UNIT – II INVESTMENT DECISIONS

CAPITAL BUDGETING

 Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or
equipment.
 The process involves analyzing a project's cash inflows and outflows to determine whether the expected return meets
a set benchmark.
 The major methods of capital budgeting include discounted cash flow, payback analysis, and throughput analysis.
 Capital budgeting's main goal is to identify projects that produce cash flows that exceed the cost of the project for a
company.
 Charles T. Harngreen: "Capital budgeting is long term planning for making and financing proposed capital outlay."

NATURE OF CAPITAL BUDGETING

There are several essential aspects in the nature of capital budgeting. These are:
1. Huge Investment: Capital expenditure is a huge investment plan for acquiring or expanding fixed assets.
2. Long-term Investment: Capital expenditure is not only a huge investment plan but also a long-term investment whose
return will be available after a considerable period of time.
3. Futuristic Investment: Capital budgeting is a futuristic investment. It is a forecasting of several years profitability of
several years.
4. Effect of Wrong Selection: Any error in the evaluation of a proposal may lead to serious consequences.
5. Permanent Commitment of Funds: the funds involved in capital expenditure are not only huge but also long-term
decisions. The longer the time, the longer the period for which risks are involved.
6. Investment Decision: Long-term capital expenditure decisions are always complex. This is because long-term
decisions are always associated with risk and uncertainty. For this reason, management should strive to make
judicious decisions.
7. Wealth Maximization: Capital expenditure directly influences a firm's financial health, and the aim should be to
avoid over-investment and under-investment in fixed assets.

PROCESS OF CAPITAL BUDGETING

Capital budgeting involves several steps:
1. Identification of Projects: Potential investment opportunities are identified, both internally generated ideas and
those solicited from various departments.
2. Estimation of Cash Flows: The expected cash flows associated with each project are estimated. This includes initial
investments, operating cash flows, and terminal cash flows.
3. Risk Assessment: Risks associated with each project are evaluated. Sensitivity analysis and scenario planning may
be employed to gauge how external factors can affect the project’s outcome.
4. Selection of Evaluation Criteria: The appropriate evaluation criteria, such as NPV, IRR, or payback period, are
selected based on the nature of the project.
5. Project Evaluation: Projects are evaluated using the chosen criteria. Those that meet or exceed the company’s
minimum requirements are considered for approval.
6. Ranking and Selection: Projects are ranked based on their attractiveness, and the company selects the projects that
align with its strategic goals and available budget.
7. Implementation and Monitoring: Approved projects are implemented, and their progress is monitored to ensure
they stay on track and deliver the expected results.
IDENTIFYING RELEVANT CASH FLOWS
Identifying relevant cash flows is crucial in capital budgeting as it directly impacts the accuracy of investment appraisal
methods such as Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period. Here’s how you can identify
relevant cash flows:
1. Incremental Cash Flows: Focus on cash flows that are incremental to the project. These are the additional cash
flows that will be generated or incurred because of the investment decision.
2. Initial Investment: Identify the initial cash outflow required to start the project, including costs for equipment, land,
building, and working capital.
3. Operating Cash Flows: These are the cash flows generated from the project’s operations and can include:
 Revenues: Cash inflows from sales of products or services.
 Operating Expenses: Cash outflows for operating costs like salaries, utilities, raw materials, etc.
 Depreciation: Even though it’s a non-cash expense, it affects taxes, which in turn affects cash flows.
 Changes in Net Working Capital: Any changes in current assets (like inventory or accounts receivable) and
current liabilities (like accounts payable) due to the project.
4. Salvage Value: The cash inflow from selling the project’s assets at the end of its useful life.
5. Tax Effects: Consider tax shields like depreciation and any tax implications on the project’s cash flows.
6. Financing Cash Flows: If the project requires financing or if there are interest expenses or dividends associated with
the project, these should be considered separately from the project’s operating cash flows.
7. Sunk Costs: Costs that have already been incurred and cannot be recovered should not be considered in the capital
budgeting analysis because they are irrelevant to future decision-making.
8. Opportunity Costs: Any potential benefits foregone by choosing one investment over another should be considered
as a relevant cash outflow.
9. Externalities: Sometimes a project may have external impacts that generate benefits or costs for other parts of the
business. These should be included if they are relevant to the decision-making process.
10. Risk and Uncertainty: Adjust cash flows for risk by using a risk-adjusted discount rate or by incorporating a risk
premium into the cash flow estimates.
Remember to consider the time value of money by discounting future cash flows back to their present value using an
appropriate discount rate. By identifying and including all relevant cash flows and discounting them appropriately, you can
make a more informed and accurate capital budgeting decision.

EVALUATION TECHNIQUES OF CAPITAL BUDGETING

Capital budgeting is a critical process that involves evaluating and selecting long-term investment projects that are expected
to generate returns over a specified period. Proper evaluation techniques are essential to ensure that the selected projects align
with the company's strategic objectives and provide a satisfactory return on investment. Here are some commonly used
evaluation techniques in capital budgeting:
1. Net Present Value (NPV):
 Concept: NPV measures the present value of all cash inflows and outflows associated with a project,
discounted at the company's required rate of return (discount rate).
 Decision Rule: A project with a positive NPV should be accepted as it indicates that the project is expected
to generate more value than its cost.
2. Internal Rate of Return (IRR):
 Concept: IRR is the discount rate that makes the NPV of a project zero. It represents the project's expected
rate of return.
 Decision Rule: A project with an IRR higher than the company's required rate of return should be accepted.
3. Payback Period:
 Concept: Payback period measures the time it takes for a project to recover its initial investment through
cash inflows.
 Decision Rule: A shorter payback period is generally preferred as it indicates quicker recovery of the initial
investment.
4. Profitability Index (PI):
 Concept: PI is calculated as the present value of future cash inflows divided by the initial investment.
 Decision Rule: Projects with a PI greater than 1 are considered acceptable; a higher PI indicates a more
favorable investment.
5. Accounting Rate of Return (ARR):
 Concept: ARR is calculated as the average annual accounting profit divided by the average investment.
 Decision Rule: A project with an ARR higher than the company's required rate of return may be considered
acceptable.
Factors to Consider while evaluating an investment
 Cash Flows: Accurate estimation of cash inflows and outflows is crucial.
 Discount Rate: Selection of an appropriate discount rate is essential as it reflects the company's required rate of
return.
 Project Life: The duration of the project can impact the choice of evaluation techniques.
 Tax Considerations: Taxes can affect cash flows and should be considered in the evaluation.
 Inflation: Inflation can erode the purchasing power of money over time and should be accounted for in cash flow
projections.
In practice, it is often recommended to use multiple evaluation techniques to make a well-informed decision. Each technique
has its strengths and limitations, and using a combination of methods can provide a more comprehensive view of a project's
potential value and risks.

COMPARISON OF DCF TECHNIQUES

 Consideration of Time Value of Money: NPV, IRR, and PI all consider the time value of money by discounting
future cash flows to their present value.
 Scale of the Project: NPV and PI consider the scale of the project by comparing the total present value of cash
inflows to the initial investment. IRR doesn't directly consider scale.
 Ease of Interpretation: IRR provides a percentage rate of return, which is easier to interpret than the dollar value of
NPV. PI is also relatively easy to interpret as a ratio.
  Discount Rate Estimation: NPV, IRR, and PI all require the estimation of a discount rate or required rate of return,
which can be subjective and may affect the results.
 Multiple IRRs: IRR can result in multiple rates for unconventional cash flows, making it challenging to interpret.
 Comprehensive Measure: NPV is often considered the most comprehensive measure as it provides a dollar value
representing the added value of the project to the firm, considering both the scale and timing of cash flows.
In practice, it's common for companies to use multiple DCF techniques to evaluate investment projects and make more
informed decisions. Each technique has its strengths and weaknesses, so using them in combination can help mitigate their
individual limitations and provide a more robust analysis.
 COST OF CAPITAL
 Cost of capital is a calculation of the minimum return that would be necessary in order to justify undertaking a capital
budgeting project, such as building a new factory. It is an evaluation of whether a projected decision can be justified
by its cost.
 Many companies use a combination of debt and equity to finance business expansion. For such companies,
the overall cost of capital is derived from the weighted average cost of all capital sources. This is known as
the weighted average cost of capital (WACC).
 A company's investment decisions for new projects should always generate a return that exceeds the firm's cost of the
capital used to finance the project. Otherwise, the project will not generate a return for investors.
 Ezra Solomon defines “Cost of capital is the minimum required rate of earnings or cutoff rate of capital
expenditure”.
MEASUREMENT OF COST OF CAPITAL
A. Cost of Debentures:
The capital structure of a firm normally includes the debt capital. Debt may be in the form of debentures bonds, term loans
from financial institutions and banks etc. The amount of interest payable for issuing debenture is considered to be the cost of
debenture or debt capital (Kd). Cost of debt capital is much cheaper than the cost of capital raised from other sources, because
interest paid on debt capital is tax deductible.
The cost of debenture is calculated in the following ways:
(i) When the debentures are issued and redeemable at par: K d = r (1 – t)
where Kd = Cost of debenture
r = Fixed interest rate
t = Tax rate
(ii) When the debentures are issued at a premium or discount but redeemable at par
Kd = I/NP (1 – t)
where, Kd = Cost of debenture
I = Annual interest payment
t = Tax rate
Np = Net proceeds from the issue of debenture.
(iii) When the debentures are redeemable at a premium or discount and are redeemable after ‘n’ period:
Kd = I(1-t)+1/N(Rv – NP) / ½ (RV – NP)
where Kd = Cost of debenture .
I = Annual interest payment
t = Tax rate
NP = Net proceeds from the issue of debentures
Ry = Redeemable value of debenture at the time of maturity

B. Cost of Preference Share Capital:

For preference shares, the dividend rate can be considered as its cost, since it is this amount which the company wants to pay
against the preference shares. Like debentures, the issue expenses or the discount/premium on issue/redemption are also to be
taken into account.
(i) The cost of preference shares (KP) = DP / NP
Where, DP = Preference dividend per share
NP = Net proceeds from the issue of preference shares.
(ii) If the preference shares are redeemable after a period of ‘n’, the cost of preference shares (K P) will be:

where NP = Net proceeds from the issue of preference shares

RV = Net amount required for redemption of preference shares
DP = Annual dividend amount.
There is no tax advantage for cost of preference shares, as its dividend is not allowed deduction from income for income tax
purposes. The students should note that both in the case of debt and preference shares, the cost of capital is computed with
reference to the obligations incurred and proceeds received. The net proceeds received must be taken into account while
computing cost of capital.

C. Cost of Equity or Ordinary Shares:

The funds required for a project may be raised by the issue of equity shares which are of permanent nature. These funds need
not be repayable during the lifetime of the organisation. Calculation of the cost of equity shares is complicated because,
unlike debt and preference shares, there is no fixed rate of interest or dividend payment.
Cost of equity share is calculated by considering the earnings of the company, market value of the shares, dividend per share
and the growth rate of dividend or earnings.
(i) Dividend/Price Ratio Method:
An investors buys equity shares of a particular company as he expects a certain return (i.e. dividend). The expected rate of
dividend per share on the current market price per share is the cost of equity share capital. Thus the cost of equity share
capital is computed on the basis of the present value of the expected future stream of dividends.
Thus, the cost of equity share capital (Ke) is measured by:
Ke = where D = Dividend per share
P = Current market price per share.
If dividends are expected to grow at a constant rate of ‘g’ then cost of equity share capital
(Ke) will be Ke = D/P + g.
This method is suitable for those entities where growth rate in dividend is relatively stable. But this method ignores the
capital appreciation in the value of shares. A company which declares a higher amount of dividend out of given quantum of
earnings will be placed at a premium as compared to a company which earns the same amount of profits but utilizes a major
part of it in financing its expansion programme.

(ii) Earnings/Price Ratio Method:

This method takes into consideration the earnings per share (EPS) and the market price of share. Thus, the cost of equity
share capital will be based upon the expected rate of earnings of a company. The argument is that each investor expects a
certain amount of earnings whether distributed or not, from the company in whose shares he invests.
If the earnings are not distributed as dividends, it is kept in the retained earnings and it causes future growth in the earnings of
the company as well as the increase in market price of the share.
Thus, the cost of equity capital (Ke) is measured by:
Ke = E/P where E = Current earnings per share
P = Market price per share.
If the future earnings per share will grow at a constant rate ‘g’ then cost of equity share capital (K e) will be
Ke = E/P+ g.
This method is similar to dividend/price method. But it ignores the factor of capital appreciation or depreciation in the market
value of shares. Adjustment of Floatation Cost There are costs of floating shares in market and include brokerage,
underwriting commission etc. paid to brokers, underwriters etc.
These costs are to be adjusted with the current market price of the share at the time of computing cost of equity share capital
since the full market value per share cannot be realised. So the market price per share will be adjusted by (1 – f) where ‘f’
stands for the rate of floatation cost.
Thus, using the Earnings growth model the cost of equity share capital will be:
Ke = E / P (1 – f) + g

D. Cost of Retained Earnings:

The profits retained by a company for using in the expansion of the business also entail cost. When earnings are retained in
the business, shareholders are forced to forego dividends. The dividends forgone by the equity shareholders are, in fact, an
opportunity cost. Thus retained earnings involve opportunity cost.
If earnings are not retained they are passed on to the equity shareholders who, in turn, invest the same in new equity shares
and earn a return on it. In such a case, the cost of retained earnings (Kr) would be adjusted by the personal tax rate and
applicable brokerage, commission etc. if any.

Many accountants consider the cost of retained earnings as the same as that of the cost of equity share capital. However, if the
cost of equity share capital i9 computed on the basis of dividend growth model (i.e., D/P + g), a separate cost of retained
earnings need not be computed since the cost of retained earnings is automatically included in the cost of equity share capital.
Therefore, Kr = Ke = D/P + g.

E. Overall or Weighted Average Cost of Capital:

A firm may procure long-term funds from various sources like equity share capital, preference share capital, debentures, term
loans, retained earnings etc. at different costs depending on the risk perceived by the investors.
When all these costs of different forms of long-term funds are weighted by their relative proportions to get overall cost of
capital it is termed as weighted average cost of capital. It is also known as composite cost of capital. While taking financial
decisions, the weighted or composite cost of capital is considered.
The weighted average cost of capital is used by an enterprise because of the following reasons:
 It is useful in taking capital budgeting/investment decisions.
 It recognises the various sources of finance from which the investment proposal derives its life-blood (i.e., finance).
 It indicates an optimum combination of various sources of finance for the enhancement of the market value of the
firm.
 It provides a basis for comparison among projects as a standard or cut-off rate.
I. Computation of Weighted Average Cost of Capital:
Computation of Weighted Average cost of capital is made in the following ways:
(i) The specific cost of each source of funds (i.e., cost of equity, preference shares, debts, retained earnings etc.) is to be
calculated.
(ii) Weights (i.e., proportion of each, source of fund in the capital structure) are to be computed and assigned to each type of
funds. This implies multiplication of each source of capital by appropriate weights.
Generally, the-following weights are assigned:
(a) Book values of various sources of funds
(b) Market values of various sources of capital
(c) Marginal book values of various sources of capital.
Book values of weights are based on the values reflected by the balance sheet of a concern, prepared under historical basis
and ignoring price level changes. Most of the financial analysts prefer to use market value as the weights to calculate the
weighted average cost of capital as it reflects the current cost of capital.
But the determination of market value involves some difficulties for which the measurement of cost of capital becomes very
difficult.
(iii) Add all the weighted component costs to obtain the firm’s weighted average cost of capital.
Therefore, weighted average cost of capital (Ko) is to be calculated by using the following formula:
Ko = K1w1 + K2w2 + …………
where K1, K2 ……….. are component costs and W1, W2 ………….. are weights.

SPECIFIC AND OVERALL COST OF CAPITAL

Specific Cost of Capital
The specific cost of capital refers to the cost associated with a particular source of finance or a specific component of the
firm's capital structure. Here are some common components and their specific costs:
1. Cost of Debt: This is the interest rate the company pays on its debt. It's usually the yield to maturity on the
company's bonds or the interest rate on its loans.
2. Cost of Preferred Stock: For companies that have preferred stock, the cost is the dividend rate on the preferred
stock.
3. Cost of Common Equity: This is the return required by the shareholders. It can be calculated using various methods
such as the Dividend Discount Model (for companies that pay dividends) or the Capital Asset Pricing Model
(CAPM).
Cost of Common Equity=Risk-Free Rate+(Beta×Market Risk Premium)Cost of Common Equity=Risk-
Free Rate+(Beta×Market Risk Premium)
Overall Cost of Capital
The overall cost of capital is the weighted average of the specific costs of each component of capital, weighted by its
proportion in the capital structure. The formula to calculate the overall cost of capital (WACC - Weighted Average Cost of
Capital) is:
Ko = K1w1 + K2w2 + …………
where K1, K2 ……….. are component costs and W1, W2 ………….. are weights.