Finanacial management and analysis department of economics (11-4-11)

FINANCIAL ANALYSIS Financial Analysis is the process of identifying the

financial strengths and weaknesses of the firm by properly establishing relationships between the items of the balance sheet and the profit and loss account.

Financial Analysis is about how to analyse the financial performance of a firm and how to manage corporate funds and liquidity.

Financial Analysis focuses on the financial decision-making and the role of financial manager as the efficient user of financial resources.

USERS OF FINANCIAL ANALYSISFinancial analysis can be undertaken by management

of the firm, or by parties outside the firm, viz, owners, creditors, investors and others. The nature of analysis will differ depending on the purpose of the analyst:

TRADE CREDITORS

SUPPLIERS OF LONG TERM-DEBT

INVESTORS

MANAGEMENT

ACCOUNTING

Accounting is concerned with the recording, classifying, summarising, analysis and interpretation of the business transaction.

According to the American Institute of Certified Public Accountants “Accounting is a art of recording, classifying and summarising in a significant manner and in terms of money, transactions and events, which are in part atleast, of a financial character and interpreting the result thereof”.

CLASSIFICATION OF ACCOUNTING

FINANCIAL ACCOUNTING

COST ACCOUNTING

MANAGEMENT ACCOUNTING

OVERVIEW OF ACCOUNTING

FINANCIAL ACCOUNTING

MANAGEMENT ACCOUNTING

PROFIT & LOSS

ACCOUNT

BALANCE SHEET

CASH FLOW

STATEMENT

COST ACCOUNTIN

G

DECISION MAKING

COSTING & PLANNING AND CONTROL

BUDGETING & STANDARD COSTING

SHORT TERM

LONG TERM

SOME CONCEPTS

TRANSACTION: Any event that affects the financial position of an organisation and requires recording.

CORPORATION: A business organised as a separate legal entity and owned by its stockholders.

ASSETS: Economic resources that are expected to benefit future activities.

LIABILITIES: The entity’s economic obligations to non-owners.

CONTD….

EQUITIES: The claim against, or interest in, an organisation assets.

OWNER’S EQUITY: The excess of assets over the liabilities.

STOCK HOLDER’S EQUITY: The owner’s equity of a corporation.

PAID-IN-CAPITAL: The ownership claim arising from funds paid-in by the owners.

RETAINED INCOME (RETAINED EARNINGS): The ownership claims arising from the reinvestment of previous profits.

ACCOUNT PAYABLE: Amounts owed to vendors for purchase on open account.

ACCOUNT RECEIVABLE: Amounts due from customers for sale on open accounts.

AUDIT: An examination or in-depth inspection of financial statements and company's records that is made in accordance with GENERALLY ACCEPTED ACCOUNTING PRINCIPLES(GAAP).

CONTD…

REVENUE: Increase in ownership claims arising from the delivery of goods and services.

EXPENSES: Decrease in ownership claims arising from delivering goods or services or using up assets.

PROFITS (EARNINGS, INCOME): The excess of revenue over expenses.

CASH BASIS: A process of accounting where revenue and expenses recognition would occur when cash is received and disbursed.

UNEXPIRED COST: Any asset that ordinarily becomes an expenses in future periods, e.g. inventory and pre-paid rent.

UNEARNED REVENUE (DEFFERED REVENUE): Collections from customers received and recorded before they are earned.

DIVIDINDS: Distributions of assets to stockholders that reduce retained income.

FINANCIAL STATEMENTS

1. BALANCE SHEET: A snapshot of the financial status of an organisation at an instant of time. It records the assets, liabilities and capital of a business at a certain point in time. Assets less liabilities will equal capital. Capital is thus the owner’s interest in the business.

2. INCOME STATEMENT (PROFIT & LOSS ACCOUNT): A statement that summarizes a company’s revenues and expenses. It measures the performance of an organisation by matching its accomplishments and its efforts. Hence, a profit and loss account, as its simplest, records the income and expenses of a business over time.

3. CASH FLOW STATEMENT: A cash flow statement shows the cash inflows and outflows of the business.

SUMMARY BALANCE SHEET AT 31 MARCH 20XX

20X1 20X2 Rs. Rs.

FIXED ASSETSTANGIBLE & INTANGIBLE ASSETS 4243.4 4387.5Investments 55.0 61.2 4298.4 4448.7

Current assets Stocks 474.4 514.7Debtors 2555.2 2355.7Cash & Investments 687.5 485.5 3717.1 3355.9

Current liabilitiesCreditors: amounts falling due within one year 2162.8 2029.8

NET CURRENT ASSETS 1554.3 1326.1TOTAL ASSETS LESS CURRENT LIABILITIES 5852.7 5774.8Creditors: amount falling due after more than one year 804.3 772.6Provisions for liabilities and charges 126.6 105.0

NET ASSETS 4921.8 4897.2SHAREHOLDER’S FUNDS (all equity) 4905.3 4883.9Minority Interests/Profit (all equity) 16.5 13.3

TOTAL CAPITAL EMPLOYED 4921.8 4897.2

SUMMARY PROFIT & LOSS A/C FOR THE YEAR ENDED 31 MARCH 20XX

20X1 20X2 Rs. Rs.

Sales 8224 8243Add: Other income 34 104 8258 8347Less: Expenses 7712 7192Profit before Taxation 546 1155TAXATION (176) (339)

Profit after Taxation 370 816Other 2 -DIVIDENDS (413) (409)

RETAINED (LOSS)/PROFIT (41) 407Note: The profit and loss account has been simplified and reconstructed. The original

summary profit and loss account can be found different.

SUMMARY CASH FLOW INFORMATION FOR THE YEAR ENDED 31 MARCH 20XX

20X1 20X2 Rs. Rs.

OPERATING ACTIVITIESReceived from customers 7989.9 7884.1Payments to suppliers (5357.1) (5464.2)Payments to and on behalf of employees (1138.3) (1153.9)Other payments (803.8) (793.1)Exceptional operating cash flows (49.2) (0.6)

CASH INFLOW FROM OPERATING ACTIVITIES 641.5 472.3

Returns on investments and servicing of finance 15.2 29.0Taxation (145.7) (345.9)Capital expenditure and financial investments (167.0) (628.1)Acquisitions and others (21.1) 1.0Equity dividends paid (413.5) (412.6)

CASH OUTFLOW BEFORE FUNDING (90.6) (884.3)

FUNDS FLOW STATEMENT

The statement of changes in financial position, prepared to determine only the sources and uses of working capital between dates of two balance sheets, is known as the funds flow statement .

Funds flow statement is referred to as the statement of changes in financial positions. Thus, the statement is intended to summarize:

Changes in assets and liabilities resulting from financial and investment transactions during the period, as well as those changes which resulted due to change in owner’s equity; and

The way in which the firm used its financial resources during the period (for example to acquire fixed assets, to pay debts, to pay dividends to shareholders and so on).

BALANCE SHEET CHANGES SOURCES AND USES OF FUNDS

(Rs. ‘000) March 31, 20X1 March 31, 20X2 ChangeASSETSCash 54 135 (+) 81Debtors 6750 8235 (+) 1485Stock 10125 22680 (+) 12555Total Current Assets 16929 31050 (+)

14121Fixed assets 2970 6075 (+) 3105Other assets 945 1890 (+) 945

Total Assets 20844 39015 (+) 18171

LIABILITIES & CAPITALBank borrowings 3510 8664 (+) 5154Creditors 2835 6615 (+) 3780Provision for taxes 270 972 (+) 702Accrued expenses 810 2700 (+) 1890Total Current Liabilities 7425 18951 (+)

11526Long-term debt 1944 1404 (-) 540

Total Liabilities 9369 20355 (+)

10986Paid-up share capital 8370 8370 --------Reserves & surplus 3105 10290 (+) 7185

Total Funds 20844 39015 (+) 18171

(Rs. ‘000)

Amount %

SOURCES INCREASE IN CURRENT LIABILITIES: Bank borrowings 5154 27.5 Creditors 3780 20.2 provision for taxes 702 3.8 Accrued expenses 1890 10.1Total 11526

61.6

Increase in share holder’s equity:Reserves (retained income) 7185 38.4

TOTAL SOURCES 18711 100.0

USESINCREASE IN CURRENT ASSETS:Cash 81 0.4Debtors 1485 7.9Stock (inventory) 12555 67.1Total 14121

75.4

Increase in fixed assets 3105 16.6Increase in other assets 945 5.1Decrease in long-term debt 540 2.9

TOTAL USES 18711 100.0

WORKING CAPITAL

Working Capital is defined as the difference between current assets and current liabilities.

Working capital determines the liquidity position of the firm.As a historically analysis, the statement of changes in working capital reveals to

management the way in which working capital was obtained and used.

Sources of working capital (Funds)1) Funds from operations (adjusted net income).

2) Sale of non-current assets: i) sale of long-term investments (shares, bonds/debentures) ii) sale of tangible fixed assets like land, building, plants, or

equipments. iii) sale if intangible fixed assets like goodwill, patents, or copyrights.

3) Long term financing: i) long-term borrowings (institutional loans, debentures, bonds etc.). ii) issuance of equity and preference shares.

4) Short-term financing such as bank borrowings.

STATEMENT OF CHANGES IN WORKING CAPITAL FOR THE YEAR ENDED DECEMBER 31, 20X1

Sources and uses of working capital

SOURCES RS.Funds from operations 1,20,000Sale of machine 30,000Issuance of debentures 1,00,000Issuance of equity shares 1,00,000Funds Provided

3,50,000

USESPurchase of long-term Investments 80,000Payment of long-termLoans 90,000Payment of cash dividends 60,000Increase in working capital 1,20,000Funds Applied

3,50,000

Schedule of changes in working capital 31 Dec. 31 Dec. Increase

Decrease 20X1 20X2 Rs. Rs. Rs.

Rs.

Current AssetsCash 80,000 1,25,000 45,000 -----------Debtors 50,000 45,000 -------------

5,000Inventory 1,15,000 1,65,000 50,000

-----------TOTAL 2,45,000 3,35,000 95,000 5,000

Current LiabilitiesBills payable 20,000 8,000 12,000 ------------Creditors 45,000 47,000 ------------

2,000Other current Liabilities 25,000 5,000 20,000

------------TOTAL 90,000 60,000 32,000 2,000

Working Capital 1,55,000 2,75,000 1,27,000 7,000

Increase in workingcapital ------- -------- --------

1,20,000

TOTAL 1,27,000 1,27,000

USES OF FUNDS AND CASH FLOW ANALYSIS

1. LIQUIDITY: What is the position of the firm?

2. CHANGES IN FINANCIAL POSITION: What are the causes of changes in the firm’s working capital or cash position?

3. ACQUISITION OF FIXED ASSETS: What fixed assets are acquired by the firm?

4. DIVIDEND PAYMENT: Did the firm pay dividends to its shareholders or not? If not, was it due to shortage of funds?

5. INTERNAL FUNDS: How much of the firm’s working capital needs were met by the funds generated from current operations?

6. EXTERNAL FUNDS: Did the firm use external sources of finance to meet its needs of fund?

7. DEBT-EQUITY: If the external financing was used, what ratio of debt and equity was maintained?

8. SALES OF NON-CURRENT ASSETS: Did the firm sell any of its non-current assets? If so, what were the proceeds from such sales?

9. DEBT PAYMENT: Could the firm pay its long-term debt as per the schedules?

10. INVESTMENTS AND FINANCING: What were the significant investment and financing activities of the firm which did not involve working capital?

RATIO ANALYSIS

A Ratio is defined as “ the indicated relationship of two mathematical expressions” and as “the relationship between two or more things”.

“RATIO ANALYSIS IS A POWERFUL TOOL OF FINANCIAL ANALYSIS”

The relationship between two accounting figures, expressed mathematically, is known as a FINANCIAL RATIO (or simply as RATIO).

In financial analysis, a ratio is used as a benchmark for evaluating the financial position and performance of a firm, because the absolute accounting figures reported in the financial statements do not provide a meaningful understanding of the performance and financial position of a firm.

TYPES OF RATIOS

LIQUIDITY RATIOS: measure the firms ability to meet current obligations.

LEVERAGE RATIOS: show the proportions of debt and equity in financing the firm’s assets.

ACTIVITY RATIOS: reflect the firm’s efficiency in utilising its assets.

PROFITABILITY RATIOS: measure overall performance and effectiveness of the firm.

LIQUIDITY RATIOS

1.CURRENT RATIO : The current ratio is a measure of the firm’s short-term solvency. It indicates the availability of current assets in rupees for every one rupee of current liability.

CURRENT RATIO = CURRENT ASSETS CURRENT LIABILITIES2. QUICK RATIO: This ratio establishes a relationship between quick, or

liquid, assets and current liabilities. QUICK RATIO = CURRENT ASSETS – INVENTORIES CURRENT LIABILITIES 3. CASH RATIO: This ratio indicates the relationship between the

availability of cash including trade investment or marketable securities to the current liabilities.

CASH RATIO = CASH + MARKETABLE SECURITIES CURRENT LIABILITIES 4. NET WORKING CAPITAL RATIO: The difference between current assets

and current liabilities excluding short-term borrowings is called net working capital (NWC) or net current assets (NCA). It is used as a measure of firm’s liquidity.

NWC RATIO = NET WORKING CAPITAL NET ASSETS

LEVERAGE RATIOS

1. TOTAL DEBT RATIO: It compute debt ratio by dividing total debt (TD) by capital employed (CE) or total net assets (NA) to analyse the long term solvency of a firm.

DEBT RATIO = TOTAL DEBT = TOTAL DEBT

TOTAL DEBT + NET WORTH CAPITAL EMPLOYED

2. DEBT-EQUITY RATIO: Shows relationship describing the lender’s contribution for each rupee of the owner’s contribution and computed by dividing total debt by net worth.

DEBT-EQUITY RATIO = TOTAL DEBT NET WORTH

3. COVERAGE RATIO: The interest coverage ratio shows the number of times the interest charges are covered by funds that are ordinarily available for their payment. It is computed by dividing earnings before interest and taxes(EBIT) by interest charges.

INTEREST COVERAGE = E B I T INTEREST

ACTIVITY RATIO1. INVENTORY TURNOVER: This ratio indicates the efficiency of the

firm in selling its products. It is calculated by dividing the cost of goods sold by the average inventory.

INVENTORY TURNOVER = COST OF GOODS SOLD AVERAGE INVENTORY DAYS OF INVENTORY HOLDINGS = AVERAGE INVENTORY X

360 COST OF GOODS SOLD 2. DEBTOR RATIO: Debtor turnover indicates the number of times

debtor turnover each year. Debtor turnover = SALES DEBTORS3. ASSETS TURNOVER: The relationship between sales and assets is

called assets turnover. ASSETS TURNOVER = SALES ASSETS

PROFITABILITY RATIOSGROSS PROFIT MARGIN = SALES – COST OF GOODS SOLD SALES

NET PROFIT MARGIN = PROFIT AFTER TAX SALES

OPERATING EXPENSES RATIO = OPERATING EXPENSES SALES

RETURN ON INVESTMENT(ROI): (I) ROI = ROTA = EBIT (1-T) = EBIT (1-T) (Return on total assets) TOTAL ASSETS TA (II) ROI = RONA = EBIT (1-T) = EBIT (1-T) ( Return on net assets) NET ASSETS NA

DIVIDEND PER SHARE = EARNINGS PAID TO SHARE HOLDERS NUMBER OF ORDINARY SHARES OUTSTANDINGS

DIVIDEND PAYOUT RATIO = DIVIDENDS PER SHARE EARNINGS PER SHARE

COMPOUNDING

The interest that is paid on the principal as well as on any interest earned but not withdrawn during earlier periods is called “compound interest”.

The process of finding the future value of payment (or receipt) or series of payments (or receipts) when applying the concept of compound interest is known as “compounding”.

Time Preference for MoneyAn individual’s preference for possession of a given amount of cash

now, rather than the same amount at some future time is called “time preference for money”.

Three reasons may be advanced to account for the individual's time preference for money:

1) Uncertainty2) Preference for consumption3) Investment opportunities.

HOW IS COMPOUND VALUE OF A LUMP SUM CALCULATED?

1) Suppose Rs.100 deposited in a bank at 10% rate of interest for 1 year. How much future sum would you receive after one year?

you would receive: FUTURE SUM = 100 + .10 X 100 = 100 (1.10) = 110.Therefore, F1 = P (1 + i )

2) AFTER 2 YEARS: FUTURE SUM = (100 + .10 x 100) + .10(100 + .10

x 100) = 100 (1.10) (1.10) = 121.Therefore, F2 = P (1 + i )2

3) AFTER n YEARS: Fn = P (1 + i ) n

HOW IS COMPOUND VALUE OF AN ANNUITY CALCULATED?

An annuity is a fixed payment (or receipt) each year for a specified number of years. For example, the equal installment loans from the housing finance companies or employers, etc.

Thus, the compound value of an annuity of Re 1 for 4 years at 6% rate of interest computed and expressed as follows:

F4 = A (1+i)3 + A(1+i)2 + A(1+i) + A = A [ (1+i)3 + (1+i)2 + (1+i) + 1 ]Where A is the annuity, we can extend the equation for n periods

and rewrite it as follows: Fn = A (1 + i)n – 1

i SINKING FUND: The fund which is created out of fixed payments

each year to accumulate to a future sum after a specified period is called sinking fund. The factor used to calculate the annuity for a given future sum is called the sinking fund factor. i.e.

A = F i (1+i)n - 1

PRESENT VALUEThe present value of a future cash inflow and outflow is the

amount of current cash that is of equivalent desirability, to the decision maker, to a specified amount of cash to be received or paid at a future date.

The process of determining present value of a future payment (or receipts) or a series of future payments (or receipts) is called discounting.

The compound interest rate used for discounting cash flows is called the discount rate.

F1 = P (1 + i )where, F1= Future value, P= Present value, i= Rate of interest. therefore, P = F1 (1 + i )

PRESENT VALUE: HOW MUCH WOULD THE INVESTOR GIVE UP NOW TO GET AN AMOUNT OF RUPEE 1 AT THE END OF ONE, TWO,

OR THREE YEARS ?

If the amount grows to F1 = Re 1 after a year at 10%, the amount to be deposited or sacrificed in the beginning:

F1 = P( 1 + i ) therefore, P = F1 (1 + i ) The present value of Re.1 inflow at the end of two years: F2 = P (1 + i )2 therefore, P = F2 (1 + i)2 The present value of Re.1 to be received after three years: F3 = P(1 + i)3 therefore, P = F3 (1 + i)3 The present value can be worked out for any number of years and for any

interest rate: P = Fn (1 + i)n or P = Fn [ (1+i) –n ]The term in brackets is the present value factor (PVF), and it is always less than

1.0 for positive i, indicating that a future amount has a smaller present value.

WHAT IS PRESENT VALUE OF AN ANNUITY?

The computation of the present value of an annuity can be written in the following general form:

P = A + A + A + ……. + A (1+i) (1+i)2 (1+i)3 (1+i)n

= A 1 + 1 + 1 + …... + 1 (1+i) (1+i)2 (1+i)3

(1+i)nWhere, A is a constant payment (or receipt) each year. Therefore,

above equation can be solved and expressed as = A 1- 1 (1-i)n i = A (1+i)n -1 i (1+i)n

CAPITAL RECOVERY

The reciprocal of the present value annuity factor is called the capital recovery factor. It is useful in determining income to be earned to recover an investment at a given rate of interest.

For example: suppose that you plan to invest Rs. 10,000 today for a period of four years. If your interest rate is 10 percent, how much income per year should you receive to recover your investment?

A = P i (1+i)n (1+i)n - 1

WHAT IS AN ANNUITY DUE?

The concept of compound value and present value of an annuity are based on the assumption that series of payments are made at the end of the year.

In practice, payments could be made at the beginning of the year. When you buy a fridge on installment sale, the dealer requires you to make the first payment immediately (viz. in the beginning of the first period) and subsequent installments in the beginning of each period.

Therefore, A series of fixed payments starting at the beginning of

each period for a specified number of periods is called an annuity due.

Fn = A (1+i)n – 1 (1+i) i

MULTIPLE COMPOUNDINGMultiple compounding indicates that the cash flow can

occur more than once a year rather than once in a year. For example, banks may pay interest on saving accounting quarterly. On bonds or debentures and public deposit, companies may pay interest semi-annually.

The interest rate is usually specified on an annual basis in a loan agreement or security (such as bonds), and is known as the nominal interest rate. If the compounding is done more than once a year, the actual rate of interest paid (or received) is called the effective interest rate (EIR); effective interest rate would be higher than the nominal interest rate.

THE FORMULA FOR CALCULATING EIR IN THE FOLLOWING GENERAL FORM

EIR = 1 + i n x m - 1 m Where i = annual nominal rate if interest, n = number of years and

m = number of compounding per year.The effective rate of interest if the compounding is done:A. For the half-yearly compounding , EIR will be: EIR = 1 + i 2 - 1 2

B. For quarterly compounding, EIR will be: EIR = 1 + i 4 -1 4

C. For weekly compounding, EIR will be: EIR = 1 + i 52 -1 52

NET PRESENT VALUENet Present Value of a financial decision is the difference between the

present value of cash inflows and the present value of cash outflows.

The Net Present Value (NPV) Method is the classical economic model of evaluating the investment proposals. It is one of the discounted cash flow (DCF) techniques explicitly recognising the time value of money.

NPV = A1 + A2 + ….. + An - Co (1+i) (1+i)2 (1+i)n

nNPV = At - Co t=1 (1+k)tWhere At is cash inflow in period t, Co cash outflow, k opportunity cost of capital and t

the time period.

THE FOLLOWING STEPS ARE INVOLVED IN THE CALCULATION OF NPV:

Cash flows of the investment projected should be forecasted based on realistic assumptions.

Appropriate discount rate should be identified to discount the forecasted cash flow. The appropriate discount rate is the firm’s opportunity cost of capital which is equal to the required rate of return expected by investors on investments of equivalent risk.

Present value of cash flows should be calculated using opportunity cost of capital as the discount rate.

Net present value should be found out by subtracting present

value of cash out flows from present value of cash inflows. The project should be accepted if NPV is positive (i.e. NPV >0)

ACCEPTANCE RULE : NPV METHOD

It should be clear that the acceptance rule using the NPV method is to accept the investment project if its net present value is positive (NPV>0) and to reject it if the net present value is negative (NPV<0).

The market value of the firm’s share would increase if projects with positive net present values are accepted. This will be so because the positive net present value will result only if the project would generate cash inflows at a rate higher than the opportunity cost of capital.

A project may be accepted if NPV=0. A zero NPV implies that project generates cash flows at a rate just equal to the opportunity cost of capital.

Thus the NPV acceptance rules are: Accept NPV > 0 Reject NPV < 0 May accept NPV = 0

INTERNAL RATE OF RETURN (IRR) METHOD

The internal rate of return can be defined as that rate which equates the present value of cash inflows with the present value of cash out flows of an investment.

In other words, it is the rate at which the net present value of the investment is zero.

It is called internal rate because it depends solely on the outlay and proceeds associated with the investment and not on any rate determined outside the investment.

Hence, the internal rate of return (IRR) method is another discounted cash flow technique which takes account of the magnitude and timing of cash flows.

CONTD…..

The IRR can be determined by solving the following equation for r :

Co = C1 + C2 + C3 + ….. + Cn

(1+r) (1+r)2 (1+r)3 (1+r)n n

C0 = Ct

t=1 (1+r)t or, n Ct - C0 = 0 t=1 (1+r)t It can be noticed that the IRR equation is the same as the one used for the NPV method with the

difference that in the NPV method the required rate of return, k, is assumed to be known and the

net present value is found, while in the IRR method the value of r has to be determined at which

the net present value is zero.

ACCEPTANCE RULE : IRR METHOD

The accept-or-reject rule, using the IRR method, is to accept the project if its internal rate of return is higher than the opportunity cost of capital (r > k). Note that k is also known as the required rate of return, or the cutoff, or hurdle rate. The project shall be rejected if its internal rate of return is lower than the opportunity cost of capital (r < k). The decision maker may remain indifferent if the internal rate of return is equal to the opportunity coat of capital.

Thus the IRR acceptance rules are: Accept r > k Reject r < k May accept r = k

PAYBACK (PB) METHOD

The payback (PB) is one of the most popular and widely recognized traditional methods of evaluating investment proposals.

“It is defined as the number of years required to recover the original cash outlay invested in a project”.

If the project generates constant annual cash inflows, the payback period can be computed by dividing cash outlay by the annual cash inflow i.e.

PAYBACK = INITIAL INVESTMENT = C0

ANNUAL CASH INFLOW C

In case of unequal cash inflows, the payback period can be found out by adding up the cash inflows until the total is equal to the initial cash outlay.

ACCEPTANCE RULE: PAYBACK METHOD

Many firms use the payback period as an accept or reject criterion as well as a method of ranking projects. If the payback period calculated for a project is less than the maximum payback period set by management, it would be accepted; if not, it would be rejected.

As a ranking method, it gives highest ranking to the project which has shortest payback period and lowest ranking to the project with the highest payback period. Thus, if the firm has to choose among two mutually exclusive projects, project with shorter payback period will be selected.

DISCOUNTING PAYBACK PERIOD

“The number of periods taken in recovering the investment outlay on the present value basis is called the discounting payback period”.

One of the serious objections of the payback method is that it does not discount the cash flows for calculating the payback period. However, the discounted payback period still fails to consider the cash flows occurring after the payback period.

COST OF CAPITAL

CONCEPT OF COST OF CAPITAL: The discount rate is the

project’s opportunity cost of capital (or simply the cost of capital) for discounting its cash flow.

The project’s cost of capital is the minimum acceptable rate of return on funds committed to the project.

The firm’s cost of capital will be the overall, or average, required rate of return on the aggregate of the investment projects.

Therefore, The cost of capital is the minimum required rate of

return on the investment project that keeps the present wealth of the share holders unchanged.

DETERMINING COMPONENT COST OF CAPITAL

The component cost of a specific source of capital is equal to the investor’s required rate of return.

But the investor’s required rate of return should be adjusted for taxes in practice for calculating the cost of specific source of capital to the firm. In the investment analysis, net cash flows are computed on after-tax basis, therefore, the component costs, used to determine the discount rate, should also be expressed on an after-tax basis.

Thus, the methods of computing the component costs of three major sources of capital are:

Debt, Preference shares, Equity shares.

contd……….

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The composite, or overall cost of capital is the weighted average of the costs of various sources of funds, weights being the proportion of each source of funds in the capital structure.

Hence, once the component costs have been calculated, they are multiplied by the weights of the various sources of capital to obtain a weighted average cost of capital (WACC).

The following steps are used to calculate the weighted average cost of capital:

To calculate the cost of the specific sources of funds (i.e. cost of debt, cost of equity, cost of preference capital etc.).

To multiply the cost of each source by its proportion in the capital structure.

To add the weighted component costs to get the firm’s weighted average cost of capital.

THE MECHANICS OF COMPUTING THE WEIGHTED AVERAGE COST OF CAPITAL IS SHOWN BELOW:

The following is the capital structure of the firm: Source of finance Amount (Rs.)

Proportion (%)Equity (paid-in) share capital 450000 45Retained earnings (Reserves) 150000 15Preference share capital 100000 10Debt 300000 30 1000000 100The firm’s expected after-tax component costs of the various sources of

finance are as follows: Source

Cost (%)Equity capital 18.0Retained earnings 18.0Preference capital 11.0Debt 8.0

contd…….

CONTD……….

The weighted average cost of capital of the firm, based on the existing capital structure is computed as follows:

COMPUTATION OF WEIGHTED AVERAGE COST OF CAPITALSource Amount Proportion After-tax Cost Weighted Cost (1) (2) (3) (4) (5)=(3)X(4)Equity capital 450000 .45 .18 .081Retained earnings 150000 .15 .18 .027Preference capital 100000 .10 .11 .011Debt 300000 .30 .08 .024 1000000 1.00 .143

Weighted Average Cost of Capital ko= 14.3%

The weighted average cost of capital of the firm can alternatively be calculated as follows:

COMPUTATION OF WEIGHTED AVERAGE COST OF CAPITALSource Amount After-tax Cost (Rate) After-tax Cost (1) (2) (3) (4) =(2)X(3)Equity capital 450000 .18 81000Retained earnings 150000 .18 27000Preference capital 100000 .11 11000Debt 300000 .08 24000 1000000 143000 Weighted Average Cost of Capital, ko = Rs. 143000 X 100 = 14.3% Rs. 100000

CAPITAL ASSET PRICING MODEL (CAPM)

Capital Asset Pricing Model (CAPM), an important tool used to analyze the relationship between risk and rate of return.

STEPS IN THE CAPM APPROACH

STEP 1: Estimate the risk-free rate, rRF.

STEP 2: Estimate the current expected market risk premium, RPM, which is the expected market return minus the risk-free rate.STEP 3: Estimate the stock’s beta coefficient, bi, and use it as an index of the stock’s risk. The i signifies the ith company’s beta. (The relevant risk of an individual stock, which is called its beta coefficient, is defined under the CAPM as the amount of risk that the stock contribute to the market portfolio). STEP 4: Substitute the preceding values into the CAPM equation to estimate the required rate of return on the stock:

rs = rRF + (RPM)bi

Where as, rs is the cost of common equity raised internally by reinvesting earnings. Thus, if a company cannot earn atleast rs on reinvested earnings, then it should pass those earnings on to its stockholders and let them invest the money themselves in assets that do provide rs.

AN ILLUSTRATION OF THE CAPM APPROACH

To illustrate the CAPM approach for firm ABC, assume that rRF=8%, RPM=6%, and bi=1.1, indicating that the firm ABC is some what riskier than average. Therefore, ABC’s cost of equity is 14.6%:

rs = 8% + (6%) (1.1)

= 8% + 6.6% = 14.6%

It should be noted that although the CAPM approach appears to yield an

accurate, precise estimate of rs, it is hard to know the correct estimates of the inputs required to make it operational because:

1. It is hard to estimate precisely the beta that investors expect the company to have in the future, and

2. It is difficult to estimate the market risk premium.

Despite these difficulties, surveys indicate that CAPM is the preferred choice for the vast majority of companies.

MODIGLIANI & MILLER (MM): MODERN CAPITAL STRUCTURE THEORY (1958)

Modigliani and Miller: No Taxes Assumptions:1. There are no brokerage cost.2. There are no taxes.3. There are no bankruptcy cost.4. Investors can borrow at the same rate as

corporations.5. All- investors have the same information as

management about the firm’s future investment opportunities.

6. EBIT is not affected by the use of debt.

IF MM ASSUMPTIONS HOLD TRUE:

MM proved that a firm’s value is unaffected by its capital structure, hence the following situation must exist:

VL = VU = SL + DHere VL is the value of a levered firm, which is equal to VU, the

value of an identical but unlevered firm. SL is the value of the levered firm’s stock, and D is the value of its debt.

Recall that the WACC is a combination of the cost of debt and the relatively higher cost of equity (rs)- if MM assumptions are correct, it does not matter how a firm finances its operation, so capital structure decisions would irrelevant

i.e. As leverage increases, more weight is given to low-cost debt, but equity gets riskier, driving up rs. Under MM’s assumptions, rs increases by exactly enough to keep the WACC constant.

WHAT IF SOME OF THE MM ASSUMPTIONS ARE RELAXED:

1. Modigliani and Miller: The Effect of Corporate Tax2. Modigliani and Miller: Trade –Off Theory (relaxed the

assumption of no bankruptcy cost).3. Modigliani and Miller: Signaling Theory.