Changes in Working capital to be factored
• Current Assets
 Capital Budgeting Process
Classification of Incremental Cash Flow (ICF)
1. Cash flows that occur only at the beginning of the
project’s life,
Time 0.
2. Cash flows that occur continuously throughout the
project’s
life, Time period 1 through n.
3. Cash flows that occur only at the end or the termination
of the project, Time period n.
ICF is sum total of above three.
 Capital Budgeting Process
1. Initial Cash Flow:
Determined by adjusting Installation costs, tax, sales
proceeds from sale of old assets etc. from Gross Cash
outflows.
2. Interim Cash flows:
After Initial investment, cash flows arising from the
project –
benefit and costs.
After-tax operating cash flows generated by the project.
3. Terminal Cash Flow:
• Final year of existence.
• Associated with unwinding of the investment decision
• Sale of Fixed Asset, Tax Effect on sale of asset,
recovery of Working capital investment
 Capital Budgeting Process
4. SELECTING THE PROJECT PROPOSAL:
• Final project selections involves usage of methods e.g.
NPV, payback period, IRR etc. (Capital Budgeting
Techniques)
• Depending on Fund availability
5. IMPLEMENTING THE PROJECT:
• Project implementationshould not involve too much or
too little time – Time overrun will impact project cost,
feasibility
• Project formulation plan - flexibility
• Responsibility accounting- Project managers
responsible for completing the project within the
specified time period / cost.
6. ONLINE MONITORING:
• The projects are monitored continuously, and they are
given feed forward control so that any deviations and
discrepancies can be checked as they arise and not later
on.
 Capital Budgeting Process
7. DETERMINING POST-AUDIT CONTROL
• Auditing is determining whether all the economic
transactions carried out by the firm are correct or not.
• Post-audit control simply compares the actual
performance of the capital expenditure decision with
the preset standard performance.
• Post-completion audit is used basically as a feedback
device.
 Limitations of Capital Budgeting
Decisions
Capital budgeting decisions involve large investments due
to the nature of investment plans such as purchasing of any
fixed asset, launching a new product, product line, product
improvisation, and branch expansion.
• Availability of funds may impact decisions and hence
growth.
• Capital budgeting decisions tend to be very rigid and are
mostly irreversible decisions.
• Inaccuracy in forecasting may lead to unbalanced
investment
• Bad investment decision may hamper liquidity,
profitability, risk structure, technological edge, capacities,
customer base etc.
 Recap
• Capital Budgeting Decisions
• Introduction
• Characteristics
• Steps:
• Identifying profitable investment
opportunities
• Planning and preparing the capital budget
• Estimating and evaluating cash flows
• Selecting the project proposal
• Implementing the project:
• Online monitoring
• Determining post-audit control
• Limitations
• Types of Projects
 Project Categories
Investment can be categorized into two
Dependent
projects and Independent
divisions:
projects.
• Dependent
Acceptanceprojects
or rejection of one affects the acceptance or
rejection
of other.
• Complementary projects – Combined cash flows of 2
projects is more than the sum of individual project’s
cash flows.
• Substitute / Mutually Exclusive Projects – Acceptance of
one
may lead to rejection of other.
Combined cash flows of 2 projects is less than the
sum of individual project’s cash flows.

• Independent projects
Acceptance or rejection of one does not affect the
 Capital Budgeting Process
Points to remember while estimating Cash Flows:
• Cash flow is different from accounting income
• Incremental Cash flows to be considered:
• Sunk
• Opportunity cost
• Time value of money and inflation (present
value)
• Cost of capital (discount rate)
• Inflation Rate
• Nominal vs Real Discount Rate
Real Discount rate = (1+ Nominal Discount rate)

1
(1+ Inflation Rate)
• Changes in Working capital to be factored
• Current Assets
 Key
• Terms
Incremental Cash flows - Difference in cash flows with or
without the investment decision.

• Sunk Cost - Already incurred and irrecoverable whether

decision to invest is made or not. Does not affect future
cashflows and cannot be changed by any current or future
action.

• Opportunity Cost - Cost associated with ( or benefit of) the

next best
alternative forgone.

• Nominal vs Real Discount Rate

Real Discount rate = (1+ Nominal Discount rate) - 1
PV (with inflation) (1+ Inflation
CF Rate)
= (1+k)^n *
(1+Inflation)^n
 Key
• Terms
Relevant Costs – Costs which will change for each option being
evaluated. Eg: Variable cost, Incremental cost, Opportunity Cost
• Irrelevant Costs – Costs which do not change for each option being
evaluated
Eg: Sunk Costs, committed costs, overheads etc.