Capital Budgeting and

Investment Decisions
AFTERSCHOOL
DEVELOPING CHANGE MAKERS
CENTRE FOR SOCIAL ENTREPRENEURSHIP
PGPSE PROGRAMME
Worlds Most Comprehensive programmes in social
entrepreneurship & spiritual entrepreneurship
OPEN FOR ALL FREE FOR ALL

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Capital Budgeting and

Investment Decisions
Dr. T.K. Jain.

AFTERSCHOOL
Centre for social entrepreneurship
Bikaner M: 9414430763
tkjainbkn@yahoo.co.in
www.afterschool.tk, www.afterschoool.tk
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What are these decisions

important?

Huge investments
Long time frame
Irreversibility
Complex decisions

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What are the criteria?

Capital cost ( how much money is to be
invested?)
Depreciation?
Operating expenditure (how much money
are you going to pay every year? )
Revenue?
Residual value?
Make or buy decisions?
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Types of decision?
Mutually exclusive projects (whether
project A or project B).
Replacement project ( should we replace
our old machine with new machine?)
Accept / Reject Decisions (should we
accept / reject a proposal).

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How should we start?

Planning phase should we really have a
project if yes - what?
Evaluation? how should we evaluate our
projects what should be our criteria?
Implementation? how should we
implement our projects?
Review : how should we review our
projects so that we can prepare better
capital budgeting decisions
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Traditional methods
These methods dont take into account
time value of money and therefore they
are not considered to be appropriate
methods now a days. However, they are
easier, quick and help in decision making.
Methods are :
A. Payback period method
B. Accounting Rate of Return
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DCF methods . ..
DCF = discounted cash flows
These are modern methods and they take
into account time value of money. They
are much superior to traditional methods.
The methods are :
A. NPV (Net present value)
C. Profitability Index
B. IRR (internal rate of return)
D. Discounted Payback.
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A project requires Rs. 1 lakh and its

cash inflow every year will be Rs.
20000. What is its payback period?
100000/20000= 5 years.

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There is a project in which we are

investing Rs. 2 lakhs and returns
are as under:

Returns:
1st year: Rs. 20000
2nd Year : Rs. 40000
3rd year : Rs. 50000
4th year: Rs. 90000
5th year: Rs. 30000
6th year: disposal of machines Rs. 4000
What is the payback period? =4 years.

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Solve the following question

a project costs Rs. 20,00,000 and yields annually a
profit of As. 3,00,000 after depreciation @ 12.5%
(straight line method) but before tax 50%. The first
step would be to calculate the cash inflow from this
project. What is payback period?
Solution:
The cash inflow is As. 4,00,000 calculated as
Profit before tax 3,00,000
Less. Tax@50% 1,50,000
Prof it after tax 1,50,000
Add: Depreciation written off 2,50,000
Total cash inflow 4,00,000
Payback period = 20 lakhs / 4 lakhs = 5 years.
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Suppose Ramesh Global Financial

services invests $ 10 million. His
returns are as under:
1st year: $ 2 million
2nd year : $4 million
3rd year : $ 4 million
4th year : $ 6 million
what is IRR?
Investment / Average returns = 2.5
As we can see 10 / 4 = 2.5. We have to find the rate at
which present value of annuity of Re. 1 when it can give
us
2.5 in 4 years. TheAFTERSCHOOL's
rate is : 18.42 MAT
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Solution
Alternate solution:
Let us find present value of cash inflows at
different rates and the rate at which the cash
inflows are equal to $ 10 million will be the
answer. The rate is 18.42% per annum)
(2 lakh) / (1.1842)^1 + (4 lakh) / (1.1842)^2 +
(4 lakh) / (1.1842)^3 + (6 lakh) / (1.1842)^4 =
10 lakhs
Thus Internal rate of return is 18.42% answer.
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What is leveraging?
When a firm uses fixed cost sources of
funds, it is called leveraging. Higher the
ratio of debt in total funds, higher the
leveraging.
Unleveraged firm is that which has no
debt.

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If there are two companies, one

with leverage of 1 and other with
leverage of 20 ,which one will you
select for investments (you are risk
averse investor)?
First company.

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A Company produces and sells

10,000 shirts. The selling price per
shirt is Rs.
500. Variable cost is Rs. 200 per
shirt and fixed operating cost is Rs.
25,00,000.
(a) Calculate operating leverage.
(b) If sales are up by 10%, then
what is the impact on EBIT?
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Solution

There are 2 ways to find leverage:

Operating leverage = contribution / EBIT
Contribution = Sales Variable cost
=50,00,000 20,00,000 = 30,00,000
EBIT = 30,00,000 25,00,000 = 5 lakhs
Operating leverage = 30 lakhs/ 5 lakhs
Thus operating leverage is 6 times. Ans.

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What will happen if sales are up by

10%, then what is the impact on
EBIT?
Operating leverage = %change in EBIT /
% change in sales
New EBIT = 55,00,000 (22,00,000 +
25,00,000) = 8 lakhs
Change = 3 lakhs or 3/5*100 = 60%
change
Operating leverage = 60%/10% = 6 times.
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Suppose there are 2 firms with the same

operating leverage, business risk and
probability of EBIT and only differ with respect
to their use of debt.

Goti International
No Debt
$20000 in assets
40% tax

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Ramesh Continental
$10000 debt at 12%
$20000 in assets
40% tax

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In the previous statement, if EBIT is

between $ 2000 to 4000 with equal
probability, what are the
possibilities?

Suppose income is
2000$
EAT = 1200
3000 is EBIT
EAT = 1800
EBIT is 4000
EAT = 2400
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Suppose income is
2000$ - int.1200
EAT = 480
3000 is EBIT - 1200
EAT = 1080
EBIT is 4000 - 1200
EAT = 1680

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Analysis
BEP = EBIT / Total
assets.
2000/20000
=.1
ROE=
PAT/NETWORTH
=1200/20000=.06
DSCR / ICR
=EBIT / INT
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BEP = EBIT / Total

assets.
2000/20000
=.1
PAT/NETWORTH
=480/10000=.048
DSCR / ICR
=EBIT / INT
=2000/1200=1.67

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APPLYING PROBABILITY
Suppose probability of EBIT of
2000,3000,4000 is .25, .5 and .25.
Thus we have to find expected BEP, ROE
and DSCR / ICR for the two firms.

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EXPECTED VALUES OF
BEP,ROE,DSCR
Goti
BEP =.25*.1 +.5*.15
+.25*.2 = .15
ROE=.25*.06 +.5*.09
+.25*.12 = .09
DSCR= NO LOAN

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Ramesh
BEP =.25*.1 +.5*.15
+.25*.2 = .15
ROE=.25*.048
+.5*.108+.25*.168 = .
108
DSCR=.25*.0167
+.5*.025+.25*.033
=.024

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Jitu Global Productions has

following details:

Sales $ 24,00,000 (@$100)

Variable cost = 50%
Fixed cost = $10,00,000
Borrowing = $10,00,000 @10%
Equity 10,00,000 (face value $100)
Find its combined leverage?

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Solution

EBIT = 2400000 (1200000+1000000)

Operating leverage
Contribution / EBIT
1200000/200000=6
Financial leverage
EBIT / (EBIT Interest)
=200000/(200000-100000) = 2
Combined leverage = 6*2 = 12 answer.

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Find the combined leverage

installed Capacity

4000 units

Actual Production and Sales

75%

Selling Price

30 per unit

Variable Cost

15 per unit

Fixed Cost:
Under Situation I

15000

Under Situation-il

20000

Financial Plan
A

B
Equity 10,000

15,000

Debt (20%) 10,000

5,000

Total 20,000

20,000

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Solution operating leverage in

plan A and plan B.
Sales : 3000*30 =
90000
Contribution
90000-45000=45000
EBIT = 90000(45000+15000)
=30000
Operating
leverage=1.5
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Sales : 3000*30 =
90000
Contribution
90000-45000=45000
EBIT = 90000(45000+20000)
=25000
Operating
leverage=1.8

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Solution Financial leverage in

plan A and plan B.

EBIT / (Ebit-interest)
EBIT =30000
30000/28000 = 1.07
Combined leverage
=1.5*1.07=1.605

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EBIT =25000
25000/24000 = 1.04
Combined leverage
=1.8*1.04=1.87

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Question on NI approach
Rupa Companys EBIT is Rs. 5,00,000.
The company has 10% 20 lakh
debentures. The equity capitalization rate
i.e. Ke is 16%.
You are required to calculate:
(i) Market value of equity and value of firm
(ii) Overall cost of capital
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Solution
Market value of the firm = Value of equity (
market value) + value of debt.
Value of equity = [EBIT Interest (1-ts)]/K
(there is an assumption that there are no
taxes in all the theories of capital
structure)
=500000 200000 = 300000
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Solution

Equity = 3 lakh / .16

=1875000
Debt = 20,00,000
Total value = 38,75,000
Answer.

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Ramesh Ltds. operating income is $ 5,00,000.

The firms cost of debt is 10%
firm employs $ 15,00,000 of debt. The overall
cost of capital of the firm is
15%. What is total value of the firm.
& Cost of equity as per NOI approach.
In NOI approach, we take up operating income
and capital structure decision is immaterial (not
relevant). Cost of equity depends on ratio of debt
(higher the debt, higher the cost of equity).
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Solution

Value of firm = 500000/ .15

=33,33,333
Value of debt = 1500000
Thus value of equity = 18,33,333
Earnings available to equity share holders:
500000 150000 = 350000 (we assume no
taxes)
Cost of equity = 3,50,000/18,33,333 *100 =
19.09% answer.
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There are two firms Goti

International & Ramesh Global.
Goti International is leveraged
company having debt of $ 100,000
@ 7%. Cost of equity of both the
companies is 11.5% and 10%
respectively.analyse using MM
approach. EBIT = $20000
As you can see that the overall value of
the firm is same so no impact of debt.
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Analysis

Goti
Debt = 100000
EAI = 20000-7000
=13000 (we assume no
taxes)
Equity
=13000/.115
=113043
Total value
=2,13,043

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Ramesh
EBIT = 20000
Equity = 20000/.1
=200000

Thus we can see that the

value of Goti International
is little bit higher

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Arbitrage process
you may invest in Goti
International
Suppose we invest
10000, we get = 1150

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You may borrow (take

personal leverage) and
invest in Ramesh
because it it unleveraged
firm
Here we can borrow
10000 and invest our own
10000. We get 2000 as
return, and we have to
pay interest of 700, so
finally we have 1300 left
out.

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Vinod Bhugari Continental has

EBIT of $ 100000. Company has
10% debentures of $ 5 Lakhs and
equity capitalisation rate is 15%.
What is the value of the firm as per
traditional approach ?

Earnings after interest = 100000-50000

=50000 (we ignore taxes)
Value of equity = 50000/.15 = 333333
Value of the firm=$ 833333 answer.

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Sarika Consultants & Pankaj Baid

Consultants are two firms. Having
NOI of $ 15 lakhs each.Pankaj Baid
consultants have taken ECB of $7
lakhs @11%. Tax rate = 33% Equity
of Sarika consultants $ 13 lakhs
and that of Pankaj Consultants is
$6 lakhs

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Solution

Sarika Consultants
EBIT = 1.5 million
Tax = 5 Lakhs
EAT = 1 million
Cost of equity
10/13 *100 = 77%
Value = 13 lakhs

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Pankaj Consultants
EBIT = 1.5 million
Interest = 77000
EAIBT= 14,23,000
Tax= 4,74,333
EAT = 9,48,666
Cost of equity =
948666/600000*100
=158%
Value of firm 13 laks

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In the previous question, what will

happen if cost of equity is given as
20% in both the cases?

Sarika Consultants
EBIT = 1.5 million
Tax = 5 Lakhs
EAT = 1 million
Value of equity
=10,00,000/.2
=50,00,000
Total value of the firm is
also 50 lakhs

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Pankaj Consultants
EBIT = 1.5 million
Interest = 77000
EAIBT= 14,23,000
Tax= 4,74,333
EAT = 9,48,666
Value of equity
=948666/.2 =47,43,330
Total value of the firm
=54,43,330 answer.

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In the previous question, what will

happen, if market capitalises operting
income as a whole @ 20%?

Sarika Consultants
EBIT = 1.5 million
Tax = 5 Lakhs
EAT = 1 million
Value of the firm
=10 lakhs / .2
= 50 lakhs
Value of equity = 50
lakhs
Cost of equity = 20%
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Pankaj Consultants
EBIT = 1.5 million
Interest = 77000
EAIBT= 14,23,000
Tax= 4,74,333
EAT = 9,48,666
Value of the firm
1500000/.2 = 7500000
Value of equity =
6800000
Cost of equity
13.94%
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Operating leverage
= % change in EBIT / % change in sales
Actually it measures the impact of fixed
cost (as aginst variable cost).

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Financial leverage
% change in EPS / % change in EBIT
Actually it measures the impact of interest
and other such fixed charge securities on
EPS.
EPS = earning per share.

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Alternate formulaes

Operating leverage
= Contribution / EBIT
Financial leverage
= EBIT / (EBIT interest)

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What is capital structure?

Combination of capital is called capital
structure. The firm may use only equity, or
only debt, or a combination of equity +
debt, or a combination of
equity+debt+preference shares or may
use other similar combinations.

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How do you design capital

structure?
1.
2.
3.
4.

It should minimise cost of capital

It should reduce risks
It should give required flexibility
It should provide required control to the
owners
5. It should enable the company to have
adequate finance.
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What are the risks associated with

capital structure decisions?
Meaning of risk = variability in income is
called risk.
Business risk = it is the situation, when the
EBIT may vary due to change in capital
structure. It is influenced by the ratio of fixed
cost in total cost. If the ratio of fixed cost is
higher, business risk is higher.
Financial risk = it is the variability in EPS due
to change in capital structure. It is caused
due to leverage. If leverage is more,
variability will be more and thus financial risk
will be more.
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Degree of financial leverage?

It shows the extend of financial risk.
Higher the DFL, higher is the financial risk.
Formula =
% change in EPS / % change in EBIT.
Suppose EBIT changes 10%, due to this
EPS changes 20%,
20/10 = 2
DFL is 2.
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EBIT - EPS analysis

Generally cost of debt is lower than cost of
equity. Therefore raising debt (trading on
equity) increases EPS and it gives benefit
to the shareholders. However, excess of
debt will create more risk and therefore it
is not advisable. A firm can identify an
ideal level of quantum of debt and equity
so that it is within proportion.
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Formula
[(EBIT I1) (1-t)]/ E1 = [(EBIT I2) (1-t)]/
E2
E1 = equity in 1st alternative (no debt or
minimum debt)
E2 = equity in 2nd alternative (no debt or
max. debt)
I1 and I2 represent interest payable in the
2 alternatives respectively.
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What do you understand from

trading on equity?
With capital, we can raise debt, and raise
our EPS, this is called trading on equity.

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What is coverage ratio or DSCR?

DSCR = debt service coverage ratio
Coverage ratio denotes the extent to which
interest is covered by the EBIT. It denotes
whether we have sufficient earnings to meet
our interest obligation. If DSCR is 1 or less
than one, it is dangerous situation.
Formula = EBIT / interest.
Higher the DSCR, less is the risk (because
there is higher coverage).
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Theory of optimal capital structure?

This theory states that we can have an
optimum capital structure as we raise the
debt, we can raise the value of the firm to
some extent. Thus level of debt can be
increased upto some level. That level is the
ideal capital structure.
Ultimate objective of Finance manager is to
raise the value of the firm and raise the
wealth which is possible by an ideal capital
structure.
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Is there indifference point?

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Solve the following

Goti continental Inc. a profit makipg company, has a paidup capital of Rs. 100 lakhs consisting of 10 lakhs ordinary
shares of Rs. 10 each. Currently, it is earning an annual
pre-tax profit of Rs. 60 lakhs. The companys shares are
listed and are quoted in the range of Rs. 50 to Rs. 80. The
management wants to diversify production and has
approved a project which will cost Rs. 50 lakhs and which
is expected to yield a pre-tax income of Rs. 40 lakhs per
annum. To raise this additional capital, the following
options are under consideration of the management:
(a) To issue equity capital for the entire additional
amount. It is expected that the new shares (face value of
Rs. 10) can be sold at a premium of Rs. 15.
(b) To issue 16% non-convertible debentures of Rs. 100
each for the entire amount. Tax rate = 30%
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Solution
(a) raising additional equity how much
equity required?
One share will give you 10 + 15 = 25
Capital required = 50 lakhs.
50/25 = 2 lakh shares. (we already have
10 lakh shares)

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Solution

(a) All equity :

Earnings = 60 + 40 = 100
Tax: 30
EAT = 70
No. of shareholders: 12
lakh shares
EPS = 70 / 12=5.83

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(B) All debt

Earnings = 60 + 40 = 100
Payment of interest:
16% of Rs. 50 lakhs =8
lakhs
EAIBT = 92
Tax: 30% = 27.6
EAT = 64.4
No. of shareholders: 10
lakh shares
EPS = 64.4 / 10=6.44

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Analysis
From the above analysis, it is clear that
EPS is higher in the case when we are
raising debt. (therefore this option is better
and the firm should go for raising debt).
We also have to look at the overall market
capitalisation and overall value of the firm.
Suppose, PE ratio of the industry is 20,
the value of the firm is as under:
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Solution

(a) all equity

5.83 *20 = 116.6
Multiply it with 12 lakhs,
The value of the firm is
1399.2 lakhs. Thus from
this analysis, this option
is better.

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Debt
Use of debt will reduce
the PE ratio to some
extent as Beta will
increase. However, let us
calculate using 20 as PE
ratio:
20*6.44 = 128.8 *10
lakhs + 16 lakhs
=1304 lakhs

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Theories of capital structures . .

1.
2.
3.
4.

There are 4 theories:

NI approach (net income approach)
NOI approach (net operating income
approach)
MM approach (Modigliani Millar
Approach)
Traditional approach

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Assumptions in capital structure

theories ..
1. There are only 2 sources of finance
debt and equity
2. Taxes are ignored
3. Dividend payout ratio is 100%
4. Business risk is constant
5. Firms total financing remains constant.

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NI approach (net income approach)

When you raise debt, leverage will increase. The
overall value of the firm will incrase. Debt will
have lower cost, so overall cost of capital will
reduce (it is better if the cost of capital reduces).
V = S+ D
V = value of the firm, S = equity, D = debt
An increase in leverage will increase the value of
the firm, it will raise EPS, it will raise the market
price of the shares and it will reduce weighted
average cost of capital, thus leverage is always
beneficial.
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NOI approach (Net operating

income approach)
Capital structure decision is irrelevant. If
you raise debt, the cost of equity will
increase. The overall cost of capital will
remain constant in spite of leverage. Thus
there is no advantage of raising debt. As
we raise the debt, the cost of equity
increases in the same proportion. The
market discounts the firm, which is
leveraged. Thus capital structure decision
has no relevance.
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MM approach
It is similar to NOI approch

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Traditional approach
It says that with the use of debt, the
overall cost of capital comes down upto
some extent and thereafer the overall cost
of capital increases. Thus there is an ideal
point, upto which the overall cost of capital
will decrease with the help of increase in
debt, beyond which the use of debt is
detrimental to the company.
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ABOUT AFTERSCHOOL
Afterschoool conducts three year integrated PGPSE (after
class 12th along with IAS / CA / CS) and 18 month
PGPSE (Post Graduate Programme in Social
Entrepreneurship) along with preparation for CS / CFP /
CFA /CMA / FRM. This course is also available online
also. It also conducts workshops on social
entrepreneurship in schools and colleges all over India
start social entrepreneurship club in your institution today
with the help from afterschoool and help us in developing
society.

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Why such a programme?

To promote people to take up entrepreneurship
and help develop the society
To enable people to take up franchising and
other such options to start a business / social
development project
To enable people to take up social development
as their mission
To enable people to promote spirituality and
positive thinking in the world
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Who are our supporters?

Afterschoolians, our past beneficiaries,
entrepreneurs and social entrepreneurs
are supporting us.
You can also support us not necessarily
by money but by being promotor of our
concept and our ideas.

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About AFTERSCHOOL PGPSE the

best programme for developing great
entrepreneurs

Most flexible, adaptive but rigorous programme

Available in distance learning mode
Case study focused- latest cases
Industry oriented practical curriculum
Designed to make you entrepreneurs not just
an employee
Option to take up part time job so earn while
you learn
The only absolutely free course on internet
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Workshops from AFTERSCHO

OL

IIF, Delhi
CIPS, Jaipur
ICSI Hyderabad Branch
Gyan Vihar, Jaipur
Apex Institute of Management, Jaipur
Aravali Institute of Management, Jodhpur
Xavier Institute of Management, Bhubaneshwar
Pacific Institute, Udaipur
Engineering College, Hyderabad

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Flexible Specialisations:

Spiritualising business and society

Rural development and transformation
HRD and Education, Social Development
NGO and voluntary work
Investment analysis,microfinance and inclusion
Retail sector, BPO, KPO
Accounting & Information system (with CA / CS /CMA)
Hospital management and Health care
Hospitality sector and culture and heritage
Other sectors of high growth, high technology and social
relevance

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Salient features:
The only programme of its kind (in the whole world)
No publicity and low profile course
For those who want to achieve success in life not just a
degree
Flexible you may stay for a month and continue the rest of
the education by distance mode. / you may attend weekend
classes
Scholarships for those from poor economic background
Latest and constantly changing curriculum keeping pace
with the time
Placement for those who are interested
Admissions open throughout the year
Latest and most advanced technologies, books and study
material
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Components

Pedagogy curriculum and approach based on IIM Ahmedabad and ISB

Hyderabad (the founder is alumnus from IIMA & ISB Hyderabad)
Meditation, spiritualisation, and self development
EsGotitial softwares for business
Business plan, Research projects
Participation in conferences / seminars
Workshops on leadership, team building etc.
Written submissions of research projects/articles / papers
Interview of entrepreneurs, writing biographies of entrepreneurs
Editing of journals / newsletters
Consultancy / research projects
Assignments, communication skill workshops
Participation in conferences and seminars
Group discussions, mock interviews, self development diaryng
Mind Power Training & writing workshop (by Dr. T.K.Jain)

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Pedagogy

Case analysis,
Articles from Harvard Business Review
Quiz, seminars, workshops, games,
Visits to entrepreneurs and industrial visits
PreGotitations, Latest audio-visuals
Group discussions and group projects
Periodic self assessment
Mentoring and counselling
Study exchange programme (with institutions out of
India)
Rural development / Social welfare projects
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Branches
AFTERSCHOOL will shortly open its
branches in important cities in India
including Delhi, Kota, Mumbai, Gurgaon
and other important cities.
Afterschooolians will be responsible for
managing and developing these branches
and for promoting social entrepreneurs.

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Case Studies
We want to write case studies on social
entrepreneurs, first generation
entrepreneurs, ethical entrepreneurs.
Please help us in this process. Help us to
be in touch with entrepreneurs, so that we
may develop entrepreneurs.

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Basic values at AFTERSCHOOL

Share to learn more

Interact to develop yourself
Fear is your worst enemy
Make mistakes to learn
Study & discuss in a group
Criticism is the healthy route to mutual support
and help
Ask fundamental questions : why, when, how &
where?
Embrace change and compete with yourself
only
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www.afterschoool.tk
social entrepreneurship for better
society

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