capital budgeting and investment decisions in financial management 11 nov

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Capital Budgeting and Investment Decisions

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Capital Budgeting and Investment Decisions

Dr. T.K. Jain.

AFTERSCHO☺OLCentre for social entrepreneurship

Bikaner M: [email protected]

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We have 2 projects, (costing 30000 each), which one should we go for.

Read the following details :

• Cash inflows: Rs. 20000 p.a. in the first project

• Cash inflow of Rs. 37500 after 1st year.in the 2nd project.

• NPV @ 10% per annum


Solution • NPV = let us calculate present values of cash

inflows and outflows and then find their difference.

• Present value of cash outflow = 30000• Present value of cash inflow: • 1st project: =20000/(1.1)^1 + (20000 / (1.1)^2) =

18181+16528 = 34710• 2nd project = 37500/(1.1)^1 = 34090 answer.• Thus NPVs are 4710 and 4090 respectively

and project 1st is better.


Solution – using IRR• Internal Rate of Return is the rate that can

equate present values of cash inflows and cash outflows. Thus IRR in these two projects is as under:

• 30000 = 20000/(1+ rate)^1 + (20000 / (1+IRR)^2)

• Solving this we get IRR of 21.53% approx. • For 2nd project: 30000 = 37500/(1+ IRR)^1• Thus here the IRR is 25%. • From IRR, 2nd project is better.


MIRR

• MIRR = Modified Internal Rate of Return. • Use 20% rate in the previous Project 1

and find out single terminal cash flow. • In MIRR we convert all cash inflows to

terminal cash flows as if taking place in the last year).

• = 20000*(1.2)^1 + (20000 *(1.2)^0• =44000 is Cash Inflow in terminal year.


Solve the question• Kap & Goti UnLtd. is considering the purchase of a new computer.

system for its Research and Development Division, which would cost Rs. 35 lakhs. The operation and maintenance costs (excluding depreciation) are expected to be Rs. 7 lakhs per annum. It is estimated that the useful life of the system would be 6 years, at the end of which the disposal value is expected to be Rs. 1 lakh. -

• The tangible benefits expected from the system in the form of reduction in design and drafts-menship costs would be Rs. 12 lakhs per annum. Besides, the disposal of used drawing, office equipment and furniture, initially, is anticipated to net Rs. 9 lakhs. Capital expenditure in research and development would attract 100% write-off for tax purpose. The gains arising from disposal of used assets may be considered tax-free. The company’s effective tax rate is 50%.The average cost of capital to the company is 12%. After appropriate analysis of cash flows, please advise the company of the financial viability of the proposal.


Solution

• Benefits from projects: • Cash inflow: 12,00,000• Less: • Depreciation : 5,66,666• Running exp. : 7,00,000 = (-66,666)• there is loss – so there is no tax. • EAT +Depreciation =-66,666 + 5,66,666 =

5 lakhs per annum


Solution ….• Returns in the first year: • Cash outflow: 35 lakhs • Less : Cash inflow: 9 lakhs = 26 lakhs• Less: tax advantage = 17.5 lakhs• Net cash outflow; 8.5 lakhs. • Annual cash inflow: 5 lakhs• NPV of cash inflows= 5/(1.12)^1+ 5/(1.12)^2+

5/(1.12)^3+ 5/(1.12)^4+ 5/(1.12)^5+ 5/(1.12)^6=20.55 lakhs. Thus NPV is 12.05 lakhs, so

project must be accepted.


What are these decisions important?

• Huge investments• Long time frame• Irreversibility• Complex decisions


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?


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).


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


Traditional methods

• These methods don’t 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


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.


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.


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.


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.


Suppose Ramesh Global Financial services invests $ 10 million. His

returns are as under: 1st year: $ 2 million2nd year : $4 million3rd year : $ 4 million4th 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. The rate is : 18.42


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.


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.


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.


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?


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.


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. Answer.


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

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


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

• Suppose income is 2000$ - int.1200

• EAT = 480• 3000 is EBIT - 1200• EAT = 1080• EBIT is 4000 - 1200• EAT = 1680


Analysis • BEP = EBIT / Total

assets. • 2000/20000• =.1• ROE=

PAT/NETWORTH• =1200/20000=.06• DSCR / ICR• =EBIT / INT

• BEP = EBIT / Total assets.

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


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.


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

• 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


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?


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.


Find the combined leverage

installed Capacity 4000 unitsActual Production and Sales 75%Selling Price 30 per unitVariable Cost 15 per unitFixed Cost:Under Situation I 15000Under Situation-il 20000Financial PlanA B

Equity 10,000 15,000Debt (20%) 10,000 5,000

Total 20,000 20,000


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

• Sales : 3000*30 = 90000

• Contribution • 90000-45000=45000• EBIT = 90000-

(45000+20000)• =25000• Operating

leverage=1.8


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

• EBIT =25000• 25000/24000 = 1.04

• Combined leverage • =1.8*1.04=1.87


Question on NI approach

• Rupa Company’s 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


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


Solution …

• Equity = 3 lakh / .16• =1875000• Debt = 20,00,000• Total value = 38,75,000 • Answer.


Ramesh Ltd’s. 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).


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.


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.


Analysis • Goti• Debt = 100000• EAI = 20000-7000• =13000 (we assume no

taxes)• Equity • =13000/.115• =113043• Total value • =2,13,043

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

• Thus we can see that the value of Goti International is little bit higher


Arbitrage process • you may invest in Goti

International • Suppose we invest

10000, we get = 1150

• 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.


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.


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


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

• 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


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

• 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.


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%

• 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%


Operating leverage…

• = % change in EBIT / % change in sales• Actually it measures the impact of fixed

cost (as aginst variable cost).


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.


Alternate formulaes

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


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.


How do you design capital structure?

1. It should minimise cost of capital2. It should reduce risks3. It should give required flexibility4. It should provide required control to the

owners 5. It should enable the company to have

adequate finance.


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.


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.


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.


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.


What do you understand from trading on equity?

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


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).


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.


Is there indifference point?


Solve the following • Goti continental Inc. a profit makipg company, has a paid-

up 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 company’s 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%


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)


Solution • (a) All equity : • Earnings = 60 + 40 = 100• Tax: 30• EAT = 70• No. of shareholders: 12

lakh shares• EPS = 70 / 12=5.83

• (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


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:


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.

• 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


Theories of capital structures . .

• There are 4 theories: 1. NI approach (net income approach)2. NOI approach (net operating income

approach)3. MM approach (Modigliani Millar

Approach)4. Traditional approach


Assumptions in capital structure theories …..

1. There are only 2 sources of finance – debt and equity

2. Taxes are ignored3. Dividend payout ratio is 100%4. Business risk is constant5. Firm’s total financing remains constant.


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.


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.


MM approach

• It is similar to NOI approch


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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capital budgeting and investment decisions in financial management 11 nov

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