Corporate Finance CREATED BY ADNAN ARSHAD (Lecturer) Govt. College University Faisalabad CONTACT NO: 0301-7120098 EMAIL: adnan_776@yahoo.com 1
BRIEF CONTENTS Topics Goal and function of finance Function of finance. investment decision, finance decision Concept in valuation time value of money, present value, bond return, dividend discounting model, measuring risk Market risk and return Efficient financial markets, security portfolio, capital assets pricing model Investment in assets and required return Administrative framework, method of evaluation, NPV vs IRR, inflation capital budgeting Theory of capital structure Cost of capital, capital structure, taxes, Making capital structure decision EBIT- EPS analysis Dividend and share repurchase Procedural aspects of paying dividend Issuing securities Public offering security Fixed income financing and pension liability Feature of debt, types of debt financing, proffered stock Page No 2 5 15 20 33 43 46 47 48 2
CHAPTER 1 Corporate finance Goal and function of finance Definition of finance The finance function is the process of acquiring and utilizing funds of a business. Financing consists of the raising, providing, managing of all the money, capital or funds of any kind to be used in connection with the business Financial Management: The process of managing the financial resources, including accounting and financial reporting, budgeting, collecting accounts receivable, risk management, and insurance for a business Major functions of financial management: 1. Accounting: Typically includes: (a) planning the program within delegated limits; (b) developing, revising, and/or adapting accounting systems; (c) executing day-to-day ledger maintenance and related operations for the classification and other recording of financial transactions; (d) analyzing the results and interpreting the effects of transactions upon the financial resources of the organization; (e) applying accounting concepts to solve problems, render advice, or to meet other needs of management; and (f) managing the total accounting program, including supervision of subordinate accountants, accounting technicians, voucher examiners, payroll clerks, and other similar supporting personnel. 2. Budgeting: Typically includes: (a) the formulation -- developing instructions, calls for estimates, preparing estimates, reviewing and consolidating estimates; (b) the presentation -- either within the organization or at hearings (within the agency, at the budget bureau, or subcommittee); and (c) the execution -- funds control, program adjustments, review of reports and preparation of reports. 3. Managerial-Financial Reporting:. Managerial-financial reporting is the process of providing appropriate data to key officials at all levels of management for the purpose of helping to achieve the 3
most effective program and financial management. Stress is placed on aiding in the making of management decisions. Normally, much of such data will be of a financial character, developed from the accounting and the budget systems; however, frequently data will be a combination of both financial and non-financial information and, in some cases, the data may be entirely non-financial in nature. In its ideal form, the data are so integrated as to represent a single total data system. Since in good managerial-financial reporting, concern is given to the development of the systems that will provide the essential data, one of the normal responsibilities of the Financial Manager is the development, revision and/or adaptation of the managerial-financial reporting system. Function of finance 1 -Investment decision. One of the most important long term decisions for any business relates to investment. Investment is the purchase or creation of assets with the objective of making gains in the future. Typically investment involves using financial resources to purchase a machine/ building or other asset, which will then yield returns to an organisation over a period of time. Decisions basically concerned with the process of acquiring funds. May be from own sources (Equity Capital) or loan sources ( Debt Capital). These decisions are concerned with answers to the following questions 1. what is the scale of the investment - can the company afford it? 2. How long will it be before the investment starts to yield returns? 3 3. How long will it take to pay back the investment? 4. What are the expected profits from the investment? 5. Could the money that is being ploughed into the investment yield higher returns elsewhere? 2-Financing decisions Decisions concerning the liabilities and stockholders' equity side of the firm's balance sheet, such as a decision to issue bonds. Concerned with utilisation of funds. These decisions relate to the selection of the assets in which funds should be invested. From the asset perspective these decisions are Capital Budgetting decisions Working Capital Management Capital budgeting decision 4
Capital budgeting is the process by which the financial manager decides whether to invest in specific capital projects or assets. In some situations, the process may entail in acquiring assets that are completely new to the firm. In other situations, it may mean replacing an existing obsolete asset to maintain efficiency. During the capital budgeting process answers to the following questions are sought: What projects are good investment opportunities to the firm? From this group which assets are the most desirable to acquire? How much should the firm invest in each of these assets? Working capital management Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash. 3- Asset management management refers to the professional management of investments such as stocks and bonds, along with real estate. Typically, asset management is only practiced by the very wealthy, as the services of a professional firm can demand considerable sums of money, and successful asset management usually requires a large and diverse portfolio. Numerous professional firms and investment banks offer asset management services, which are often handled by a team of financial professionals for the best results. The firms handling the largest accounts are based in the United States, although several venerable European firms also work with high volume accounts. Typically, the investor meets with an asset management team before surrendering control of the assets to discuss goals and investment styles. In general, the team works with the investor to set realistic goals to grow the investor's wealth and measure the performance of the team. The investor also usually expresses directions as to what type of investment style he would prefer the team to engage in. For example, single young investors sometimes choose less conservative investment schemes than older individuals or couples. Meetings with the asset management team are held on a regular basis so that the investor can be apprised of progress and kept up to date. 5
CHAPTER 2 Time value of money The idea that money available today is worth more than the same amount of money in the future, Time value of money is the concept of measuring the value of money over time. Why do we care, because value of money changes with time and it s crucial to analysis of a real estate investment to be able to measure and solve for those changes. Everyone knows that money deposited in a savings account will earn interest. Because of this, the sooner it starts earning interest, the better. For example, assuming a 5% interest rate, a $100 investment today will be worth $105 in one year ($100 multiplied by 1.05). Conversely, $100 received one year from now is worth only $95.24 today ($100 divided by 1.05), assuming a 5% interest rate. There are two components Present value Present value defines what a dollar is worth today. The current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations PV = FV/ (1+i) ⁿ Annuity An annuity is a cash flow, either income or outgoings, involving the same sum in each period. An annuity is the payment or receipt of equal cash flows per period for a specified amount of time. For example, when a company set aside a fixed sum each year to meet a future obligation, it is using annuity. The time period between two successive payments is called payment period or rent period. 6
A = P [ (1+i)ⁿ - 1 / (1+i) ] A = Annual or future value which is the sum of the compound amounts of all payments P = Amount of each instalment i = Interest rate per period n = Number of periods Present value of ordinary annuity The present value of an ordinary annuity is the sum of the present value of a series of equal periodic payments. An annuity where the first payment is delayed beyond one year, the annuity is called a deferred annuity. PVA = R [ 1 (1+i)ⁿ / i ] Present value of perpetuity A perpetuity is a financial instrument that promises to pay an equal cash flow per period forever, that is, an infinite series of payments and principal amount never be repaid. The present value of perpetuity is calculated with the following formula: Present value of annuity due The Present Value of an Annuity Due is identical to an ordinary annuity except that each payment occurs at the beginning of a period rather than at the end. Since each payment occurs one period earlier, we can calculate the present value of an ordinary annuity and then multiply the result by (1 + i). PVAD = R [ 1 (1+ i)ⁿ /I ] ( 1 + i) Future value The future value of a sum of money invested at interest rate i for one year is given by: FV = PV ( 1 + i ) where FV = future value PV = present value i = annual interest rate 7
If the resulting principal and interest are re-invested a second year at the same interest rate, the future value is given by: FV = PV ( 1 + i ) ( 1 + i ) In general, the future value of a sum of money invested for n years with the interest credited and re-invested at the end of each year is: FV = PV ( 1 + i )ⁿ Future value of ordinary annuity The future value of an annuity is simply the sum of the future value of each payment. The equation for the future value of an annuity due is the sum of the geometric sequence: FV = R [ (1+ i)ⁿ - 1 / i] Future value of annuity due FV = R [ (1+ i)ⁿ - 1 / i] (1 + i) Valuation of long term security We are concern with the valuation of firm long term securities bonds, preferred stock, and common stock This value is the present value of the cash flow stream provided to the investor, discounted at a required rate of return appropriate for the risk involved There are different types of securities 1- Bond valuation A bond is a long-term debt instrument issued by a corporation or government. A bond is a security that pays a stated amount of interest to the investor, period after period, until it is finally retired by the issuing company Terms of bond Face value The maturity value (MV) [or face value] of a bond is the stated value. In the case of a U.S. bond, the face value is usually $1,000. Coupon rate The bond s coupon rate is the stated rate of interest; the annual interest payment divided by the bond s face value. Discount rate 8
The discount rate (capitalization rate) is dependent on the risk of the bond and is composed of the risk-free rate plus a premium for risk Types of bond Perpetual bond A perpetual bond is a bond that never matures. It has an infinite life. These are indeed rare but they help to illustrate the valuation technique in its simplest form Present value of bond would simply be equal to the capitalized value of an infinite stream of interest payment V = I I + +... + (1 + k d ) 1 (1 + k d ) 2 (1 + k d ) I = t=1 (1 + k d ) t or I (PVIFA kd, ) V = I / k d [Reduced Form] Example Bond P has a $1,000 face value and provides an 8% annual coupon. The appropriate discount rate is 10%. What is the value of the perpetual bond? I = $1,000 ( 8%) = $80. kd = 10%. V = I / kd [Reduced Form] = $80 / 10% = $800. Non zero coupon paying bond A non-zero coupon-paying bond is a coupon paying bond with a finite life. If the bond has a finite maturity then we must not only consider the interst stream but also the terminal or maturity value ( face value ) in the valuing bond the valuation equation for a such a bond that pays interest at the end of each years 9
V = I I I + MV + +... + (1 + k d ) 1 (1 + k d ) 2 (1 + k d ) n n I MV = + (1 + k t=1 d ) t (1 + k d ) n V = I (PVIFA kd, n ) + MV (PVIF kd, n ) Bond C has a $1,000 face value and provides an 8% annual coupon for 30 years. The appropriate discount rate is 10%. What is the value of the coupon bond? V = $80 (PVIFA10%, 30) + $1,000 (PVIF10%, 30) = $80 (9.427) + $1,000 (.057) [Table IV] [Table II] = $754.16 + $57.00 = $811.16. Zero coupon bond A zero coupon bond is a bond that pays no interest but sells at a deep discount from its face value; it provides compensation to investors in the form of price appreciation V = MV (1 + k d ) n = MV (PVIF kd, n ) Bond Z has a $1,000 face value and a 30 year life. The appropriate discount rate is 10%. What is the value of the zero-coupon bond? V = $1,000 (PVIF10%, 30) = $1,000 (.057) = $57.00 2 -Preferred stock valuation Preferred Stock is a type of stock that promises a (usually) fixed dividend, but at the discretion of the board of directors. Preferred Stock has preference over common stock in the payment of dividends and claims on assets. The payment of preferred stock is similar to an annuity, so the valuation model of a preferred stock is V = Dp / Kp Example Stock PS has an 8%, $100 par value issue outstanding. The appropriate discount rate is 10%. What is the value of the preferred stock? Dp = $100 ( 8% ) = $8.00. Kp = 10%. 10
V = Dp / kp = $8.00 / 10% = $80 3 -Common stock valuation Common stock is the security that represent the ultimate ownership (and risk) position in a corporation The difficult issues of valuation: uncertainty and payment of stock dividend, different risk levels, etc. Unlike bond and preferred stock cash flow which are contractually stated much more uncertainty surrounds the future stream of return connected with common stock Are the dividend foundation The value of a share of common stock can be viewed as the discounted value of all expected cash dividends provided by issuing firm until the end of time Case 1: hold the stock for a long time V D1 D2 ( 1 r ) 2... (1 r) Dt is a cash dividend Ke is the investor required return D n (1 r) n n t 1 D t t (1 r) V Case 2: hold the stock for a short time (e.g., 2 years) Note: D1, D2 Dn and P2 are all estimates D D P 1 2 2 ( 1 r ) 2 (1 r) (1 r ) 2 P2 expected sale price Chapter 3 Concept in valuation Dividend discounting models A procedure for valuing the price of a stock by using predicted dividends and discounting them back to present value. The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued. In other words, it is used to evaluate stocks based on the net present value of the future dividends. 11
There are 3 models used in the dividend discount model: zero-growth model zero growth which assumes that all dividends paid by a stock remain the same; Since the zero-growth model assumes that the dividend always stays the same, the stock price would be equal to the annual dividends divided by the required rate of return. Stock s Intrinsic Value = Annual Dividends / Required Rate of Return This is basically the same formula used to calculate the value of a perpetuity, which is a bond that never matures, and can be used to price preferred stock, which pays a dividend that is a specified percentage of its par value. A stock based on the zero-growth model can still change in price if the capitalization rate changes, as it will if perceived risk changes, for instance. Example Intrinsic Value of Preferred Stock If a preferred share of stock pays dividends of $1.80 per year, and the required rate of return for the stock is 8%, then what is its intrinsic value? Intrinsic Value of Preferred Stock = $1.80/0.08 = $22.50. the constant-growth model, (gordon growth model ) constant growth model which assumes that dividends grow by a specific percent annually; The constant-growth DDM (Gordon Growth model, because it was popularized by Myron J. Gordon) assumes that dividends grow by a specific percentage each year, and is usually denoted as g, and the capitalization rate is denoted by k. Constant-Growth Rate DDM Formula Intrinsic Value = D1 k g D1 = Next Year s Dividend 12
k = Capitalization Rate g = Dividend Growth Rate The constant-growth model is often used to value stocks of mature companies that have increased the dividend steadily over the years. Although the annual increase is not always the same, the constant-growth model can be used to approximate an intrinsic value of the stock using the average of the dividend growth and projecting that average to future dividend increases. Example Calculating Next Year s Stock Price Using the Constant-Growth DDM If a stock pays a $4 dividend this year, and the dividend has been growing 6% annually, then what will be the price of the stock next year, assuming a required rate of return of 12%? Next Year s Stock Price = $4 x 1.06 / (12% - 6%) = 4.24 / 0.06 = $70.67 This Year s Stock Price = $4 / 0.06 = 66.67 Growth Rate of Stock Price = $70.67 / $66.67 = 1.06 = Dividend Growth Rate Note that if both the capitalization rate and dividend growth rate remains the same every year, then the denominator doesn t change, so the stock s intrinsic value will increase annually by the percentage of the dividend increase. In other words, both the stock price and the dividend amount will increase by the constant-growth factor, g. variable-growth model, (multi stage growth model ) variable growth model which typically divides growth into 3 phases: a fast initial phase, then a slower transition phase that ultimately ends with a lower rate that is sustainable over a long period. Variable-growth rate models (multi-stage growth models) can take many forms, even assuming the growth rate is different for every year. However, the most common form is one that assumes 3 different rates of growth: an initial high rate of growth, a transition to slower growth, and lastly, a sustainable, steady rate of growth. Basically, the constant-growth rate model is extended, with each phase of growth calculated using the constant-growth method, but using 3 different growth rates of the 3 13
phrases. The present values of each stage are added together to derive the intrinsic value of the stock. Sometimes, even the capitalization rate, or the required rate of return, may be varied if changes in the rate are projected. Measuring risk Variation in return is called risk. uncertainty in return is called risk Chance that actual return on investment will be different from the expected return. This includes the possibility of losing some or all of the original investment. Risk is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment. Many companies now allocate large amounts of money and time in developing risk management strategies to help manage risks associated with their business and investment dealings. A key component of the risk management process is risk assessment, which involves the determination of the risks surrounding a business or investment. Expected risk return trade off The principle that potential return rises with an increase in risk. Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if it is subject to the possibility of being lost Risk free rate of return The theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. Variation in return is called risk. uncertainty in return is called risk Chance that actual return on investment will be different from the expected return. This includes the possibility of losing some or all of the original investment. Risk is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment. Many companies now allocate large amounts of money and time in developing risk management strategies to help manage risks associated with their business and investment dealings. A key component of the risk management process is risk assessment, which involves the determination of the risks surrounding a business or investment. Market risk Change in price of security is called market risk Political risk Risk face due to political instability in country Financial risk The risk face by the business due to more debts used in the business 14
International risk and currency risk The risk face due to exchange the rates of the currency is called currency risk and exchange rate risk Individual security analysis Return = E(R) = R P E(R) = expected return R= expected return on different time period P= probability Risk = S.D= [R-E(R)]² p Portfolio risk Risk reflects the chance that the actual return on an investment may be very different than the expected return. One way to measure risk is to calculate the variance and standard deviation of the distribution of returns. If the answer of correlation of the portfolio is positive it means that the security in that portfolio are depend on each other and this portfolio is a very risky. Portfolio if the answer of correlation is negative it mean that the securities in that not depend on each other and this portfolio is a less risky portfolio Portfolio Variance and Standard Deviation The variance/standard deviation of a portfolio reflects not only the variance/standard deviation of the stocks that make up the portfolio but also how the returns on the stocks which comprise the portfolio vary together. Two measures of how the returns on a pair of stocks vary together are the covariance and the correlation coefficient. The Covariance between the returns on two stocks can be calculated using the following equation: where s12 = the covariance between the returns on stocks 1 and 2, N = the number of states, pi = the probability of state i, R1i = the return on stock 1 in state i, E[R1] = the expected return on stock 1, R2i = the return on stock 2 in state i, and E[R2] = the expected return on stock 2. 15
The Correlation Coefficient between the returns on two stocks can be calculated using the following equation: where r12 = the correlation coefficient between the returns on stocks 1 and 2, s12 = the covariance between the returns on stocks 1 and 2, s1 = the standard deviation on stock 1, and s2 = the standard deviation on stock 2 Chapter 4 Market efficiency Market efficiency that prices on traded assets (e.g., stocks, bonds, or property) already reflect all available information, and instantly change to reflect new information. Stages of market efficiency There are three stages of market efficiency Weak form efficiency One of the most historical types of information used in assessing security values in market data, which refers to all past price information. If security price are determined in market that is weak form efficient, historical price and volume data should already be reflected in current price should be of no value in predicting future price changes.t Test of usefulness of price data are called weak form tests of EMH (efficient market hypotheses). If the weak form of EMH is true past price changes should be unrelated to future price change. Semi strong efficiency A more comprehensive level of market efficiency involves not only known and publicly available market data, but all publicly known and available data such as earning, dividend, and stock split announcements, new product developments, financing difficulties and accounting changes. A market that quickly incorporates all such information into prices is said to show semi strong efficiency Strong form of market efficiency 16
The most stringent form of market efficiency is strong form which asserts that stock prices fully reflect all information, public and non public. If market is strong form efficient no group of investors should be able to earn, over reasonable period of time. Abnormal rates of return by using publicly available information in a superior manner Efficient Market Hypothesis (EMH) Fama also created the Efficient Market Hypothesis (EMH) theory, which states that in any given time, the prices on the market already reflect all known information, and also change fast to reflect new information. Therefore, no one could outperform the market by using the same information that is already available to all investors, except through luck. Market risk and return Capital assets pricing model A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf). The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the 17
required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas). Security market line The relation between an asset s risk premium and its market beta is called the Security Market Line (SML). K = Rf + ( Km Rf ) β K security market line Rf = risk free rate Km = expected return on market portfolio The graph below depicts the SML. Note that the slope of the SML is equal to (E[Rm] - Rf) which is the market risk premium and that the SML intercepts the y-axis at the riskfree rate. 18
In capital market equilibrium, the required return on an asset must equal its expected return. Thus, the SML equation can also be used to determine an asset's required return given its Beta.sumption of capital assets pricing model The Beta (Bi) The beta for a stock is defined as follows: where sim = the Covariance between the returns on asset i and the market portfolio and s2m = the Variance of the market portfolio. Note that, by definition, the beta of the market portfolio equals 1 and the beta of the riskfree asset equals 0. An asset's systematic risk, therefore, depends upon its covariance with the market portfolio. The market portfolio is the most diversified portfolio possible as it consists of every asset in the economy held according to its market portfolio weight. Assumption of CAPM The CAPM is simple and elegant. Consider the many assumptions that underlie the model. Are they valid? Zero transaction costs. The CAPM assumes trading is costless so investments are priced to all fall on the capital market line. Zero taxes. The CAPM assumes investment trading is tax-free and returns are unaffected by taxes. Yet we know this to be false: (1) many investment transactions are subject to capital gains taxes, thus adding transaction costs; (2) taxes reduce expected returns for many investors, thus affecting their pricing of investments; (3) different returns (dividends versus capital gains, taxable versus tax-deferred) are taxed differently, thus inducing investors to choose portfolios with tax-favored assets; (4) different investors (individuals 19
versus pension plans) are taxed differently, thus leading to different pricing of the same assets. Homogeneous investor expectations. The CAPM assumes invests have the same beliefs about expected returns and risks of available investments. But we know that there is massive trading of stocks and bonds by investors with different expectations. Available risk-free assets. The CAPM assumes the existence of zero-risk securities, of various maturities and sufficient quantities to allow for portfolio risk adjustments. But we know even Treasury bills have various risks: reinvestment risk -- investors may have investment horizons beyond the T-bill maturity date; inflation risk -- fixed returns may be devalued by future inflation; currency risk -- the purchasing power of fixed returns may diminish compared to that of other currencies. (Even if investors could sell assets short -- by selling an asset she does not own, and buying it back later, thus profiting from price declines -- this method of reducing portfolio risk has costs and assumes unlimited short-selling ability.) Borrowing at risk-free rates. The CAPM assumes investors can borrow money at risk-free rates to increase the proportion of risky assets in their portfolio. We know this is not true for smaller, noninstitutional investors. In fact, we would predict that the capital market line should become kinked downward for riskier portfolios (ß > 1) to reflect the higher cost of riskfree borrowing compared to risk-free lending. Beta as full measure of risk. The CAPM assumes that risk is measured by the volatility (standard deviation) of an asset's systematic risk, relative to the volatility (standard deviation) of the market as a whole. But we know that investors face other risks: inflation risk -- returns may be devalued by future inflation; and liquidity risk -- investors in need of funds or wishing to change their portfolio's risk profile may be unable to readily sell at current market prices. Moreover, standard deviation does not measures risk when returns are not evenly distributed around the mean (non-bell curve). This uneven distribution describes our stock markets where winning companies, like Dell and Walmart, have positive returns (35,000% over ten years) that greatly exceed losing companies' negative returns (which are capped at a 100% loss). 20
Chapter 5 Investment in assets and required return Administrative framework There are following steps involve in administrative framework 1- Generation of investment proposal 2- Estimation of cash flow for the proposals 3- Evaluation of cash flow 4- Selection of project based on acceptance criterion 5- Continual revaluation of investment project after their acceptance Method of evaluation ( also called capital budgeting technique ) 1- payback period 2- internal rate of return 3- net present value 4- profitability index 21
chapter 6 Difference between NPV and IRR NPV IRR 22
NPV is a mathematical tool which uses the discounting process, NPV is calculated in terms of currency NPV Method is preferred over other methods since it calculates additional wealth NPV is used to evaluate the project. The internal rate of return method is also known as the yield method. The IRR IRR of a project/investment is defined as the rate of discount at which the present value of cash inflows and present value of cash outflows are equal IRR is expressed in terms of the percentage return a firm expects the capital project to return; IRR method does not preferred over other methods since it can not calculate additional wealth. The IRR Method cannot be used to evaluate projects Formula of NPV is Formula of IRR ICO = CF1 / (1+IRR) 1 + CF2 / (1+IRR)2 +--------+CFn /(1+IRR)n NPV care about the reinvestment o the inflow from the project The IRR does not care about the reinvestment of the inflows from the project. Capital budgeting Definitions " Capital: Fixed assets used in production " Budget: Plan of in- and outflows during some period 23
" Capital Budget: A list of planned investment (i.e., expenditures on fixed assets) outlays for different projects. " Capital Budgeting: Process of selecting viable investment projects. " Technique of capital budgeting Pay back period: In this technique, we try to figure out how long it would take to recover the invested capital through positive cash flows of the business. Reverting back to the cafe example, an initial investment of Rs. 200,000 is required to start the business; Rs 10,000 per month are expected to be earned for the first year, and Rs 20,000 would be earned every month in the second year. Now according to the aforementioned assumptions, in the first year, you earn Rs.10, 000 per month, which make Rs. 120,000 for the year (twelve months). Since you had invested Rs. 200,000 initially of which Rs. 120,000 have been recovered in the first year, you are still Rs.80, 000 short of recovering your initial investment. In the second year, you would be earning Rs. 20,000 per month, so the remaining Rs. 80,000 can be recovered in the next four months. We can say that the initial invested capital can be recovered in 16 months, or the payback period for this investment is 16 months. The shorter the payback period of a project, the more an investor would be willing to invest his money in the project. While the payback period is a simple and straightforward method for analyzing a capital budgeting proposal, it has certain limitations. First and the foremost problem is that it does not take into account the concept of time value of money. The cash flows are considered regardless of the time in which they are occurring. You must have noticed that we have not used any interest rate while making calculation. Advantages Of Payback Period It is easy to understand and apply. The concept of recovery is familiar to every decision-maker. Business enterprises facing uncertainty - both of product and technology - will benefit by the use of payback period method since the stress in this technique is on early recovery of investment. So enterprises facing technological obsolescence and product obsolescence - as in electronics/computer industry - prefer payback period method. Liquidity requirement requires earlier cash flows. Hence, enterprises having high liquidity requirement prefer this tool since it involves minimal waiting time for recovery of cash outflows as the emphasis is on early recumbent of investment. Disadvantages Of Payback Period The time value of money is ignored. For example, in the case of project A Rs.500 received at the end of 2nd and 3rd years are given same weight age. Broadly a rupee received in the first year and during any other year within the payback period is given same weight. But it is common knowledge that a rupee received today has higher value than a rupee to be received in future. But this drawback can be set right by using the discounted payback period method. The discounted payback period method looks at recovery of initial investment after considering the time value of inflows. 24
Management Science-II Prof Another important drawback of the payback period method is that it ignores the cash inflows received beyond the payback period. In its emphasis on early recovery, it often rejects projects offering higher total cash inflow. Return on Investments: The concept of return on investment loosely defined, as there are a number of ratios that can be used to analyze return on investment. However, in capital budgeting it implies the annual average cash flow a business is making as a percentage of investment. In other words, it is an average percentage of investment recovered in cash every year. The formula for return on investment is as follows: ROI= ( CF/n)/ IO Return on Investment is also very easy to calculate, but like payback period, it does not take into account the time value of money concept. A high ROI ratio is considered better and 90% is a very good rate of return but before deciding whether or not this project should be taken up, Accounting Rate Of Return Advantages It Is Easy To Calculate. The Percentage Return Is More Familiar To The Executives. Accounting Rate Of Return Disadvantages The definition of cash inflows is erroneous; it takes into account profit after tax only. It, therefore, fails to present the true return. Definition of investment is ambiguous and fluctuating. The decision could be biased towards a specific project, could use average investment to double the rate of return and thereby multiply the chances of its acceptances. Net Present Value (NPV): NPV is a mathematical tool which uses the discounting process, something that we have found missing in the aforementioned capital budgeting techniques. The formula for calculating NPV is as follows: NPV = Where,CF1=cash flows occurring in different time periods ICO= Initial cash outflow i=discount /interest rate n=year in which the cash flow takes place Initial cash outflow, being an outflow, is always expressed as a negative figure. 25
NPV is considered one of the most popular capital budgeting criteria. The disadvantage with the NPV is that it is difficult to calculate since these calculations are based on too many estimates. In order to calculate the NPV we need to forecast the future cash flows and sales; the discount factor is also an estimate. If the NPV of a project is more than zero, it should be accepted. If two or more projects under contemplation, then the one with the higher NPV, should be accepted. When a company invests in projects with positive NPV, they raise the shareholders wealth or company s value. This would also increase the market value added and the economic value added for the firm. Probability Index: It is quite similar to the NPV in terms of concept and calculation. Profitability index may be defined as the ratio of the present value of future cash flows to the initial investment. The profitability index can be calculated using the following formula. PI = CF1/ (1+ K) 1 + CF2 /(1+ K) 2 +-----------+ CFn1+ K) n / ICO NPV method, would also be acceptable on the profitability index criteria. So for as accept reject decision are concerned all the three discounted cash flow (DCF) methods lead to same decision. But in case of ranking mutually exclusive project some time there will be conflict decision between NPV and IRR. In such situations a choice has to be made between these methods. Since PI is a relative ranking method, this fits most suitably for valuating mutually exclusive projects Therefore, the project is acceptable. Notice that we have taken into consideration the annualized return. The same can be calculated using the monthly returns with a slight adjustment in the formula as we have studied in the previous lectures. If there were two or more projects that need ranking, the one with the highest profitability index would be acceptable. Let us now talk about the fifth and the final capital budgeting criteria of our course, known as Internal Internal Rate of Return (IRR): The internal rate of return method is also known as the yield method. The IRR IRR of a project/investment is defined as the rate of discount at which the present value of cash inflows and present value of cash outflows are equal. IRR can be restated as the rate of discount, at which the present value of cash flow (inflows and outflows) associated with a project equal zero. let at be the cash flows (inflow or outflow) in period t then IRR of the project is found out by solving for the value of 'r' in the following equation: Where t = 0,1,2...... n years ICO = CF1 / (1+IRR) 1 + CF2 / (1+IRR)2 +--------+CFn /(1+IRR)n The capital budgeting process 26
There re following step involve in capital budgeting process Strategic planning A strategic plan is the grand design of the firm and clearly identifies the business the firm is in and where it intends to position itself in the future. Strategic planning translates the firm s corporate goal into specific policies and directions, sets priorities, specifies the structural, strategic and tactical areas of business development, and guides the planning process in the pursuit of solid objectives. A firm s vision and mission is encapsulated in its strategic planning framework. There are feedback loops at different stages, and the feedback to strategic planning at the project evaluation and decision stages This feedback may suggest changes to the future direction of the firm Identification of investment opportunities The identification of investment opportunities and generation of investment project proposals is an important step in the capital budgeting process. Project proposals cannot be generated in isolation. They have to fit in with a firm s corporate goals, its vision, mission and long-term strategic plan. Of course, if an excellent investment opportunity presents itself the corporate vision and strategy may be changed to accommodate it. Thus, there is a two-way traffic between strategic planning and investment opportunities. These investments normally represent the strategic plan of the business firm and, in turn, these investments can set new directions for the firm s strategic plan. Some firms have research and development (R&D) divisions constantly searching for and researching into new products, services and processes and identifying attractive investment opportunities. Sometimes, excellent investment suggestions come through informal processes such as employee chats in a staff room or corridor. Preliminary screening of projects Generally, in any organization, there will be many potential investment proposals generated. Obviously, they cannot all go through the rigorous project analysis process. Therefore, the identified investment opportunities have to be subjected to a preliminary screening process by management to isolate the marginal and unsound proposals, because it is not worth spending resources to thoroughly evaluate such proposals. The preliminary screening may involve some preliminary quantitative analysis and judgments based on intuitive feelings and experience. Financial appraisal of projects This stage is also called quantitative analysis, economic and financial appraisal, project evaluation, or simply project analysis. This project analysis may predict the expected future cash flows of the project, analyze the risk associated with those cash flows, develop alternative cash flow forecasts, examine the sensitivity of the results to possible changes in the predicted cash flows, subject the cash flows to simulation and prepare alternative estimates of the project s net present value. Thus, the project analysis can involve the application of forecasting techniques, project evaluation techniques, risk analysis and mathematical programming techniques such as linear programming. While the basic concepts, principles and techniques of project evaluation are the same for different projects, Financial appraisal will provide the 27
estimated addition to the firm s value in terms of the projects net present values. If the projects identified within the current strategic framework of the firm repeatedly produce negative NPVs in the analysis stage, these results send a message to the management to review its strategic plan. Qualitative factors in project evaluation When a project passes through the quantitative analysis test, it has to be further evaluated taking into consideration qualitative factors. Qualitative factors are those which will have an impact on the project, but which are virtually impossible to evaluate accurately in monetary terms. They are factors such as: _ the societal impact of an increase or decrease in employee numbers _ the environmental impact of the project _ possible positive or negative governmental political attitudes towards the project _ the strategic consequences of consumption of scarce raw materials _ positive or negative relationships with labor unions about the project _ possible legal difficulties with respect to the use of patents, copyrights and trade or brand names _ impact on the firm s image if the project is socially questionable. The accept/reject decision NPV results from the quantitative analysis combined with qualitative factors form the basis of the decision support information. The analyst relays this information to management with appropriate recommendations. Management considers this information and other relevant prior knowledge using their routine information sources, experience, expertise, gut feeling and, of course, judgment to make a major decision to accept or reject the proposed investment project. Project implementation and monitoring Once investment projects have passed through the decision stage they then must be implemented by management. During this implementation phase various divisions of the firm are likely to be involved. An integral part of project implementation is the constant monitoring of project progress with a view to identifying potential bottlenecks thus allowing early intervention. Deviations from the estimated cash flows need to be monitored on a regular basis with a view to taking corrective actions when needed. Post-implementation audit Post-implementation audit does not relate to the current decision support process of the project; it deals with a post-mortem of the performance of already implemented projects. An evaluation of the performance of past decisions, however, can contribute greatly to the improvement of current investment decision-making by analyzing the past rights and wrongs.the post-implementation audit can provide useful feedback to project appraisal or strategy formulation. Inflation The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. As inflation rises, every dollar will buy a 28
smaller percentage of a good. For example, if the inflation rate is 2%, then a $1 pack of gum will cost $1.02 in a year. Measuring inflation is a difficult problem for government statisticians In North America, there are two main price indexes that measure inflation: Consumer Price Index (CPI) - A measure of price changes in consumer goods and services such as gasoline, food, clothing and automobiles. The CPI measures price change from the perspective of the purchaser. U.S. CPI data can be found at the Bureau of Labor Statistics. Producer Price Indexes (PPI) - A family of indexes that measure the average change over time in selling prices by domestic producers of goods and services. PPIs measure price change from the perspective of the seller. U.S. PPI data can be found at the Bureau of Labor Statistics. CAUSES OF INFLATION Inflation is caused when the aggregate demand exceeds the aggregate supply of goods and services. We analyze the factors which lead to increase in demand and the shortage of supply. Factors Affecting Demand Both Keynesians and monetarists believe that inflation is caused by increase in the aggregate demand. They point towards the following factors which raise it. 1. Increase in Money Supply. Inflation is caused by an increase in the supply of money which leads to increase in aggregate demand. The higher the growth rate of the nominal money supply, the higher is the rate of inflation. Modern quantity theorists do not believe that. true inflation starts after the full employment level. This view is realistic because all advanced countries are faced with high levels of unemployment and high rates of inflation. 2. Increase in Disposable Income. When the disposable income of the people increases, it raises their demand for goods and services. Disposable income may increase with the rise in national income or reduction in taxes or reduction in the saving of the people. 3. Increase in Public Expenditure. Government activities have been expanding much with the result that government expenditure has also been increasing at a phenomenal rate, thereby raising aggregate demand for goods and services. Governments of both developed and developing countries are providing more facilities under public utilities and social services, and also nationalizing industries and starting public enterprises with the result that they help in increasing aggregate demand. 29
4. Increase in Consumer Spending. The demand for goods and services increases when consumer expenditure increases. Consumers may spend more due to conspicuous consumption or demonstration effect. They may also spend more when they are given credit facilities to buy goods on hire-purchase and installment basis. 5. Cheap Monetary Policy. Cheap monetary policy or the policy of credit expansion also leads to increase in the money supply which raises the demand for goods and services in the economy. When credit expands, it raises the money income of the borrowers which, in turn, raises aggregate demand relative to supply, thereby leading to inflation. This is also known as credit-induced inflation. 6. Deficit Financing. In order to meet its mounting expenses, the government resorts to deficit financing by borrowing from the public and even by printing more notes. This raises aggregate demand in relation to aggregate supply, thereby leading to inflationary rise in prices. This is also known as deficit-induced inflation. 7. Expansion of the Private Sector. The expansion of the private sector also tends to raise the aggregate demand. For huge investments increase employment arid income, thereby creating more demand far goods and services. But it takes time for the output to enter the market. 8. Black Money. The existence of black money in all countries due to corruption, tax evasion etc. increases the aggregate demand. People spend such unearned money extravagantly, thereby creating unnecessary demand for commodities. This tends to raise the price level further. 9. Repayment of Public Debt. Whenever the government repays its past internal debt to the public, it leads to increase in the money supply with the public. This tends to raise the aggregate demand for goods and services. 10. Increase in Exports. When the demand for domestically produced goods increases in foreign countries, this raises the earnings of industries producing export commodities. These, in turn, create more demand for goods and services within the economy. Factors Affecting Supply Factors Affecting Supply There are also certain factors which operate on the opposite side and tend to reduce the aggregate supply. Some of the factors are as follows: 30