Financial Management

Chapter IV
Cost of Capital
Aim
The aim of this chapter is to:

explain the concept of cost of capital

elucidate the cost of different sources of finance

explicate the capital asset pricing model approach

Objectives
The objectives of this chapter are to:

define the cost of equity

determine the cost of preference shares cost of irredeemable and redeemable share

enlist the factors affecting WACC

Learning outcome
At the end of this chapter, you will be able to:

understand the concept of Weighted Average Cost of Capital (WACC)

identify the steps involved in the computation of WACC

describe the importance of cost of capital

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4.1 Introduction to Cost of Capital

Cost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal
provided by the business concern. It is used as a discount rate in determining the present value of future cash flows
associated with capital projects. Cost of capital is also called as cut-off rate, target rate, hurdle rate and required
rate of return. When the firms are using different sources of finance, the finance manager must take careful decision
with regard to the cost of capital; because it is closely associated with the value of the firm and the earning capacity
of the firm.
Meaning of Cost of Capital
Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value
and attract funds. Cost of capital is the required rate of return on its investments which belongs to equity, debt and
retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it
will result in the reduction of overall wealth of the shareholders.
Definitions
The following important definitions are commonly used to understand the meaning and concept of the cost of
capital.
According to the definition of John J. Hampton Cost of capital is the rate of return the firm required from investment
in order to increase the value of the firm in the market place.
According to the definition of Solomon Ezra, Cost of capital is the minimum required rate of earnings or the cutoff rate of capital expenditure.
According to the definition of James C. Van Horne, Cost of capital is A cut-off rate for the allocation of capital
to investment of projects. It is the rate of return on a project that will leave unchanged the market price of the
stock.
According to the definition of William and Donaldson, Cost of capital may be defined as the rate that must be
earned on the net proceeds to provide the cost elements of the burden at the time they are due.
Cost of capital from three different viewpoints

Investors view point: The measurement of the sacrifice made by the individual for capital formation"

Firm's view point: It is the minimum required rate of return needed to justify the use of capital. It is supported
by Hompton, John.

Capital Expenditure view point: The cost of capital is the minimum required rate of return or the cut off rate
used to value cash flows.

Importance of cost of capital

Computation of cost of capital is a very important part of the financial management to decide the capital structure
of the business concern. Following points illustrates the importance of cost of capital.

Importance to capital budgeting decision: Capital budget decision largely depends on the cost of capital of each
source. According to net present value method, present value of cash inflow must be more than the present value
of cash outflow. Hence, cost of capital is used to capital budgeting decision.

Importance to structure decision: Capital structure is the mix or proportion of the different kinds of long term
securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to
take decision regarding structure.

Importance to evolution of financial performance: Cost of capital is one of the important determine which
affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial
performance of the firm.

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Importance to other financial decisions: Apart from the above points, cost of capital is also used in some other
areas such as, market value of share, earning capacity of securities etc. hence, it plays a major part in the financial
management.

4.2 Cost of Different Sources of Finance

It can be further classified into below mentioned categories:
4.2.1 Cost of Equity
Firms may obtain equity capital in two ways:

Retention of earnings

Issue of equity shares to the public

The cost of equity or the returns required by the equity shareholders is the same in both the cases shareholders are
providing funds to the firm to finance firm's investment proposals. Retention of earnings involves an opportunity cost.
Shareholders could receive the earnings as dividends and invest the same in alternative investments of comparable
risk to earn returns. So, irrespective of whether a firm raises equity finance by retaining earnings or issue of additional
equity shares, the cost of equity is same. But issue of additional equity shares to the public involves a flotation cost
where as there is no flotation cost for retained earnings.
Cost of Retained Earnings (Kre)
Retained earnings are those parts of net earnings that are retained by the firm for investing in capital budgeting
proposals instead of paying them as dividends to shareholders.
The opportunity cost of retained earnings is the rate of return the shareholders forgoes by not putting their funds
elsewhere, because the management has retained the funds. The opportunity cost can be well computed with the
following formulae.

Where, Ke = Cost of equity capital [D P or (E/P) + g]

Ti = Marginal tax rate applicable to the individuals concerned
Tb = Cost of purchase of new securities
D = Expected dividend per share
NP = Net proceeds of equity share
g= Growth rate (%)
For instance
A company paid a dividend of Rs. Per share, market price per share is Rs. 20, income tax rate is 60% and brokerage
is expected to be 2%. Compute cost of retained earnings.
Solution:
=
= 0.10 X 0.408 X 100 = 4.1 %
Cost of Issue of Equity Shares (Ke)
The cost of equity capital (Ke) may be defined as the minimum rate of return that a firm must earn on the equity
financed portions of an investment project in order to leave unchanged the market price of the shares. The cost of
equity is not the out-of-pocket cost of using equity capital as the equity shareholders are not paid dividend at a fixed
rate every year.

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It is the most difficult and controversial cost to measure there is no common basis for computation.
4.2.2 Cost of Preference Shares
Preference share is one of the types of shares issued by companies to raise funds from public. Preference share is
the share that has two preferential rights over equity shares:

Preference in payment of dividend, from distributable profits

Preference in the payment of capital at the time of liquidation of the company

Cost of Irredeemable (Perpetual) Preference Share

Share that cannot be paid till liquidation of the company are called as irredeemable preference shares. The cost is
measured by the following formulas:

Where, Kp = Cost of preference share

D= Dividend per share
CMP = Current market price per share
NP = Net proceeds
Cost of irredeemable preference stock (with dividend tax)

Where Dt = Tax on preference dividend

For instance
(Kp with dividend tax) : A coy planning to issue 14% irredeemable preference share at the face value of Rs. 250 per
share, with an estimated flotation cost of 5%. What is cost of preference share with 10% dividend tax.
Solution:
= 16.21 %
Cost of Redeemable Preference Share
Shares that are issued for a specific maturity period or redeemable after a specific period are known as redeemable
preference shares. Cost of preference share when the principal amount is repaid in one lump sum amount.

Where, Kp = Cost of preference share

NP = Net sales proceeds (after discount, flotation cost)
D = Dividend on preference share
Pn = Repayment of principal amount at the end of n years
Short cut formula is :
4.2.3 Cost of Debentures
Companies may raise debt capital through issue of debentures or raise loan from financial institutions or deposits
from public. All these resources involve a specific rate of interest. Computation of cost of debenture or debt capital
depends on their nature.

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Cost of Irredeemable Debt

Perpetual debt provides permanent funds to the firm, because the funds will remain in the firm till liquidation. Cost
of perpetual debt is the rate of return that lender expect. The following formulae used to compute cost of debentures
or debt of bond.

Pre-tax cost =

Post-tax cost =

Where, Kdi = Pre-tax cost of debentures, I Interest , P = Principle amount or face vlue
P = Net sales proceeds , t = Tax rate
For instance: XYZ Company Ltd., decides to float perpetual 12%, debentures of Rs. 100 each. The tax rate is 50.
Calculate cost of debenture (pre and post tax cost)
Solution: Pre-tax cost =
Post-tax cost =
Cost of Redeemable Debt
Redeemable debentures are those having a maturity period or repayable after a certain given period of time. These
type of debentures are issued by many companies when they require capital for temporary needs. It is calculated
by the following formula:

Where, Kd = Cost of debentures, n = Maturity period, NI= Net interest (after tax adjustment)
Pn = Principal repayment in the year n

4.3 Capital Asset Pricing Model Approach (CAPM)

CAPM was developed by William F.Sharpe. From cost of capital point of view, CAPM explains the relationship
between the required rate of return, and the non-diversifiable or relevant risk, of the firm as reflected in its index of
non-diversifiable risk that is beta (). It shows the relationship between risk and return for efficient and inefficient
portfolios. Symbolically,

Where, Ke = Cost of equity capital, Rf = Rate of return required on a risk free security (%)
= Beta coefficient, Rmf = Required rate of return on the market portfolio of assets, that can be viewed as the
average rate of return on all assets.
Assumptions of CAPM
CAPM approach is based on the following assumptions
Perfect Capital Market: all investors have same information about securities

There are no restrictions on investments

Securities of completely divisible

There are no transaction costs

There are no taxes

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Investors Preference: Investors are risk averse

Investors have homogenous expectations regarding the expected returns, variances and correlation of returns
among all securities.

Investors seek to maximise the expected utility of their portfolios over a single period planning horizon

For instance
The capital Ltd. Wishes to calculate its cost of equity capital using the Capital Asset Pricing Model (CAPM)
approach. Companys analyst found that its risk free rate if return equals 12%, beta equals 1.7 and the return on
market portfolio equals 14.5 %.
Solution:
= 12 + [14.5 12]1.7
= 12+4.25= 16.25 %

4.4 Weighted Average Cost of Capital (WACC)

A company has to employ a combination of creditors and owners funds. The composite cost of capital lies between
the least and most expensive funds. This approach enables the maximisation of profits and the wealth of the equity
shareholders by investing the funds in projects earning in excess of the overall cost of capital.
Steps involved in computation in WACC

Determination of the source of funds to be raised and their individual share in the total capitalization of the
firm

Computation of cost of specific source of funds

Assignment of weight to specific source of funds

Multiply the cost of each source by the appropriate assigned weights

Add individual source weight cost to get cost of capital

Assignment of Weights
The weights to specific funds may be assigned based on the following:

Book values: Book value weights are based on the values found on the balance sheet. The weight applicable to a
given source of fund is simply the book value of the source of fund divided by the book value of total funds.

Capital structure weights: Under this method weights are assigned to the components of capital structure based
on the targeted capital structure. Depending on target, capital structures have some difficulties in using it. They
are
A company may not have a well defined target capital structure
It may be difficult to precisely estimate the components capital cost, if the target capital is different from
present capital structure.

Market value weights: Under this method, assigned weights to a particular component of capital structure is
equal to the market value of the component of capital dividend by the market value of all components of capital
and capital employed by the firm.

For instance a firm has the following capital structure as the latest statement
Source of finance

Amount (Rs.)

After Tax Cost %

Debt Capital

30,00,000

4.0

Preference Share Capital

10,00,000

8.5

Equity Share Capital

20,00,000

11.5

Retained earnings

40,00,000

10.0

Total

100,00,000
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Solution:
Computation of cost of capital
Source of Finance
Debt
Preference share
Equity share
Retained earnings

Weights
0.30*
0.10
0.20
0.40
1.00

Specific Cost (%)

4.0
8.5
11.5
10.0

Weighted Cost
1.2
8.5
2.3
4.0
8.35

Note * Debt weight =

4.4.1 Factors Affecting WACC
Weighted average cost of capital is affected by a number of factors. They are divided into two categories such as:

Controllable factors (Internal factor)

Uncontrollable factors (External factors)

Controllable factors (Internal factor): Controllable factors are those factors that affect WACC, but the firm can
control them. They are:

Capital structure policy

Dividend policy

Investment policy

Uncontrollable factors (External factors): The factors those are not possible to be controlled by the firm and
mostly affects the cost of capital. These types of factors are known as external factors.

Tax rates

Level of interest rates

Market risk premium

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Summary

Cost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal
provided by the business concern.

Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value
and attract funds.

Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained
earnings.

Computation of cost of capital is a very important part of the financial management to decide the capital structure
of the business concern. Following points illustrates the importance of cost of capital.

The cost of equity or the returns required by the equity shareholders is the same in both the cases shareholders
are providing funds to the firm to finance firm's investment proposals.

Shareholders could receive the earnings as dividends and invest the same in alternative investments of comparable
risk to earn returns.

Retained earnings are those parts of net earnings that are retained by the firm for investing in capital budgeting
proposals instead of paying them as dividends to shareholders

References

Reddy, G. S., 2008. Financial Management. Mumbai: Himalaya publications.

Paramasivan, C. & Subramanian, T., 2009. Financial Management. New Age International.

Defining the cost of capital, [Pdf] Available at: <http://www.iassa.co.za/articles/002_may1973_02.pdf> [Accessed

28 May 2013].

The cost of capital, [Pdf] Available at: <http://www.goldsmithibs.com/resources/free/Cost-of-Capital/notes/

Summary%20-%20Cost%20of%20Capital.pdf> [Accessed 28 May 2013].

2009. Introduction to Cost of Capital, [Video online] Available at: <http://www.youtube.com/

watch?v=AGaoDQgicVg>[Accessed 28 May 2013].

2013. Cost of Capital Part 1, [Video online] Available at: <http://www.youtube.com/

watch?v=suqQ3huNtrk>[Accessed 28 May 2013].

Recommended Reading

Pratt , S. P., 2010. Cost of Capital: Workbook and Technical Supplement, 4th ed., Wiley.

Tennent, J., 2008. Guide to Financial Management, Profile Books/The Economist.

Avadhani, V.A., 2010. International Financial Management. Global Media.

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Self Assessment
1. Existence of perfect capital market is one of the assumptions of ______.
a. WACC
b. CAPM
c. equity
d. debentures
2. Cost of the capital is the ___________ required rate of return expected by investors.
a. minimum
b. maximum
c. higher
d. reduced
3. Which of the following statements is false?
a. Cost of capital comprises of three components
b. Cost of capital is the minimum required rate of needed to justify
c. There is no cost for internally generated funds
d. CAPM approach is one of the approaches used in computation of equity capital
4. _______ value weights are based on the values found on the balance sheet
a. Book
b. Capital
c. Market
d. Weighted
5. CAPM stands for?
a. Capital asset price model
b. Capital asset pricing model
c. Capital asset pricing maturity
d. Capital assignment pricing model
6. The composite cost of capital lies between the least and most _________ funds.
a. expensive
b. costly
c. low cost
d. cheap
7. ____________debentures are those having a maturity period or repayable after a certain given period of time.
a. Redeemable
b. Irredeemable
c. Capital
d. Asset

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8. Retention of earnings involves an __________ cost

a. opportunity
b. fixed
c. capital
d. explicit
9. Retained earnings are those parts of ________ earnings that are retained by the firm for investing in capital
budgeting proposals instead of paying them as dividends to shareholders
a. reduced
b. net
c. complete
d. entire
10. Cost of preference share when the _______ amount is repaid in one lump sum amount.
a. interest
b. total
c. principal
d. half

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Financial Management

Chapter V
Capital Structure and Leverages
Aim
The aim of this chapter is to:

explain the concept of capital structure

explicate the features of appropriate capital structure

elucidate the factors that determine a firm's capital structure

Objective
The objective of the chapter is to:

define capital structure

enlist the forms of capital structure

define leverage

Learning outcome
At the end of this chapter, you will be able to:

undertsand the concept of leverages

decribe the types of leverages

identify the objectives of capital structure

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5.1 Meaning of Capital Structure

Capital is the major part of all kinds of business activities, which are decided by the size, and nature of the business
concern. Capital may be raised with the help of various sources. If the company maintains proper and adequate level
of capital, it will earn high profit and they can provide more dividends to its shareholders.
Meaning of capital structure
Capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization. It is the
mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-term loans
and retained earnings. The term capital structure refers to the relationship between the various long-term source
financing such as equity capital, preference share capital and debt capital. Deciding the suitable capital structure
is the important decision of the financial management because it is closely related to the value of the firm. Capital
structure is the permanent financing of the company represented primarily by long-term debt and equity.
Definition of capital structure
The following definitions clearly initiate, the meaning and objective of the capital structures.
According to the definition of Gerestenbeg, Capital Structure of a company refers to the composition or make up
of its capitalization and it includes all long-term capital resources.
According to the definition of James C. Van Horne, The mix of a firms permanent long-term financing represented
by debt, preferred stock, and common stock equity.
According to the definition of Presana Chandra, The composition of a firms financing consists of equity, preference,
and debt.
According to the definition of R.H. Wessel, The long term sources of fund employed in a business enterprise.
Capital Structure is that part of financial structure, which represents long-term sources. The term capital structure
is generally defined to include only long-term debt and total stockholders investment.
To quote Bogan "Capital structure may consists of a single class of stock, or it may be comprised by several issues
of bonds and preferred stock, the characteristics of which may vary considerably". Capital structure is indicated by
the following equations:

Capital Structure = Long-term Debt + Preferred Stock + Net worth OR

Capital Structure = Total assets Current Liabilities

Optimum capital structure

Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and
thereby the value of the firm is maximum. Optimum capital structure may be defined as the capital structure or
combination of debt and equity, that leads to the maximum value of the firm.
Objectives of capital structure
Decision of capital structure aims at the following two important objectives:

Maximize the value of the firm.

Minimize the overall cost of capital

Forms of capital structure

Capital structure pattern varies from company to company and the availability of finance. Normally the following
forms of capital structure are popular in practice.
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Equity shares only

Equity and preference shares only

Equity and Debentures only.

Equity shares, preference shares and debentures

Factors determining capital structure

The following factors are considered while deciding the capital structure of the firm.

Leverage: It is the basic and important factor, which affect the capital structure. It uses the fixed cost financing
such as debt, equity and preference share capital. It is closely related to the overall cost of capital.

Cost of Capital: Cost of capital constitutes the major part for deciding the capital structure of a firm. Normally
longterm finance such as equity and debt consist of fixed cost while mobilization. When the cost of capital
increases, value of the firm will also decrease. Hence the firm must take careful steps to reduce the cost of
capital.
Nature of the business: Use of fixed interest/dividend bearing finance depends upon the nature of the
business. If the business consists of long period of operation, it will apply for equity than debt, and it will
reduce the cost of capital.
Size of the company: It also affects the capital structure of a firm. If the firm belongs to large scale, it can
manage the financial requirements with the help of internal sources. But if it is small size, they will go for
external finance. It consists of high cost of capital.
Legal requirements: Legal requirements are also one of the considerations while dividing the capital structure
of a firm. For example, banking companies are restricted to raise funds from some sources.
Requirement of investors: In order to collect funds from different type of investors, it will be appropriate
for the companies to issue different sources of securities.

Government policy: Promoter contribution is fixed by the company Act. It restricts to mobilize large, longterm
funds from external sources. Hence the company must consider government policy regarding the capital
structure

5.2 Features of an Appropriate Capital Structure

An appropriate capital structure should have the following features:

Profitability

Solvency

Flexibility

Conservation

Control

Considerations
Financial manager has to consider the following while developing optimum capital structure
Return on Investment (ROI)
Financial manager need to raise fixed cost sources) loans, debenture, preference shares) of funds, only when ROI
is higher that the fixed cost funds.
Tax benefit
Since debt is the cheapest source, because the interest paid on the debt is allowed as a deductible expense in
determining tax payment. Hence, a business firm should take the advantage of tax deduction.
Perceived financial risk
Use of more debt in capital structure leads to increase perceived financial risk in the minds of equity shareholders
which reduces the market price of equity share, thereby firm's wealth. Therefore financial management should not
increase debt in capital structure when ordinary shareholders perceived an excessive risk.
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5.3 Determination of Capital Structure

The capital structure should be determined keeping in mind the objective of wealth maximisation. Following are
the factors affecting the capital structure:

Tax benefit of debt

Flexibility

Control

Industry leverage ratios

Seasonal variations

Degree of competition

Industry life-cycle

Timing of public issue

Requirements of investors

Patterns of capital structure

Construction of optimum capital structure is possible only when there is a appropriate mix of the above sources
(debt and equity). The following are the forms of capital structure

Complete equity share capital

Different proportions of equity and preference share capital

Different proportions of equity and debenture (debt) capital and

Different proportions of equity, preference, and debenture (debt) capital

5.4 Theories of Capital Structure

Equity and debt are the two important sources of long-term sources of finance of a firm. The proportion of debt and
equity in a firm's capital structure has to be independently decided case to case. Many theories have been propounded
to understand the relationship between financial leverage and firm value.
Assumption of capital structure theories

There are only two sources of funds i.e.: debt and equity.

The total assets of the company are given and do no change.

The total financing remains constant. The firm can change the degree of leverage either by selling the shares
and retiring debt or by issuing debt and redeeming equity.

Operating profits (EBIT) are not expected to grow.

All the investors are assumed to have the same expectation about the future profits.

Business risk is constant over time and assumed to be independent of its capital structure and financial risk.

Corporate tax does not exit.

The company has infinite life.

Dividend payout ratio = 100%

5.4.1 Net Income Approach

According to net income approach the firm can increase its value or lower the overall cost of capital by increasing
the proportion of debt in the capital structure.
Assumptions of the Net Income (NI) Approach

The use of debt does not change the risk perception of investors; as a result, the equity capitalisation rate, Ke,
and the debt capitalisation rate Kd, remain constant with changes in leverage.

The debt capitalisation rate is less than the equity capitalisation rate

The corporate income taxes do not exist.

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Give below is the graphical representation of the net income approach:

Ke, Ko

Ke,

Cost
Ko
Kd

Kd.

Debt
Fig. 5.1 Net income approach
According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they
remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the
firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100
per cent debt financing under NI approach.
For instance:
Assume that a firm has an expected annual net operating income of Rs.200,000 an equity rate, Ke, of 10% and Rs.
10,00,000 of 6% debt.
Solution: The value of the firm according to Net Income approach:
Net Operating Income NI = 2, 00,000
Total cost of debt Interest = KdD (10, 00,000 X 0.6) = 60,000
Net Income available to shareholders, NOI-I = Rs.1, 40,000
Therefore:
Market Value of Equity (Rs. 140,000/.10) = 14, 00,000
Market Value of debt D (Rs. 60,000/.06) = 10, 00,000
Total = 24, 00,000
The cost of equity and debt are respectively 10% and 6% and are assumed to constant under the Net income
approach.
Ko = NOI/V = 200,000/24, 00,000 = 0.0833 = 8.33%
5.4.2 Net Operating Income (NOI) Approach
In Net operating income approach the market value of the firm is not affected by the change in capital structure, the
weighed average cost of capital is said to be constant.
Assumptions of the Net Operating Income (NOI) Approach

The market capitalises the value of the firm as a whole. Thus, the split between debt and equity is not
important

The market uses an overall capitalisation rate Ko to capitalise the net operating income. Ko depends on the
business risk. If the business risk is assumed to remain unchanged, Ko is a constant.

The use of less costly debt funds increases the risk to shareholders. This causes the equity capitalisation rate
to increase.

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Give below is the graphical representation of the net operating income approach:
Ke, Ko

Ke,

Cost
Ko
Kd

Kd.

Debt
Fig. 5.2 Net operating income approach
According to NOI approach the value of the firm and the weighted average cost of capital are independent of the
firms capital structure. In the absence of taxes, an individual holding all the debt and equity securities will receive
the same cash flows regardless of the capital structure and therefore, value of the company is the same.
For instance:
Assume that a firm annual net operating income of Rs. 2,00,000 an average cost of capital Ko, of 10% and intial
debt of Rs. 10,00,000 at 6%.
Solution: Net operating Income = 2,00,000
Therefore, Market value of firm, V = S+D = 2,00,000/0.10 = 20,00,000
Market value of the debt, D = 10,00,000
Market value of the equity S= V-D = 10,00,000
Ko = NOI/V = 200,000/0.10 = 20,00,000
Here, Ke is not constant as that in NI approach. It is computed using the formula:
Ke = Ko + (Ko-Kd)D/S
= 0.10 + (0.10+0.06)10,00,000/10,00,000
= 0.10 + 0.04(1) = 0.14
To verify that the weighted average cost of capital is a constant:
Ko = Kd(D/V) + Ke(S/V)
= 0.06(10, 00,000/20, 00,000) + 0.14(10, 00,000/20, 00,000)
= 0.06(0.50) + 0.14(0.5)
= 0.03 + 0.07 = 0.10
5.4.3 Traditional Approach
This is also known as intermediate approach. It is a compromise between the NI and NOI approach. According to
this view the value of the firm can be increased or the cost of the capital can be reduced by a judicious mix of dent
and equity capital.
This approach implies that the cost of capital decreases within the reasonable limit of debt and then increases with
the leverage.
This approach has the following propositions as shown in the Fig. below:

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Ke,

Ko
Kd

Cost

Debt
Fig. 5.3 Traditional approach

kd remains constant until a certain degree of leverage and thereafter rises at an increasing rate

ke remains constant or rises gradually until a certain degree of leverage and thereafter rises very sharply

as a sequence to the above 2 propositions, ko decreases till a certain level, remains constant for moderate
increases in leverage and rises beyond a certain point

5.4.4 Miller and Modigliani Approach

Miller and Modigliani criticise that the cost of equity remains unaffected by leverage up to a reasonable limit and
Ko being constant at all degrees of leverage. The assumptions for their analysis are:
Perfect Capital Markets
Securities can be freely traded, there are no hindrances on the borrowing, no presence of transaction costs, securities
infinitely divisible, availability of all required information at all times.
Investors Behave Rationally
They choose that combination of risk and return that is most advantageous to them
Homogeneity
of investors risk perception, that is, all investors have the same perception of business risk and returns.
Taxes
There is no corporate or personal income tax
Dividend pay-out is 100%
that is, the firms do not retain earnings for future activities.
Following three propositions can be derived based on the above assumptions:
Proposition I:
The market value of the firm is equal to the total market value of equity and total market value of debt and is
independent of the degree of leverage.
Proposition II
The expected yield on equity is equal to discount rate (capitalisation rate) applicable plus a premium.

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Proposition III
The average cost of capital is not affected by the financing decisions as investment and financing decisions are
independent.
Criticism of MM Propositions
Risk perception
The assumption that risks are similar is wrong and the risk perceptions of investors are personal and corporate
leverage is different.
Convenience:
Investors find personal leverage inconvenient.
Transaction Costs:
Due to presence of such costs in buying and selling securities, it is necessary to invest a higher amount to earn the
same amount of return.

Taxes:
When personal taxes are considered along with corporate taxes, the Miller and Modigliani approach fails the fails
to explain the financing decision and firm's value.

5.5 Leverages
Financial decision is one of the integral and important parts of financial management in any kind of business
concern. A sound financial decision must consider the board coverage of the financial mix (Capital Structure), total
amount of capital (capitalisation) and cost of capital (Ko ). Capital structure is one of the significant things for the
management, since it influences the debt equity mix of the business concern, which affects the shareholders return
and risk. Hence, deciding the debt-equity mix plays a major role in the part of the value of the company and market
value of the shares. The debt equity mix of the company can be examined with the help of leverage. The concept of
leverage is discussed in this part. Types and effects of leverage is discussed in the part of EBIT and EPS.
Meaning of leverage
The term leverage refers to an increased means of accomplishing some purpose. Leverage is used to lifting heavy
objects, which may not be otherwise possible. In the financial point of view, leverage refers to furnish the ability to
use fixed cost assets or funds to increase the return to its shareholders.
Definition of leverage
James Horne has defined leverage as, the employment of an asset or fund for which the firm pays a fixed cost or
fixed return. Types of Leverage Leverage can be classified into three major headings according to the nature of the
finance mix of the company.
Types of Leverages

Operating leverage

Financial leverage

5.5.1 Operating Leverage

Operating leverage is present any time in a firm when it has operating (fixed) costs regardless of the level of
production. It can be defined as "The firm's ability to use operating costs to magnify the effects of changes in sales
on its earnings before interest and taxes. The operating costs are categorised into three:

Fixed Costs: which do not vary with the level of production they must be paid regardless of the amount of
revenue available

Variable Costs: raw materials, direct labor, costs and so on that varies directly with the level of production

Semi-variable Cost: which partly vary and partly fixed

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The degree of operating leverage may be defined as the change in the percentage of operating income (EBIT), for
a given change in % of sales revenue.

When the data is given for one year, then we have to compute operating leverage, by the following formula:

For instance:
From the following particulars of ABC Ltd., calculate degree of operating leverage.
Particulars

Previous Year 2009

Current Year 2010

Sales revenue

10,00,000

12,50,000

Variable cost

6,00,000

7,50,000

Fixed cost

2,50,000

2,50,000

Solution: Calculation of EBIT on a percentage change

Particulars
Sales Revenue
Less: Variable cost
Contribution
Less: fixed cost
EBIT

2009
10,00,000
6,00,000

2010
12,50,000
7,50,000

% change
25
25
25
66.67

4,00,000
2,50,000

5,00,000
2,50,000

1,50,000

2,50,000

Operating leverage 2.667 indicates that when there is 25% change in sales, the change in EBIT is 2.66 times.
Application of operating leverage

It is helpful to know how operating profit would change with a given change in units produced.

It will be helpful in measuring business risk.

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5.5.2 Financial Leverage

Financial manager job is to raise funds for long-term activities with different composition of sources. The required
funds may be raised by two sources: equity and debt. The use of fixed charge sources of funds such as debt and
preference share capital along with the equity share capital in capital structure is described as financial leverage.
According to Lawrence, financial leverage is "the ability of the firm to use fixed interest bearing securities to magnify
the rate of return as equity shares". It is also known as "trading as equity".
Formula for calculating financial leverage is given below:

OR

For instance
A firm has sales of 1, 00,000 units at Rs. 10/ unit. Variable cost of the produced products is 60% of the total sales
revenue. Fixed cost id Rs. 2, 00,000. The firm has used a debt of Rs. 5, 00,000 at 20% interest. Calculate the operating
leverage and financial leverage.
Solution: Calculation of EBT
Particulars
Sales Revenue (1,00,000 units X Rs.10/unit)

Amount (Rs.)
10,00,000
6,00,000

Less: Variable cost (10,00,000 X 0.60)

4,00,000
2,00,000

Contribution

2,00,000
1,00,000

Less: Fixed cost

EBIT
Less: Interest (5,00,000 X 20/100)
Earning Before Tax (EBT)

1,00,000

Operating Leverage = Contribution EBIT = 4, 00,000 2, 00,000 = 2times

Financial Leverage = EBITEBT = 2, 00,000 1, 00,000 = 2 times
Application of financial leverage

It is helpful to know how EPS would change with a change in operating profit.

It is helpful for measuring financial risk.

5.5.3 Combined Leverage

The operating leverage has its effects on operating risk and is measured by the % change in EBIT due to the %
change in sales. The financing leverage has its effects on financial risk and is measured by the % change in EPS due
to the % change in EBIT. Since, both these leverages are closely related with the ascertainment of the firm's ability
to cover fixed charges, the sum of them gives us the total leverage or combined leverage and the risk associated
with combined leverage is known as total risk.

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The degree of combined leverage may be defined as the % change in EPS due to the % change in sales. Thus
combined leverage is:

For instance:
ABC corporation has sales of Rs. 40 lakhs, variable cost 70% of the sales and fixed cost is Rs. 8,00,000. The firm
has raised Rs. 20 lakhs funds by issue of debentures at the rate of 10%. Compute operating, financial and combined
leverages.
Solution: Calculation of EBT or PBT
Particulars
Sales revenue
Less: Variable cost (40,00,000 X 0.70)
Contribution
Less: Fixed Cost
EBIT
Less: interest (20,00,000 X 0.10)
EBT

Amount (Rs.)
40,00,000
28,00,000
12,00,000
8,00,000
4,00,000
2,00,000
2,00,000

Operating leverage = Contribution EBIT = 12, 00,000 4, 00,000 = 3 times

Financial leverage = EBIT EBT = 4, 00,000 2, 00,000 = 2 times
Combined leverage = OL x FL = 3x2 = 6 times
The combined leverage can work in both directions. It is favorable if sales increase and unfavorable when sales
decrease.

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Summary

Capital is the major part of all kinds of business activities, which are decided by the size, and nature of the
business concern.

The term capital structure refers to the relationship between the various long-term source financing such as
equity capital, preference share capital and debt capital.

Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and
thereby the value of the firm is maximum.

Optimum capital structure may be defined as the capital structure or combination of debt and equity, that leads
to the maximum value of the firm

The capital structure should be determined keeping in mind the objective of wealth maximisation.

Construction of optimum capital structure is possible only when there is a appropriate mix of debt and equity.

Equity and debt are the two important sources of long-term sources of finance of a firm.

In the financial point of view, leverage refers to furnish the ability to use fixed cost assets or funds to increase
the return to its shareholders.

References

Paramasivan, C. & Subramanian, T., 2009. Financial Management. New Age International.

Khan, M. Y.., 2004. Financial Management: Text, Problems And Cases, 2nd ed., Tata McGraw-Hill
Education.

Capital Structure and Leverage, [Pdf] Available at: <http://faculty.unlv.edu/msullivan/FIN301%20-%20

Chpts%2013%20and%2014%20-%20Capital%20Structure%20and%20Dividends-%20classnotes.pdf>
[Accessed 29 May 2013].

Capital Structure and Leverage, [Pdf] Available at: <http://www.csun.edu/~dm59084/FIN303/Ch%2013.pdf>

[Accessed 29 May 2013].

2011. Capital Structure class I, [Video online] Available at: <http://www.youtube.com/watch?v=lqHuYKGByIQ>

[Accessed 29 May 2013].

2011. Capital Structure class II, [Video online] Available at: <http://www.youtube.com/watch?v=6vtuNgGxbso>
[Accessed 29 May 2013].

Recommended Reading

Brigham,E. F., 2003. Fundamentals of Financial Management. 10th ed., South-Western College Pub.

Brigham, E. F. & Ehrhardt, M. C., 2008. Financial management: theory and practice, 12th ed., Cengage
Learning.

Gitman, 2007. Principles Of Managerial Finance, 11th ed., Pearson Education India.

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Financial Management

Self Assessment
1. Optimum capital structure may be defined as the capital structure or combination of debt and __________, that
leads to the maximum value of the firm.
a. liabilities
b. assets
c. equity
d. cost
2. Contribution is equal to sales minus _________ cost.
a. fixed
b. variable
c. operating
d. semi-variable
3. Which of the following statements is false?
a. Optimum capital structure may be defined as the capital structure or combination of debt and equity, that
leads to the maximum value of the firm.
b. Use debt to any extent to maximise EPS.
c. Financial leverage is multiplied by financial leverage to get combined leverage.
d. Financial leverage is also known as trading on equity.
4. S-V-EBIT =?
a. Variable cost
b. Fixed cost
c. Operating cost
d. Profit
5. The use of leverage is essential to maximise ____________.
a. profit
b. loss
c. earnings
d. contribution
6. Total assets Current liabilities =?
a. Optimal capital structure
b. Financial leverage
c. Operating leverage
d. Capital structure
7. _________ of operating leverage and high degree of financial leverage is ideal situation
a. Low degree
b. High degree
c. Medium degree
d. Optimum degree

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8. Financial leverage is also known as __________.

a. indifference point
b. trading on equity
c. combined leverage
d. capital structure
9. Increased use of debt ______ the financial risk of equity shareholders.
a. increases
b. decreases
c. constant
d. reduces
10. Contribution is divided by EBIT to get ________ leverage
a. financial
b. operating
c. combined
d. fixed

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Chapter VI
Capital Budgeting
Aim
The aim of this chapter is to:

introduce the term capital budgeting

explicate the methods for evaluating the capital investment proposals

elucidate profitability index method and its rule of acceptance

Objectives
The objectives of this chapter are to:

explain the formula for reciprocal pay-back period

explicate principles or factors of capital budgeting decisions

define capital budgeting

Learning outcome
At the end of this chapter, you will be able to:

distinguish between traditional methods and discounted cash flow method

understand importance of capital budgeting

identify capital budgeting process

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6.1 Introduction
The term Capital Budgeting refers to the long-term planning for proposed capital outlays or expenditure for the
purpose of maximising return on investments. The capital expenditure may be:

Cost of mechanization, automation and replacement.

Cost of acquisition of fixed assets, e.g., land, building and machinery etc.

Investment on research and development.

Cost of development and expansion of existing and new projects.

6.2 Definition of Capital Budgeting

Capital Budget is also known as Investment Decision Making or Capital Expenditure Decisions or Planning
Capital Expenditure etc. Normally such decisions where investment of money and expected benefits arising there
from are spread over more than one year, it includes both rising of long-term funds as well as their utilisation.
Charles T. Horngnen has defined capital budgeting as Capital Budgeting is long term planning for making and
financing proposed capital outlays.
In other words, capital budgeting is the decision making process by which a firm evaluates the purchase of major
fixed assets including building, machinery and equipment. According to Hamption, John. J., Capital budgeting is
concerned with the firms formal process for the acquisition and investment of capital. From the above definitions,
it may be concluded that capital budgeting relates to the evaluation of several alternative capital projects for the
purpose of assessing those which have the highest rate of return on investment.

6.3 Importance of Capital Budgeting

Capital budgeting is important because of the following reasons:

Capital budgeting decisions involve long-term implication for the firm, and influence its risk complexion.

Capital budgeting involves commitment of large amount of funds.

Capital decisions are required to assessment of future events which are uncertain.

Wrong sale forecast; may lead to over or under investment of resources.

In most cases, capital budgeting decisions are irreversible. This is because it is very difficult to find a market
for the capital goods. The only alternative available is to scrap the asset, and incur heavy loss.

Capital budgeting ensures the selection of right source of finance at the right time.

Many firms fail, because they have too much or too little capital equipment.

Investment decision taken by individual concern is of national importance because it determines employment,
economic activities and economic growth.

6.4 Objectives of Capital Budgeting

The following are the important objectives of capital budgeting:

To ensure the selection of the possible profitable capital projects.

To ensure the effective control of capital expenditure in order to achieve by forecasting the long-term financial
requirements.

To make estimation of capital expenditure during the budget period and to see that the benefits and costs may
be measured in terms of cash flow.

Determining the required quantum takes place as per authorisation and sanctions.

To facilitate co-ordination of inter-departmental project funds among the competing capital projects.

To ensure maximisation of profit by allocating the available investible.

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6.5 Principles or Factors of Capital Budgeting Decisions

A decision regarding investment or a capital budgeting decision involves the following principles or factors:

A careful estimate of the amount to be invested.

Creative search for profitable opportunities.

Careful estimates of revenues to be earned and costs to be incurred in future in respect of the project under
consideration.

A listing and consideration of non-monetary factors influencing the decisions.

Evaluation of various proposals in order of priority having regard to the amount available for investment.

Proposals should be controlled in order to avoid costly delays and cost over-runs.

Evaluation of actual results achieved against those budget.

Care should be taken to think all the implication of long range capital investment and working capital
requirements.

It should recognise the fact that bigger benefits are preferable to smaller ones and early benefits are preferable
to latter benefits

6.6 Capital Budgeting Process

The following procedure may be considered in the process of capital budgeting decisions:

Identification of profitable investment proposals

Screening and selection of right proposals

Evaluation of measures of investment worth on the basis of profitability and uncertainty or risk

Establishing priorities, i.e., uneconomical or unprofitable proposals may be rejected.

Final approval and preparation of capital expenditure budget

Implementing proposal, i.e., project execution

Review the performance of projects

6.7 Types of Capital Expenditure

Capital Expenditure can be of two types:

Capital expenditure increases revenue

Capital expenditure reduces costs

Capital Expenditure Increases Revenue: It is the expenditure which brings more revenue to the firm either by
expanding the existing production facilities or development of new production line.
Capital Expenditure Reduces Costs: Such a capital expenditure reduces the cost of present product and thereby
increases the profitability of existing operations. It can be done by replacement of old machine by a new one.

6.8 Types of Capital Budgeting Proposals

A firm may have several investment proposals for its consideration. It may adopt after considering the merits and
demerits of each one of them. For this purpose capital expenditure proposals may be classified into:

Independent Proposals

Dependent Proposals or Contingent Proposals

Mutually Exclusive Proposals

Independent Proposals: These proposals are said be to economically independent which are accepted or rejected on
the basis of minimum return on investment required. Independent proposals do not depend upon each other.

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Dependent Proposals or Contingent Proposals: In this case, when the acceptance of one proposal is contingent upon
the acceptance of other proposals, it is called as Dependent or Contingent Proposals. For example; construction
of new building on account of installation of new plant and machinery describes it.
Mutually Exclusive Proposals: Mutually Exclusive Proposals refer to the acceptance of one proposal results in the
automatic rejection of the other proposal. Then the two investments are mutually exclusive. In other words, one can be
rejected and the other can be accepted. It is easier for a firm to take capital budgeting decisions on such projects.

6.9 Methods of Evaluating Capital Investment Proposals

There are number of appraisal methods which may be recommended for evaluating the capital investment proposals.
We shall discuss the most widely accepted methods. These methods can be grouped into the following categories:
Traditional Methods
Traditional methods are grouped in to the following:

Pay-back period method or Payout method

Improvement of Traditional Approach to Pay-back Period Method

Post Pay-back profitability Method
Discounted Pay-back Period Method
Reciprocal Pay-back Period Method

Rate of Return Method or Accounting Rate of Return Method

Time Adjusted Method or Discounted Cash Flow Method

Time Adjusted Method further classified into:

Net Present Value Method

Internal Rate of Return Method

Profitability Index Method

6.9.1 Traditional Methods

Pay-back Period Method: Pay-back period is also termed as Pay-out period or Pay-off period. Pay out Period
Method is one of the most popular and widely recognised traditional methods of evaluating investment proposals.
It is defined as the number of years required to recover the initial investment in full with the help of the stream of
annual cash flows generated by the project. Calculation of Pay-back Period: Pay-back period can be calculated into
the following two different situations:

In the case of constant annual cash inflows.

In the case of uneven or unequal cash inflows.

In the case of constant annual cash inflows: If the project generates constant cash flow the Pay-back period can be
computed by dividing cash outlays (original investment) by annual cash inflows. The following formula can be
used to ascertain pay-back period:
Pay-back Period =
Example 1:
A project requires initial investment of Rs. 40,000 and it will generate an annual cash inflow of Rs. 10,000 for 6
years. You are required to find out pay-back period.

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Financial Management

Solution:
Calculation of Pay-back period:
Pay-back Period =

=
= 4 years
Pay-back period is 4 years, i.e., the investment is fully recovered in 4 years.
Example 2: In the case of Uneven or Unequal Cash Inflows
In the case of uneven or unequal cash inflows, the Pay-back period is determined with the help of cumulative cash
inflow. It can be calculated by adding up the cash inflows until the total is equal to the initial investment.
From the following information you are required to calculate pay-back period:
A project requires initial investment of Rs. 40,000 and generates cash inflows of Rs. 16,000, Rs. 14,000, Rs. 8,000
and Rs. 6,000 in the first, second, third, and fourth year respectively.
Solution:

Calculation Pay-back Period with the help of Cumulative Cash Inflows

Annual Cash Inflows
Rs.
16,000
14,000
8,000
6,000

Year
1
2
3
4

Cumulative Cash Inflows

Rs.
16,000
30.000
38,000
44,000

The above table shows that at the end of 4th years the cumulative cash inflows exceeds the investment of Rs. 40.000.
Thus the pay-back period is as follows:
Pay-back Period = 3 Years+

= 3 Years+
= 3.33 Years
Accept or Reject Criterion
Investment decisions based on pay-back period are used by many firms to accept or reject an investment proposal.
Among the mutually exclusive or alternative projects whose pay-back periods are lower than the cut off period, the
project would be accepted, if not it would be rejected.
Advantages of Pay-back Period Method

It is an important guide to investment policy.

It is simple to understand and easy to calculate.

It facilitates to determ.ine the liquidity and solvency of a firm.

It helps to measure the profitable internal investment opportunities.

It enables the firm to select an investment which yields a quick return on cash funds.

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It used as a method of ranking competitive projects.

It ensures reduction of cost of capital expenditure.

Disadvantages or Pay-back Period Method

It does not measure the profitability of a project

It does not value projects of different economic lives

This method does not consider income beyond the pay-back period

It does not give proper weight to timing of cash flows

It does not indicate how to maximise value and ignores the relative profitability of the project

It does not consider cost of capital and interest factor which are very important factors in taking sound investment
decisions.

6.9.2 Improvement of Traditional Approach to Pay-back Period

The demerits of the pay-back period method may be eliminated in the following ways:
(a) Post Pay-back Profitability Method
One of the limitations of the pay-back period method is that it ignores the post pay-back returns of project. To rectify
the defect, post pay-back period method considers the amount of profits earned after the pay-back period. This
method is also known as Surplus Life over Payback Method. According to this method, pay-back profitability is
calculated by annual cash inflows in each of the year, after the pay-back period. This can be expressed in percentage
of investment.
Post Pay-back Profitability = Annual Cash Inflow x (Estimated Life - Pay-back Period)
The post pay-back profitability index can be determined by the following equation:
Post Pay-back Profitability Index =
(b) Discounted Pay-back Method
This method is designed to overcome the limitation of the payback period method. When savings are not leveled, it
is better to calculate the pay-back period by taking into consideration the present value of cash inflows. Discounted
pay-back method helps to measure the present value of all cash inflows and outflows at an appropriate discount rate.
The time period at which the cumulated present value of cash inflows equals the present value of cash outflows is
known as discounted pay-back period.
(c) Reciprocal Pay-back Period Method
This methods helps to measure the expected rate of return of income generated by a project Reciprocal pay-back
period method is a close approximation of the Time Adjusted Rate of Return, if the earnings are leveled and the
estimated life of the project is somewhat more than twice the pay-back period. This can be calculated by the
following formula:
Reciprocal Pay-back Period =
Example 3:
The company is considering investment of Rs. 1, 00,000 in a project. The following are the income forecasts, after
depreciation and tax, 1st year Rs. l 0,000, 2nd year Rs. 40.000, 3rd year Rs. 60,000, 4th year Rs. 20,000 and 5th
year Rs. Nil. From the above information you are required to calculate: (1) Pay-back Period (2) Discounted Payback Period at 10% interest factor.
Solution:
(1) Calculation of Pay-back Period

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Financial Management

Annual Cash Inflows

Rs.
10,000
40,000
60.000
20,000
--

Year
1
2
3
4
5

Cumulative Cash Inflows

Rs.
10,000
50,000
1,10,000
1,30.000
1,30,000

The above table shows that at the end of 3rd year the Cumulative Cash Inflows exceeds the investment of Rs. 1,
00,000. Thus the Pay-back Period is as follows:
Pay-back Period = 2 Years +

= 2 Years +
= 2 Years + 0.833 = 2.833 Years
(2) Calculation of Discounted Pay-back Period 10% Interest Rate
Year

Cash Inflows

Present Value of
Cash Inflows
(Z x3)
4
Rs.

Cumulative Value
of Cash Inflows

Discontinuing Present Value

Factor at 10%
3

1
1
2
3
4
5

10,000
40,000
60,000
20,000
--

0.9091
0.8265
0.7513
0.6830
0.6209

9,091
33,060
45,078
13,660
--

9.091
42,151
87,229
1,00,889
1,00,889

Rs.

From the above table, it is observed that up to the 4th year Rs. 1, 00,000 is recovered. Because the Discounting
Cumulative Cash Inflows exceeds the original cash outlays of Rs. 1, 00,000. Thus the Discounted Pay-back Period
is calculated as follows:
Pay-back Period = 3 Years +
= 3 Years+
= 3 Years + 0.935 == 3.935 Years
6.9.3 Average Rate of Return Method (ARR) or Accounting Rate of Return Method
Average Rate of Return Method is also termed as Accounting Rate of Return Method. This method focuses on the
average net income generated in a project in relation to the projects average investment outlay. This method involves
accounting profits not cash flows and is similar to the pe1formance measure of return on capital employed.

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The average rate of return can be determined by the following equation:

Average Rate of Return (ARR) =

Where,
Average investment would be equal to the Original investment plus salvage value divided by 2.
Average Investment =
(or)

=
Advantages

It considers all the years involved in the life of a project rather than only pay-back years

It applies accounting profit as a criterion of measurement and not cash flow

Disadvantages

It applies profit as a measure of yardstick not cash flow

The time value of money is ignored in this method

Yearly profit determination may be a difficult task

6.9.4 Discounted Cash Flow Method (or) Time Adjusted Method

Discount cash flow is a method of capital investment appraisal which takes into account both the overall profitability
of projects and also the timing of return. Discounted cash flow method helps to measure the cash inflow and outflow
of a project as if they occurred at a single point in time so that they can be compared in an appropriate way. This
method recognises that the use of money has a cost, i.e., interest foregone. In this method risk can be incorporated
into Discounted Cash Flow computations by adjusting the discount rate or cut off rate.
Disadvantages
The following are some of the limitations of Discounted Pay-back Period Method:

There may be difficulty in accurately establishing rates of interest over the cash flow period.

Lack of adequate expertise in order to properly apply the techniques and interpret results.

These techniques are based on cash flows, whereas reported earnings are based on profits.

The inclusion of Discounted Cash Flow Analysis may cause projected earnings to fluctuate considerably and thus
have an adverse on share prices.
6.9.5 Net Present Value Method (NPV)
This is one of the Discounted Cash Flow techniques which explicitly recognise the time value of money. In this
method all cash inflows and outflows are converted into present value (i.e., value at the present time) applying an
appropriate rate of interest (usually cost of capital).
In other words, Net Present Value Method discount inflows and outflows to their present value at the appropriate
cost of capital and set the present value of cash inflow against the present value of outflow to calculate Net Present
Value. Thus, the Net Present Value is obtained by subtracting the present value of cash outflows from the present
value of cash inflows.
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Financial Management

Advantages of Net Present Value Method

It recognises the time value of money and is thus scientific in its approach.

All the cash flows spread over the entire life of the project are used for calculations.

It is consistent with the objectives of maximising the welfare of the owners as it depicts the positive or otherwise
present value of the proposals.

Disadvantages

This method is comparatively difficult to understand or use.

When the projects in consideration involve different amounts of investment, the Net Present Value Method
may not give satisfactory results.

6.9.6 Internal Rate of Return Method (IRR)

Internal Rate of Return Method is also called as Time Adjusted Rate of Return Method. It is defined as the rate
which equates the present value of each cash inflows with the present value of cash outflows of an investment. In
other words, it is the rate at which the net present value of the investment is zero.
Horngren and Foster define Internal Rate of Return as the rate of interest at which the present value of expected
cash inflows from a project equals the present value of expected cash outflows of the project. The Internal Rate
of Return can be found out by Trial and Error Method. First, compute the present value of the cash flow from an
investment, using an arbitrarily selected interest rate, for example 10%. Then compare the present value so obtained
with the investment cost.
If the present value is higher than the cost of capital, try a higher interest rate and go through the procedure again.
On the other hand if the calculated present value of the expected cash inflows is lower than the present value of cash
outflows a lower rate should be tried. This process will be repeated until and unless the Net Present Value becomes
zero. The interest rate that brings about this equality is defined as the Internal Rate of Return.
Alternatively, the internal rate can be obtained by Interpolation Method when we come across two rates; one with
positive net present value and other with negative net present value. The IRR is considered as the highest rate of
interest which a business is able to pay on the funds borrowed to finance the project out of cash inflows generated
by the project. The Interpolation formula can be used to measure the Internal Rate of Return as follows:
Lower Interest Rate +

(higher rate lower rate)

Evaluation
A popular discounted cash flow method, the internal rate of return criterion has several virtues:

It takes into account the time value of money.

It considers the cash flows over the entire life of the project.

It makes more meaningful and acceptable to users because it satisfies them in terms of the rate of return on
capital.

Limitations

The internal rate of return may not be uniquely defined.

The IRR is difficult to understand and involves complicated computational problems.

The internal rate of return figure cannot distinguish between lending and borrowings and hence high internal
rate of return need not necessarily be a desirable feature.

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6.9.7 Profitability Index Method

Profitability Index is also known as Benefit Cost Ratio. It gives the present value of future benefits, computed at the
required rate of return on the initial investment. Profitability Index may either be Gross Profitability Index or Net
Profitability Index. Net Profitability Index is the Gross Profitability Index minus one. The Profitability Index can
be calculated by the following equation:
Profitability Index =

Rule of Acceptance

As per the Benefit Cost Ratio or Profitability Index a project with Profitability Index greater than one should be
accepted as it will have Positive Net Present Value. Likewise if Profitability Index is less than one the project is not
beneficial and should not be accepted.
Advantages of Profitability Index:

It duly recognises the time value of money.

For calculations when compared with internal rate of return method it requires less time.

It helps in ranking the project for investment decisions.

As this method is capable of calculating incremental benefit cost ratio, it can be used to choose between mutually
exclusive projects.

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Financial Management

Summary

The term Capital Budgeting refers to the long-term planning for proposed capital outlays or expenditure for the
purpose of maximising return on investments.

Capital Budget is also known as Investment Decision Making or Capital Expenditure Decisions or Planning
Capital Expenditure etc.

According to Hamption, John. J., Capital budgeting is concerned with the firms formal process for the
acquisition and investment of capital.

Capital budgeting decisions involve long-term implication for the firm, and influence its risk complexion.

Investment decision taken by individual concern is of national importance because it determines employment,
economic activities and economic growth.

Capital Expenditure Increases Revenue is the expenditure which brings more revenue to the firm either by
expanding the existing production facilities or development of new production line.

A firm may have several investment proposals for its consideration.

There are number of appraisal methods which may be recommended for evaluating the capital investment
proposals.

Pay-back period is also termed as Pay-out period or Pay-off period.

One of the limitations of the pay-back period method is that it ignores the post pay-back returns of project.

Discounted pay-back method helps to measure the present value of all cash inflows and outflows at an appropriate
discount rate.

Average Rate of Return Method is also termed as Accounting Rate of Return Method.

Discount cash flow is a method of capital investment appraisal which takes into account both the overall
profitability of projects and also the timing of return.

Net Present Value is obtained by subtracting the present value of cash outflows from the present value of cash
inflows.

Internal Rate of Return Method is also called as Time Adjusted Rate of Return Method.

Horngren and Foster define Internal Rate of Return as the rate of interest at which the present value of expected
cash inflows from a project equals the present value of expected cash outflows of the project.

Profitability Index is also known as Benefit Cost Ratio.

As per the Benefit Cost Ratio or Profitability Index a project with Profitability Index greater than one should
be accepted as it will have Positive Net Present Value.

Reference

Peterson, P. P. & Fabozzi, J. F., 2004. Capital Budgeting: Theory and Practice, John Wiley & Sons.

Periasamy, P., 2010. A TEXTBOOK OF FINANCIAL COST AND MANAGEMENT ACCOUNTING, Global
Media.

WHAT IS CAPITAL BUDGETING? [Pdf] Available at: <http://www2.sunysuffolk.edu/rosesr/ACC212/Lessons/

CapitalBudget/CapitalBudgetingTraining.pdf> [Accessed 16 May 2013].

CHAPTER 29 Capital Budgeting [Pdf] Available at: <http://mfile.narotama.ac.id/files/Accounting%20

&%20Financial/A%20Textbook%20of%20Financial%20Cost%20&%20Management%20Accounting%20
(Revised%20Edition)/Chapter%2029%20%20Capital%20Budgeting.pdf> [Accessed 16 May 2013].

Irfanullah, A., 2011. CFA Level I Capital Budgeting Video Lecture by Mr. Arif Irfanullah part 2 [Video online]
Available at: <http://www.youtube.com/watch?v=qfzQwqLdXH0> [Accessed 16 May 2013].

Capital Budgeting [Video online] Available at: <http://www.youtube.com/watch?v=qGgVGUcBqAg> [Accessed

16 May 2013].

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Recommended Reading

Jacobs & Davina, F., 2006. A Reviews of Capital Budgeting Practices, International Monetary Fund.

Dayananda, D., 2002. Capital Budgeting: Financial Appraisal of Investment Projects, 2nd ed. Cambridge
University Press.

Baker, K. H. & English, P., 2011. Capital Budgeting Valuation: Financial Analysis for Todays Investment
Projects, John Wiley & Sons.

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Financial Management

Self Assessment
1. ___________ is concerned with the firms formal process for the acquisition and investment of capital.
a. Investment
b. Capital budgeting
c. Capital expenditure
d. Planning
2. Which of the following statements is false?
a. Capital budgeting involves commitment of small amount of funds.
b. Wrong sale forecast; may lead to over or under investment of resources.
c. Many firms fail, because they have too much or too little capital equipment.
d. Capital decisions are required to assessment of future events which are uncertain.
3. ____________ is the expenditure which brings more revenue to the firm either by expanding the existing
production facilities or development of new production line.
a. Mutually Exclusive Proposals
b. Independent Proposals
c. Capital Expenditure Increases Revenue
d. Capital Expenditure Reduces Costs
4. What reduces the cost of present product and thereby increases the profitability of existing operations?
a. Mutually Exclusive Proposals
b. Independent Proposals
c. Capital Expenditure Increases Revenue
d. Capital Expenditure Reduces Costs
5. ____________ refer to the acceptance of one proposal results in the automatic rejection of the other proposal.
a. Mutually Exclusive Proposals
b. Dependent Proposals
c. Contingent Proposals
d. Independent Proposals
6. Which proposals are said be to economically independent?
a. Mutually Exclusive Proposals
b. Independent Proposals
c. Dependent Proposals
d. Contingent Proposals
7. Which of the following formula calculates Profitability Index?
a. Average Rate of Return (ARR) =
b. Lower Interest Rate +
c. Reciprocal Pay-back Period =
d. Profitability Index =

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(higher rate lower rate)

8. ____________ is defined as the number of years required to recover the initial investment in full with the help
of the stream of annual cash flows generated by the project.
a. Profitability Index Method
b. Internal Rate of Return Method
c. Pay out Period Method
d. Net Present Value Method
9. If the project generates constant cash flow the pay-back period can be computed by dividing __________ by
annual cash inflows.
a. constant annual cash inflows
b. investment proposals
c. cash inflows
d. cash outlays
10. ____________ is a method of capital investment appraisal which takes into account both the overall profitability
of projects and also the timing of return.
a. Discount cash flow
b. Cash flow
c. Net present value method
d. Internal rate of return method

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