Financial Management

Financial Management

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Unit-I Financial management-scope finance functions and its organization, objectives of financial management; time value of money Meaning of Financial Management:Financial Management is such a managerial process, which is concerned with the planning and control of Financial resources. It is being studied as a separate subject in 20th century. Till now it was used as a part of economics. Now, its scope has undergone some basic changes from time to time. In present time, it analyses all financial problems of a business. Financial Manager estimates the requirements of funds, plans the different sources of funds and performs functions of collection of funds and its effective utilization. Finance is such a powerful source that it performs an important role to operate and coordinate the various economic activities of business. Finance is of two types:(1) Public finance. (2) Private finance. 1. Public Finance:Means government finance under which principles and practices relating to the procurement and management of funds for central government, state government and local bodies are covered. 2. Private Finance:means procurement and management of funds by individuals and private institutions. Under it we observe as to how individuals and private institution procure funds and utilise it. Scope:What is finance? What are a firm’s financial activities? How are they related? Firm create manufacturing capacities for production of goods, some provide services to customers. They sell goods or services to earn profit and raise funds to acquire manufacturing and other facilities. Thus, the 3 most important activities of business firm are:(1) Production (2) Marketing (3) Finance. A firm secures whatever capital it needs and employs it (finance activity) in activities, which generate returns on, invested capital (production and marketing activities.) Real and financial Assets:A firm acquire real assets to carry on its business. Real assets can be tangible or intangible. Plant, machinery, factory, furniture etc. are examples of tangible real assets, while technical know-how, patents, copy rights are examples of intangible real assets.

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The firm sells financial assets or securities such as shares and bonds or debentures, to investors in capital market to raise necessary funds. Financial assets also include borrowings from banks, finance institutions and other sources. Funds applied to assets by the firm are called capital expenditure or investment. The firm expects to receive return on investment and distribute return as dividends to investors. EQUITY AND BORROWED FUNDS:There are two types of funds that a firm can raise:- Equity funds and borrowed funds. A firm sells shares to acquire equity funds. Shares represent ownership rights of their holders. Buyers of shares are called share holders and they are legal owners of the firm whose share they hold share holders invest their money shares of a company in expectation of return on their invested capital. The return on shares holder’s capital consists of dividend and capital gain by selling their shares. Another important source of securing capital is creditors or lenders. Lenders are not the owners of the company. They make money available to firm on a lending basis and retain title to the funds lent. The return on loans or borrowed funds is called interest. Loans are furnished for a specified period at a fixed rate of interest. Payment of interest is a legal obligation. The amount of interest is allowed to be treated as expense for computing corporate income taxes. Thus the payment of interest on borrowings provides tax shied to a firm. The firm may borrow funds from a large number of sources, such as banks, financial institutions, public or by issuing bonds or debentures. A bond or debenture is a certificate acknowledging the money lent by a bond holder to the company. It states the amount, the rate interest and maturity of bonds or dentures. Finance Functions:(a) Financing decisions (b) Investment decisions (C) Dividend policy decision (d) Liquidity Decision (a) Financing Decisions are decisions regarding process of raising the funds. This function of finance is concerned with providing answers to various questions like (a) What should be amount of funds to be raised. (b) What are the various sources available to organisation for raisaing the required amount of funds? For this purpose, the organisation can go for internal & external sources. (c) What should be proportion in which internal & external sources should be used by organisation? (d) If organisation, wants to raise funds from different sources, it is required to comply with various legal & procedural formalities. (e) What kinds of changes have taken place recently affecting capital market in the country?

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(b) Investment decisions:- are decisions regarding application of funds raised by organisation. These relate to selection of the assets in which funds should be invested. The assets in which funds can be invested are of 2 types (a) Fixed assets:- are the assets which bring returns to organisation over a longer span of time. The investment decisions in these types of assets are “capital budgeting decisions.” Such decisions include 1 How fixed assets should be selected to make investment ? What are various methods available to evaluate investment proposals in fixed assets? 2 How decisions regarding investment in fixed assets should be made in situation of risk & uncertainity? (b) Current assets:- are assets which get generated during course of operations & are capable of getting converted in form of cash with in a short period of one year. Such decisions include (1) What is meaning of Working Capital management & its objectives? (2) Why need for working capital orises? (3) What are factors affecting requirements of working capital? (4) How to quantity requirements of working capital? (5) What are sources available for financing the requirement of working capital? (c ) Dividend Policy Decisions:- Such decisions include (1) What are forms in which dividend can be paid to share holders? (2) What are legal & procedural formalities to be completed while paying dividend different forms? (d) Liquidity Decisions:- Current assets should be managed efficiently for safe guarding firm against of liquidity & insolvency. In order to ensure that neither insufficient nor unnecessary funds are invested in current assets, the financial manager should develop sound technique of managing current assets. Organisation of Finance Function The organisation of finance function implies the division and classification of functions relating to finance because financial decisions are of utmost significance to firms. Therefore, to perform the functions of finance, we need a sound and efficient organisation. Although in case of companies, the main responsibility to perform finance function rests with the top management yet the top management (Board of Directors) for convenience can delegate its powers to any subordinate executive which is known as Director Finance, Chief

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Financial Controller, Financial Manager or Vice President of Finance. Besides it is finally the duty of Board of Directors to perform the finance functions. There are various reasons to assign the responsibility to the Board of Directors. Financing decisions are quite significant for the survival of firm. The growth and expansion of business is affected by financing policies. The loan paying capacity of the business depends upon the financial operations. The organisation of finance function is not similar in all businesses but it is different from one business to another. The organisation of finance function for a business depends on the nature, size financial system and other characteristics of a firm. For a small business, no separate officer is appointed for the finance function. Owner of the business himself looks after the functions of finance including the estimation of requirements of funds, preparation of cash budget and arrangement of the required funds, examination of all receipts and payments, preparation of credit policy, collecting debtors etc. with the increase in the size of business, specialists were appointed for the finance function and the decentralisation of the finance function began. For a medium sized business, the responsibility of the finance function is given to a separate officer who is known as financial controller, finance manager, deputy chairman (finance), finance executive or treasurer. In a large sized company the finance function has become more difficult and complex and the position of financial manager has become very important. He is the member of top management of an organisation. For such large organisations it is not possible for a finance manager to perform all the finance functions or to co-ordinate with the various departments. Therefore, finance and financial control are separated and allocated to two different subdepartments. For the ‘finance’ sub-department treasurer is appointed and for the ‘financial control’ sub department, financial controller is appointed. Each of them have various sub-units under them. Financial planning and financial control are quite significant for a large sized organisation. Therefore, a finance committee is established between the Board of Directors and Managing Director. It includes the financial Manger, representatives of the directors and departmental heads of various departments. Managing Director is the chairman of the committee. Its main function is to advise the Board of Directors on financial planning and financial control and co-ordinate the activities of various departments. The following chart 1.1. explains the organisation of finance function. From the chart 1.1. it is clear that treasurer and financial control work under finance Manager. Financial Manager is responsible to the Managing Director for his actions.

Board of Directors

Financial Management

Managing Directing

Production Manager

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Finance Committee

Personnel Manager

Financial Manager

Marketing Manager

Controller

Treasurer

Banking Relations

Cash Magt.

Credit Analysis

Assets Protection

Corporate Accounting & Cost

Annual Reports

Internal Auding

Planning & Budgeting

Securities Mgt.

Statistics

Treasurer performs the functions of procurement of essential funds, their utilisation, investment, banking, cash management credit management, dividend distribution, pension, management etc. Financial, controller is responsible for general accounting, cost accounting, auditing, budget, reporting and preparing financial statement etc. In India the function of financial manager is given to secretary in most of the companies. He performs the functions of treasurer and financial controller along with the routine functions of secretary. He collects necessary data and information and sends them to the Managing Director. Functions of the Chief Financial Manager.

Chief Financial manager is the top officer of finance department. In America he is known as Vice-president finance and in India he is called Chief Financial Controller. He performs following functions: (1) Financial Planning :- He determines the capital structure and prepares financial plan. (2) Procurement of Funds:- Financial manager makes the necessary funds available from different sources. (3) Co-ordination:- Financial manager establishes co-ordination among the financial needs of various departments. He is a member of finance committee.

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(4) Control:- Financial manager examines whether the work is being performed as per pre-determined standards or not. He gets the reports prepared, controls the cost and analyses profits. (5) Business Forecasting:- Financial manager evaluates the effects of all national, international, economic, social and political events on industry and company. (6) Miscellaneous Functions:- It includes the management of assets, management of inventory, arrangement of data and management of bank deposits etc. Functions of Treasurer The following are the functions of treasurer. (1) Provisions of finance:- It includes the estimation of funds necessary for procurement preparing programmes and implementing them, establishing relation among various sources of funds, issuing the securities and managing debt etc. (2) Banking Function:- It includes opening bank accounts, depositing cash, payment of company liabilities, accounting cash receipts & payments, responsibility for transacting actual assets etc. (3) Custody:- The treasurer is the custodian of funds and securities. (4) Management of credit and collection:- The treasurer determines credit risk of customers and arranges for collection. (5) Investments: It involves the investment of surplus funds. (6) Insurance:- The treasurer signs the cheques, agreement and other letters of company forecasts cash receipts and payments, pay property taxes and follows government regulations. Functions of controller The controller performs the following functions:(1) Planning:- The controller prepares plan for controlling the business activities which are the main constituents of management and in which proper arrangement regarding profit planning, capital expenditure planning, sales forecasting and expenditure budgeting is made. (2) Accounting:- Controller determines the accounting system and arrangements for costing and management accounting systems and prepares financial statements. (3) Auditing:- Controller Manages internal auditing. (4) Reports :- Controller prepares financial reports according to various needs and presents them to the managers. He advises the management to correct the deviation between the standard performance and actual performance.

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(5) Government Reporting :Controller sends essential information’s to the government by obeying the legal requirement. (6) Tax Administration :- Controller prepares statement on tax liability. (7) Economic Appraisal :- He determines and analyses the effect of economic and social factors on business. OBJECTIVES OF FINANCIAL MANAGEMENT:It is the duty of management to clarify the objectives of business so that the departmental objectives could be determined accordingly. Financial objectives of a firm provide a concrete framework within which optimum financial decisions can be made. The main objective of any firm should be to maximise the economic welfare of its shareholders. Accordingly, there are 2 approaches in this regard. (A) Profit maximisation Approach. (B) Wealth maximisation Approach. (A) PROFIT MAXIMISATION APPROACH:According to this approach, a firm should undertake all those activities which add to its profits and eliminate all others which reduce its profits. This objectives highlights the fact that all decisions:- financing, dividend and investment, should result in profit maximisation. Following arguments are given in favour of profit maximisation approach:(i) (ii) (iii) (iv) (v)

Profit is a yardstick of efficiency on the basis of which economic efficiency of a business can be evaluated. It helps in efficient allocation and utilisation of scarce means because only such resources are applied which maximise the profits. The rate of return on capital employed is considered as the best measurement of the profits. Profit acts as motivator which helps the business organisation to be more efficient through hard work. By maximising profits, social & economics welfare is also maximised.

However this approach has been criticised on various counts:(1)

Ambiguity:-

Profit can be expressed in various forms i.e it can be short term or long term or it can be profit before tax or after tax or it can be gross profit or net profit. Now the question arises, which profits can be maximised under profit maximisation approach. (2)

Time Value of Money

This approach is also criticised because it ignores time value of money i.e. under this approach income of different years get equal weight. But, in fact, the value of rupee today will be greater as compared to the value of rupee receivable after one year. In the same manner, the value of income received in the first year will be greater from that which will be received in later year e.g. the profits of 2 different projects are:-

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Example:YEAR 1 2 3

PROJECT1 5,000 10,000 5,000

PROJECT2 10,000 10,000

Both the projects have a total earnings of Rs 20,000 in 3 years and according to this approach both will be considered equally profitable. But Project 1 has greater profits in the initial years of the project & therefore, is more profitable in terms of value of income. The profits earned in initial years can be reinvested and more profits can be earned. (3)

Risk Factor:-

This approach ignores risk factor. The certainity or uncertainity of income receivable in future can be high or less. High uncertainity increases risk and less uncertainity reduces risk. Less income with more certainity is considered better as compared to high income with greater uncertainity. Thus, this approach was more significant for sole trader & partnership firms because at that time when personal capital invested in business, they wanted to increase their assets by maximising profits. Companies are now managed by professional managers and capital is provided by shareholders, debenture holders, financial institutions etc. one of the major responsibilities of business management is to co-ordinate the conflicting interest of all these parties. In such a situation profit maximisation approach does not appear proper and practicable for financial decisions. B Wealth Maximisation Approach Value Maximisation Approach or Maximum net present worth. According to this approach , financial management should take such decision’s which increase net present value of the firm and should not undertake any activity which decrease net present value. This approach eliminates all the 3 basic criticisms of the profit maximization approach. As the value of an asset is considered from view point of profit accruing from it, in the same manner the evaluation of an activity depends on the profits arising from it. Therefore, all 3 main decisions of financial manager-financing decision, investment decision dividend decision affect net present value of the firm. The greater the amount of net present value, the greater will be value of firm and more it will be in the interest of share holders. When the value of firm increases, the market price of equity shares also increase. Thus to maximize net present worth means to maximize the market price of shares. Net present worth can be calculated with the help of following equation. A1 W=

A2 +

(1+k)

(1+k) 2

An + --------------------- +

(1+k) n

-c

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n At = ∑ -C t t=1 (1+k)

Where W = Net present worth. A, A2--- An= Stream of expected cash benefits from a course of action over a period of time. K = Discount rate to measure risk & timing. C= Initial outlay to acquire that asset If W is positive, the decision should be taken & vice versa. If W is Zero, it would mean that it does not add or reduce the present value of the asset. This approach is considered good for the companies in present situation. This approach gives due consideration to the time value of expected income receivable over different period of time. Under this approach, risk and uncertainty is analyzed with the help of interest rate. If uncertainty & time period are greater, higher rate of interest will be used to calculate present value of expected future cash benefits where as the interest rate will be lower for the projects with low risk & uncertainty. Besides, this approach uses cash flows instead of accounting profits which removes ambiguity associated the term profit. On the basis of above explanation, we can conclude that wealth maximization approach is better to profit maximisation approach to establish mutual relation among the various data. It is possible only through statistics. Cash and inventory management, forecast of financial needs, credit policy decision all are based on the advanced techniques of statistics. Finance is also related to law. Any decision regarding financial policy should be in line with the laws of the country. Time Value of Money:The evaluation of capital expenditure proposals involves the comparison between cash outflows & cash inflows. The pecularity of evaluation of capital expenditure proposals is that it involves the decision to be taken today where as the flow of funds, either outflow or inflow, may be spread over a number of years. It goes without saying that for a meaningful comparison between cash outflows and cash inflows, both the variables should be on comparable basis. As such, the question which arises is “that is the value of flows arising in future the same in terms of today.” For Example:- if a proposal involves cash inflow of Rs 10,000 after one year, is the value of this cash inflow really Rs 10,000 as on today when capital expenditure proposal is to be evaluated.? The ideal reply to this question is ‘no’. The value of Rs 10000 received after one year is less than Rs 10,000 if received today. The reasons for this can be stated as below:(i) There is always an element of uncertainety attached with the future cash flows.

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(ii) The purchasing power of cash inflows received after the year may be less than that of equivalent sum if received today. (iii) There may be investment opportunities available if the amount is received today which cannot be exploited if equivalent sum is received after one year. Time Value of money: Example:- If Mr. X is given the option that he can receive an amount of Rs 10000 either on today or after one year, he will most obviously select the first option why? Because, if he receives Rs 10000 today he can always invest the same say in fixed deposit with the bank carrying interest of say 10% p.a As such, if choice is given to him, he will like to receive Rs 10000 today or Rs 11000 (i.e. Rs 10000 plus interest @ 10% p.a. on Rs 10000) after one year. If he has jto receive Rs 10,000) only after one year, the real value of same in terms of today is not Rs 10000 but something less than that. This concept is called time value of money.

Unit-II Investment decisions importance, difficulties, determining cash flows, methods of capital budgeting; risk analysis (risk adjusted discount rate method and certainty equivalent method); cost of different sources of raising capital; weighted average cost of capital. Investment decisions The investment decisions of a firm generally known as capital budgeting or capital expenditure decisions. A capital budgeting decision may be defined as the firm’s decision to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of year. The long term assets are those which affect the firm’s operations beyond the one year period. The firm’s investment decision would generally include expansion, acquisition, modernisation and replacement of long term assets. Sale of a division or business (Investment) is also analysed as an investment decision. Activities such as changes in the methods of sales distribution or undertaking an advertisement compaign or a research and development programme have long-term implication’s for the firm’s expenditure and benefits and therefore, they may also be evaluated as investment decisions. Features:1) The exchange of current funds for future lengths. 2) The funds are invested in long term assets. 3) The future benefits will occur to the firm over a series of year. Importance of Investment Decisions Investment decision require special attention because of the following reasons:

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1) They influence the firm’s growth in the long turn. 2) They affect the risk of the firm. 3) They involve commitment of large amount of funds. 4) They are irreversible or reversible at substantial loss. 5) They are among the most difficult decisions to make. 1) GROWTH: A firm’s decision to invest in long term assets has a decisive influence on rate and direction of its growth. A wrong decision can prove disastrous for continued survival of firm, unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm. On other hand, inadequate investment in assets would make it difficult for the firm to complete successfully and maintain its market share. 2) Risk: A long-term commitment of funds may also change risk complexity of the firm. If the adoption of an investment increases overage gain but causes frequent fluctuations in its earnings the firm will become more risky. 3) Funding: Investment decisions generally involve large amount of funds which make it imperative for firm to plan its investment programmes very carefully and make an advance arrangement for procuring finance internally or externally. 4) Irreversibility: It is difficult to find a market for such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped. 5) Complexity: Investment decisions are an assessment of future events which are difficult to predict. It is really a complex problem to correctly estimate future cash flow of an investment. The uncertainty in cash flow is caused by economic, political, social and technological forces. Techniques of Capital Budgeting: it may be grouped in the following two categories:(A) Discounted cash flow (DCF) Criteria. (1) (2) (3) (4)

Net present value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Discounted Payback Period.

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(B) Non-discounted Cash flow Criteria: (1) Pay back period (PB) (2) Accounting rate of return (ARR) (A) Discounted Cash Flow (DCP) Criteria – These techniques are considered good because they take into account time value of money.

(1) Net Present Value (NPV) This method take into account time value of money. In this method present value of cash flows is calculated for which cash flows are discounted. The rate of interest is called cost of capital and is equal to minimum rate of return which must accrue from the project. Later, present value of cash out flows is calculated in same manner and subtracted from present value of cash inflows. This difference is called Net Present value or NPV. In case investment is made only in beginning of the project, it present value is equal to the amount invested in the project. Taking this assumption, NPV can be calculated as under: NPV = CF1

CF2 +

(1+k) 1 n Cft = ∑ t=1 (1+k) t

Cfn +--

(1+k) 2

-C (1+k) n

-C

Where Cf1, Cf2 represent cash inflows K = Cost of Capital C = Cost of investment proposal n = Expected life of Proposal If the project has a salvage value also, it should be added in cash inflows of last year. Similarly, if some working capital is also needed, it will be added to initial cost of project and to cash flows of last year. Acceptance Rule:1) Accept if NPV >O (i.e. NPV is Positive) 2) Reject if NPV 1.0 Reject if Pl standard pay back.

MERITS 1. Easy to understand and compute. 2. This method follows short terms view point, as a result, the obsolescence are minimum. 3. Emphasis liquidility, therefore useful for the companies which faces the problem of liquidity. Such companies will invest their funds in such projects in which investment can be recovered in minimum time. 4. Used to find out internal Rate of Return. 5. Suitable for those organisations which emphasise on short-term investments rather than long terms development. 6. Uses cash flow information. 7. Easy and crude way to cope with risk. Demerits 1. Ignores the value of money. 2. Ignores the cash flows occurring after the pay back period. Thus does not take into account the whole profitability of the project. For eg: investment in a project is Rs 50,000. Its life 10 years and cash flows every year are Rs 10,000. Then its Pay back period will be 5 years. But the cash inflows of Rs 50,000 during the last 5 years have been taken into account. 3. No objective way to determine the standard payback. 4. This method also does not take into account the time value of money. The time value of money is the interest on investment. The payback period of two projects may be the same but a project may get more CFAT in the initial years and less in the later years. In such a case the cash flows in the initial years can fetch additional income of interest. Such a project may become more profitable than the others. But this method ignores this fact. 5. This method does not take into account the total life time of the project. 6. No relation with the wealth maximisation principle. 7. not a measure of profitability. II. Average Rate of Return Method: This method is also called Accounting Rate of Return Method. This method is based on accounting information rather than cash flows. There are various ways of calculating Average Rate of Return. It can be calculated as:Average annual Profit after Tax ARR = ___________________________X100

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Average Investment Average Annual Profit = Total of after tax profit of all the year ___________________________ No. Of years Average Investment = Original Investment + Salvage Value ________________________________ 2 or Original Investment – Salvage Value ________________________________ + Salvage Value 2 If working Capital is also required in the initial year of the project, the average investment will be= Net working Capital + Salvage value + ½ (initial cost of Machine- Salvage Value). In another method instead of average investment original cost is used. In this method, to evaluate the project all those projects are accepted on which average rate of return is more than the predetermined rate. Thus, the project is given more significant on which the average rate of return is the highest. Acceptance Rule • •

Accept if ARR > minimum rate. Accept if ARR < minimum rate.

Merits 1). Easy to understand. Necessary informations to calculate average rate of return are available easy. 2). This method takes into account all the profits during the life time of the project, whereas pay back period ignores the profits accruing after the pay back period 3). Give more weightage to future receipts. 4). Easy to understand and calculate. 5). Uses accounting data with which executives are familiar. Demerits 1). Ignore the time value of money. 2). Does not use cash flow. 3). No objective way to determine the minimum acceptable rate of return.

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4). This method does not account for the profits arising on sale of profit on old machinery on replacement. 5). ARR method does not consider the size of investment for each project. It may be time that the competing ARR of two projects may be the same but they may require different average investments. It becomes difficult for the management to decide which project should be implemented.

Risk analysis Risk exists because of inability of decision maker to make perfect forecasts. Forecasts cannot be made with perfection or certainty since the future events on which they depend are uncertain. An investment is not risky if, we can specify a unique sequence of cash flows for it. But the whole trouble is that cash flows cannot be forecast accurately, & alternative sequence of cash flows can occur depending on future events. Thus, risk arises in investment evaluation because we cannot anticipate occurrence of possible future events with certainty & consequently, cannot make any connect prediction about cash flow sequence. Techniques to handle Risk 1) Pay back 2) Risk-adjusted discount rate. 3) Certainty equivalent. 2) Risk-adjusted Discount Rate:To allow a risk, businessman required a premium over and above an alternative which was risk free. Accordingly, more uncertain the returns in future, the greater the risk & greater premium required. Based on this reasoning, it is proposed that risk premium be incorporated into capital budgeting analysis through discount rate. That is, if time preference for money is to be recognised by discounting estimated future cash flows, at same risk-free rate, to their present value, than, to allow for riskiness of those future cash flows a risk premium rate may be added to risk free discount rate. Such a composite discount rate, called risk-adjusted discount rate, will allow for both time preference & risk preference & will be a sum of risk-free rate & riskpremium rate reflecting the investors attitude towards risk. The risk adjusted discount rate method can be expressed as follows: N NPV = ∑ NCFt t=0 (1+k) t Where K= Risk-adjusted rate. That is, Risk-adjusted discount rate= Risk free Rate+ Risk Premium K= kf +kr

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Under CAPM risk- premium is difference between market rate of return & risk free rate multiplied by beta of the project. The risk adjusted discount rate accounts for risk by varying discount rate depending on degree of risk of investment projects. A higher rate will be used for riskier projects & a lower rate for less risky projects. The net present value will decrease with increasing k, indicating that riskier a project is perceived, the less likely it will be accepted. In contrast to net present value method, if firm uses IRR method, then to allow for risk of an investment project, the IRR for project should be compared with risk-adjusted minimum required rate of return. If IRR is higher than this adjusted rate, the project would be accepted, otherwise it should be rejected.

Evaluation:Advantages:1) Simple to understand. 2) Has a great deal of intuitive appeal for risk adverse businessman. 3) It incorporates an attitude towards uncertainty. Disadvantages:1) There is no easy way of deriving a risk-adjusted discount rate. 2) It does not make any risk adjustment is numerator for cash flows that are for cast over future years. 3) It is based on assumption that investors are risk-averse. Though it is generally true, there exists a category of risk seekers who do not demand premium for assuming risks, they are willing to pay a premium to take risks. Accordingly, composite discount rate would be reduced, not increased, as the level of risk increases. •

It is based on the assumption that investors are risk averse. Though it is generally true, there exists a category or risk seekers who do not demand premium for assuming risks; they are willing to pay a premium to take risk. Accordingly, the composite discount rate would be reduced, not increased, as the level of risk increases.1

Certainty Equivalent Yet another common procedure for dealing with risk in capital budgeting is to reduce the forecasts of cash flows to some conservative levels. For example, if an investor, according to his ‘best estimate,’ expects a cash flow of Rs 60,000 next year, he will apply an intuitive correction factor and may work with Rs 40,000 to be on safe side. There is a certaintyequivalent cash flow. In formal way, the certainty equivalent approach may be expressed as: N NPV = ∑ t=0

?t NCFt (1+kf )t

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NCFt = the forecasts of net cash flow without risk-adjustment ?t = the risk-adjustment factor or the certainty equivalent coefficient Kf = risk-free rate assumed to be constant for all periods.

The certainty- equivalent coefficient, ?t assumes a value between 0 and 1, and varies inversely with risk. A lower ?t will be used if greater risk is perceived and a higher ?t will be used if lower risk is anticipated. The coefficients are subjectively or objectively established by the decision maker. These coefficients reflect the decision-maker’s confidence in obtaining a particular cash flow in period t. For example, a cash flow of Rs 20,000 may be estimated in the next year, but if the investor feels that only 80 per cent of it is a certain amount, then the certainty-equivalent coefficient will be 0.80. That is, he considers only Rs 16000 as the certain cash flow. Thus, to obtain certain cash flows, we will multiply estimated cash flows by the certainty-equivalent coefficients. The certainty-equivalent coefficient can be determined as a relationship between the certain cash flows and the risky cash flows. That is:

?t =

NCFt * = NCFt

Certain net cash flow Risky net cash flow

For example, if one expected a risky cash flow of Rs 80,000 in period t and considers a certain cash flow of Rs 60,000 equally desirable, then ?t will be 0.75=60,000/80,000. ILLUSTRATION 15.2 A project costs Rs 6,000 and it has cash flows of Rs 4,000, Rs 3,000, Rs 2,000 and Rs 1,000 in year 1 through 4. Assume that the associated ?t factors are estimated to be: ?o = 1.00, ?1=0.90, ?2=0.70, ?3=0.50 and ?4=0.30, and the risk free discount rate is 10 per cent. The net present value will be: NPV = 1.0(-6,000) +

0.90(4,000) 0.70(3,000) 0.50(2,000) 0.30(1,000) + + + = Rs 37 (1+0.10) (1+0.10)2 (1+0.10)3 (1+010)4

The project would be rejected as it has a negative net present value. If the internal rate of return method is used, we will calculate that rate of discount which equates the present value of certainty-equivalent cash inflows with the present value of certainty-equivalent cash outflows. The ratio so found will be compared with the minimum required risk-free rate. Project will be accepted if the internal rate is higher than, the minimum rate; otherwise it will be unacceptable. Evaluation of Certainty Equivalent The certainty-equivalent approach explicitly recognizes risk, but the procedure for reducing the forecasts of cash flows is implicit and is likely to be inconsistent from one investment to another. Further, this method suffers from many dangers in a large enterprise. First, the forecaster,

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expecting the reduction that will be made in his forecasts, may inflate them in anticipation. This will no longer give forecasts according to ‘best estimate.’ Second, if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate the original forecasts or to make it ultra conservative. Third, by focusing explicit attention only on the gloomy outcomes, chances are increased for passing by some good investments. Risk-adjusted Discount Rate VS. Certainty-Equivalent The certainty-equivalent approach recognizes risk in capital budgeting analysis by adjusting estimated cash flows and employs risk-free rate to discount the adjusted cash flows. On the other hand, the risk-adjusted discount rate adjusts for risk by adjusting the discount rate. It has been suggested that the certainty equivalent approach is theoretically a superior technique over the risk-adjusted discount approach because it can measure risk more accurately.1 The risk-adjusted discount rate approach will yield the same result as the certaintyequivalent approach if the risk-free rate is constant and the risk-adjusted discount rate is the same for all future periods. Thus, ?t NCFt

NCFt =

To solve for ?l

(1+kf )t

(1+k) t

?t NCF (1+k) t = NCFt (1+kf )t ?t =

NCFt (1+kf )t NCFt (1+k) t

=

(1+kf )t (1+k) t

For period t+1, Equation (6) will becomes ?t+1 =

(1+kf )t+1

(1+k) t+1 Earlier, we have stated that the values of ?1 will vary between 0 and 1. Thus, if Kf and k are constant for all future periods, then K must be larger than Kf to satisfy the condition that ?t varies. 1. Robichek and Myers, op. cit., pp. 82-86.

Cost of Capital The project’s cost of capital is minimum acceptable rate of return on funds committed to the project. The minimum acceptable rate or required rate of return is a compensation for time and risk in use of capital by project. Since investment projects may differ in risk, each one of them will have its own unique cost of capital. The firm represent aggregate of investment projects under taken by it. Therefore, the firm’s cost of capital will be overall, or average, required rate of return on aggregate of investment projects.

Financial Management

VIMAL JOSHI

Determining Component Cost of Capital:1) Cost of Debt:A Company may raise debt in various ways. It may borrow funds from financial institutions or public either in form of public deposits or debentures for a specified period of time at certain rate of interest. A debenture or bond may be issued at per or at discount or premium. (a) Debt issued at Par:The before tax cost of debt is rate of return required by lenders. It is easy to compute before tax cost of debt issued & to be redemed at par, it is simply equal to contractual interest. For example, a company decides to sell a new issue of 1 years 15% bond of Rs 100 Each at par. If company realises full face value of Rs 100 bond & will pay Rs 100 Principal to bond holders at maturity, the before tax cost of debt will simply be equal to rate of interest of 15%. Thus:Kd= I= INT ___ Bo Where, KD= before-tax cost of debt. I = coupan rate of interest. B = Issue price of debt. INT = amt. of interest. (B) Debt issued at Discount or Premium:-

Bo =

n INTt ∑ _________ t=1 (1+kd)t

Bn + _________ (1+ kd)n

Where Bn= repayment of debt on maturity and other variable as defined earlier. This equation is used to find out whether cost of debt issued at par or discount or premium. i.e. Bo= f or Bo>f or Bo