Capital Budgeting

The investing decisions of a firm are called as capital

budgeting or capital investment decisions. These decisions
pertain to fixed or long term decisions which by definition
refer to assets which are n operation and yield a rate of
return over a definite period of time, normally exceeding a
year. Thus a capital budgeting decisions involves current
outflow of cash resources in consideration for a series of cash
inflows which are scattered in the future periods exceeding a
year. Capital Budgeting or Capital Investment Decisions can
be classified in the following categories:

• Decisions for expansion of assets

• Modernization / Replacement of Assets
• Choice between two alternative investment
decisions.

Capital Budgeting may be considered as a cost benefit

analysis. What we do is make a detailed project analysis of
cash outlays (incurred for undertaking a project) with the
cash inflows generated if such project is undertaken.
For eg: A Ltd. proposes to purchase a particular machine
work for Rs.1,00,000. The machine is likely to provide a
revenue of Rs.20,000, Rs.40,000 and Rs.50,000 at the end of
1st ,2nd & 3rd year respectively. In the above case Rs.1,00,000
is the project cash outflow. Likewise, Rs.20,000, Rs.40,000
and Rs.50,000 represent cash inflow.

We Speak only in terms of cash:

In evaluating a decision pertaining to acquisition,
modernization or replacement of assets, what we are
concerned is the actual cash that we spend and cash that we
earn over a period of time. It becomes necessary to state this
because we are not concerned with accounting profit or book
profit. What we are looking for is the actual cash spent and
actual cash generated from the capital investment decision.

Why there is a difference between Cash Profit and Accounting

Profit ?
The basic difference arises because while computing
accounting profit we take into consideration several non-cash
expenses like depreciation, amortisation of goodwill and the
likes. In cash flow approach we take into consideration only
cash income and cash expenses. An illustrative example is
provided below for better understanding.

Example:

A Ltd. intends to purchase a machine costing Rs.1,00,000.

The estimated revenues and operating expenses are provided
below for a period of 3 years:

Year Revenue Expenses Depreciation

1 Rs.60,00 Rs.10,00 Rs.30,000
0 0
2 Rs.50,00 Rs.10,00 Rs.30,000
0 0
3 Rs.60,00 Rs.15,00 Rs.30,000
0 0

At the end of 3rd year the machine can be sold for Rs.5,000.

Accounting Profit Year 1 Year 2 Year 3

Revenue Rs.60,000 Rs.50,000 Rs.60,000

(-) Expenses Rs.30,000 Rs.10,000 Rs.15,000
(-) Depreciation Rs.30,000 Rs.30,000 Rs.30,000
(-) Loss on sale of Rs. - Rs. - Rs. 5,000
machine
________ ________ ________
Accounting profit Rs.20,000 Rs.10,000
Rs.10,000

Total Accounting Profit: Rs. 40,000.

Purchase Price of the Asset: Rs1,00,000.

Considering this we would not go for the purchase of this

machine.

Cash Flow Approach Year 1 Year 2 Year 3

Revenue Rs.60,000 Rs.50,000 Rs.60,000

(-) Expenses Rs.10,000 Rs.10,000 Rs.15,000
________ ________ ________
Actual Cash Inflow Rs.50,000 Rs.40,000
Rs.45,000
(+) Sale of Machine Rs. 5,000
 ________ ________ ________
Actual Cash Inflow Rs.50,000 Rs.40,000 Rs.50,000

Total Cash Inflow Rs.1,40,000

Initial Cash Outflow Rs.1,00,000

Considering this we conclude that it is beneficial t go for the

purchase of the machine.
Thus under capital budgeting we always follow cash flow
approach.
Only Cash inflow and outflow specific to the rpoject:

When we consider cash inflows and outflows, they must be

specific to the capital asset, which is intended to be
purchased. Indirect cash expenses not specific to the project
will be ignored. Similarly any inflow not relevant to the
project would be ignored.

It is necessary to note that capital budgeting involves

blockage of money in a project for a long period of time. This
capital blocked has alternative uses and can be utilized for
any other revenue earning activity which would also yield a
consistent rate of return over a period of time. This concept
is known as opportunity cost of capital.

Similarly, we must note that while we undertake a capital

expenditure, cash outflows takes place at the beginning of
the project period while cash inflows may be at the end of
Year 1, Year 2, Year 3 etc. This gives rise to a new
phenomenon of “Time Value of Money”. As per this concept
value of money in hand today will not be the same if it is to
be received a year after.
An illustrative example is provided below:

X Ltd. decides to purchase an equipment of Rs.5,00,000. The

equipment could generate a revenue of Rs.5,50,000 at the
end of the year. If the expenditure was not undertaken then
the same could be deposited with the bank at 15%.

In the above case, 15% is as called as the “Opportunity Cost

of Capital”. It means that money has alternative uses and in
the given example means the revenue lost by making a
decision to invest in the equipment.
Similarly we notice that cash outflow takes place at the
beginning of the year but the inflow is received at the end of
the year.
In the above case, if we opt for capital expenditure, we
require Rs.5,00,000 to earn Rs.5,50,000 at the end of the
year. The worth of Rs.5,50,000 which we get at the end of the
first year will not be the same today. If we assume that we
invest the money in the bank, to earn Rs.5,50,000 we would
require Rs.5,50,000 * 100/115 that is Rs.4,78,261 today.
To put in simple words we can say that the present value of
Rs.5,50,000 which we are going to receive at the end of one
year is Rs.4,78,261.
We then compare the cost of equipment with the present
value of future cash flows. In the above case we can conclude
that it is not profitable to go for the capital expenditure.
Thus, in capital budgeting, the most important aspect we
need to analyze is that of present value of cash flows. The
present value of cash flows can be can be found by
discounting them with the opportunity cost of capital.

In the above example:

Present Value of Future Cash inflows : Rs.4,78,261

Cost of Equipment : Rs.5,00,000
_________

Net Present Value : (Rs.21,739)

Since net present value is negative, Project proposal should

be rejected.

Important Rule:

Where NPV is negative, Project must be rejected.

Where NPV is positive, Project must be accepted.
Where NPV is zero, we are indifferent in acceptance or
rejection.

Question Bank:

1. Project X costs Rs.2,500 and is expected to generate the

following cash flows at the end of year 1 – 5:

Year 1: Rs.900 , Year 2: Rs.800 , Year 3: Rs.700 , Year 4:

Rs.600 , Year 5: Rs.500. The opportunity cost of capital
may be assumed to 10%. Suggest whether to accept the
proposal or not.
(PV Year1 – 5: 0.9091, 0.8264, 0.7513, 0.683, 0.6209)
 2. Project Y requires an initial investment of es.10,00,000.
Th eprojected cash inflows at the end of Year 1 – 4 are

Year 1 : Rs.4,00,000 Year 2 : Rs.3,00,000

Year 3 : Rs.3,00,000 Year 4 : Rs.2,75,000
Depreciation is charged at 25% under SLM. Corporate
taxes may be taken at 40% and depreciation is admissible
expenses for tax purposes. The opportunity cost of capital is
10%. Find whether the project should be accepted. You are
informed that the terminal value of initial investment is
Rs.50,000 and there are no taxes on capital gains.
3. Swastik Ltd is a manufacturing concern and is
periodically assisted by visiting teams of consultants.
The management is worried about the steady increase
in the expenses in the recent years. An analysis of last
years expenses reveals the following:
__________________________________________________Consultants
Remuneration : Rs.2,50,000
Travel and conveyance : Rs.1,50,000
Accommodation Expenses : Rs.6,00,000
Boarding Charges : Rs.2,00,000
Special allowances : Rs. 50,000
__________
Total : Rs12,50,000

The management expects the accommodation expenses

to increase by Rs.2,00,000 annually. As a part of cost
reduction drive, Swastik Ltd. is proposing to construct a
consultancy center to take care of the accommodation
requirements of the consultants. This center will
additionally save Rs.50,000 in boarding charges and
Rs.2,00,000 in the cost of executive training programme
conducted outside the company’s premises.
The following details are available regarding the
construction and maintenance of the new center:
• Land : at a cost of Rs.8,00,000 already owned by
the company.
• Construction cost : Rs.15,00,000 including
furnishing.
• Cost of annual Maintenance : Rs.1,50,000.
• Construction cost will we written off (at a uniform
rate) over 5 years, being its useful life.
Assuming that the cost written off is accepted for tax
purposes, that the rate of tax will be 35% and the
desired rate of return is 15%, you are required to
 analyze the feasibility of the proposal and make
recommendations. Use net present value up to 2 digits.

4. A company is considering a new capital investment at a

cost of Rs.50,000. The expected life of the asset is 5
years and has no salvage value. The tax rate is 35% and
depreciation charged under SLM basis is allowed as
deduction for tax purposes. The estimated cash flows
before tax and depreciation are as follows:
Year1: Rs.10,000 Year2: Rs.10,692
Year3: Rs.12,769 Year4: Rs.13,462
Year4: Rs.20,385
5. The united petroleum Ltd. has a retail outlet of petrol,
diesel and petroleum products. Presently, it has 2
pumps exclusively for petrol, one for non-leaded petrol
and one for diesel. Free air filling is carried out for
vehicles buying petrol and diesel. The pumps have a
useful life of 10 years with no salvage value.
UPL sells petrol and diesel @ Rs.23 and Rs.10per litre
respectively. The existing annual sale for petrol is 5
lakhs and for diesel is 2 lakhs. Its earnings are
commission at 4% on sales.
Due to manifold increase in the traffic, the existing
pumps are not able to meet the demand during peak
hours. The UPL is contemplating installation of
additional pumps for diesel and petrol at a cost of
Rs.10,00,000 together with additional working capital of
Rs.5,00,000. The additional sales for petrol and diesel
are expected to be 2 lakhs and 1 lakhs per annum
respectively.
As a result of the installation of the new pump, the
operating costs would increase by Rs.24,000 annually by
way of salary to pump operator. Other yearly associated
additional cost are estimated to be:
Insurance 1% of cost of pumps, maintenance cost
Rs.12,000 and power costs Rs.13,000.
UPL pays 35% tax on its income. Depreciation is charged
on SLM basis which is allowed for tax purposes.
The management of UPL seeks your advice on the
financial viability of the expansion proposal. Prepare a
report for its consideration, assuming 12% required rate
of return.

6. A plastic manufacturer has under consideration the

proposal of production of high quality plastic glasses.
The necessary equipment to manufacture the glasses
 would cost Rs.1,00,000 and would last for 5 years. The
tax relevant rate for depreciation is 25% on written
down value. There is no other asset in this block. The
expected salvage value is Rs.10,000.The glasses can be
sold at Rs.4 each. Regardless the level of production the
manufacturer will incur cash expenditure of Rs.25,000
every year if the project is undertaken. The overhead
costs allocated to this new line would be Rs.5,000. The
variable costs are estimated to be Rs.2 per glass
produced. The sales for-cast is 75000 glasses per annum
and the tax rate is 35%. Should the proposed equipment
be purchased? Assume the cost of capital to be 20% and
that the additional working capital requirement is
Rs.50,000.

7. SCL Ltd. is engaged in the manufacture o power

intensive products. As a part of its diversification plans,
the company proposes to put up a windmill to generate
electricity. The details of the scheme are as follows:
• Cost of windmill is Rs.300 lakhs.
• Cost of Land is Rs.15 lakhs.
• Subsidy from the state government to be received
at the end of the first year of installation is Rs.15
lakhs.
• Cost of electricity of Rs.2.25 per unit in year1. This
will increase by Rs.0.25 per unit every year up to
Year7. After that, it will increase every year by
Rs.0.50 per year till year10.
• Maintenance cost will be Rs.4 lakhs per year and
the same will increase by Rs.2 lakhs every year.
• Estimated life is 10 years and cost of capital is
15%.
• Residual value is nil. However the value of the land
will go up to Rs.60 lakhs at the end of year 10.
• Depreciation will be 100% of the cost of the
windmill in the first year and the same is allowed
for tax purposes.
• As windmills are expected to work on the basis od
wind velocity, the efficiency is expected to be in an
average 30%. Gross electricity generated at this
level is 25 lakhs units per annum, 4% of which is
committed to the state electricity board as per the
agreement.
• Tax rate is 35%.
 Calculate the Net Present Value. Ignore tax on capital
gains.

8. Rohtas mills is analyzing to construct a pulp mill. The capital

budgeting department has developed the following data:
a. Building Acquisition at start of year1: Rs.3,00,000
b. Plant Construction at start of year2 : Rs.7,00,000
c. Equipment purchase at start of year3: Rs.10,00,000
d. Net working capital at start of year4: Rs.4,00,000
Operations will begin in year 4 and continue for 10 years till
year13. Sales revenues and operating costs are assumed to
come at the end of each year. The following assumptions are
made:
• The plant and equipment would be depreciated over 10
years from year4. The equipment would be worthless
after 10 years of use. The building would have a
residual value of Rs.3,00,000. The company uses SLM
basis for depreciation, which is allowed for tax
purposes.
• The cost of capital is 14% and the normal tax rate is
35%.
• Annual fixed operating cost excluding depreciation are
Rs.1,35,000 at full capacity.
• Annual variable cost are Rs.2,00,000.
Should the project be accepted? Use NPV analysis.
9. Senior Executives of Laxmi Rice Mills Ltd. have been
considering the proposal to replace the existing coal
fired furnace in the paddy boiling section by a new
furnace is cyclone type husk-fired furnace. The capital
cost of the new furnace is expected to be Rs.1 lakh. It
will have useful life of 10 years at the end of which
period its residual value will be negligible. The present
furnace has a book value of Rs.15,000 and can be used
for another 10 years with only minor repairs. If scrapped
now, it can fetch Rs.10,000 but cannot fetch anything if
scrapped after 10 further years of use.
The basic advantage of new furnace is that it does not
depend upon coal whose supplies are becoming
increasingly erratic in recent years. On a conservative
estimate, the new furnace will result in saving of
Rs.25,000 per annum on account of eliminated coal cost.
However, the cost of electricity and other operating
expenses is likely to go up by Rs.8,000 and Rs.4,000 per
annum respectively.
The husk which results as a by-product during normal
milling operations at 3000 metric ton of paddy milled
per year is considered adequate for operating the new
 furnace. On an average for every ton of paddy milled,
the husk content is 20%. At present, the husk resulting
during the milling operations is sold at a price of Rs.50
per metric ton. Once the new furnace is installed, the
husk will be diverted for own use. ‘White ash’ which
constitutes about 5% of the husk burnt in the new
furnace, will be collected in a separate ash-pit as it has
a considerable demand in the refractory industry. It can
be sold very easily at a price of Rs.1,500 per metric ton.
The new furnace will require a motor of 15HP, whose
cost is not included in Rs.1 lakh, the capital cost of the
furnace. A 15 HP motor is lying idle with the polishing
section of the Mill which can fetch Rs.3000 on sale. It
has a net book value of Rs.5,000. The motor can be used
for the new furnace. At the end of the ten years, it can
be scrapped at zero residual value.
All the assets of the company are in the same block.
Depreciation will be on a straight line basis and the
same is assumed to be acceptable for income tax
purposes. The tax rate applicable is 35% and the cost of
capital is 12%.
Recommend whether the project is acceptable or not.

10. Seshasayee Industries Ltd. is considering replacing a

hand operated weaving machine with a new fully automated
machine. Given the following information, advise the
management whether the machine should be replaced or not?
Assume that the company has only this machine in the 25%
block of assets and the block will cease to exist after the
useful life of the automated machine:

EXISTING MACHINE:

One full time operator’s salary : RS.36,000

Variable Overtime : Rs.3,000
Fringe Benefits : Rs.3,000
Cost of defects : Rs.3,000
Original price of hand operated machine : Rs.60,000
Expected Life : 10 years
Age : 5 years
Marginal rate of taxation : 35%
Required rate of return : 15%
 PROPOSED SITUATION:

Fully-automated operation, no operator required.

Cost of Machine : Rs.1,80,000
Transportation charges : Rs.3,000
Installation Charges : Rs.15,000
Expected Economic Life : 5 years
Annual Maintenance : Rs.3,000
Cost of Defects : Rs.3,000
Salvage Value after 5 years : Rs.20,000

In both the years the method of depreciation adopted was

written down value.

11. An existing company has a machine which has been

in operations for last two years and its estimated useful
remaining life is 4 years with no salvage value in the end.
Its current market value is RS.25,000. The management is
considering the proposal to purchase an improvement
model of the machine which gives improved output. The
relevant particulars are as follows:

Particulars Existin New

g Machine
Machin
e
Purchase Price (Rs.) 60,000 1,07,500
Estimated life (Years) 6 4
Salvage Value 0 0
Annual Operating Hours 1,000 1,000
Selling Price per Unit (Rs.) 3 3
Material per unit (Rs.) 0.40 0.40
Output per hour (units) 15 30
Labour Cost per hour (Rs.) 11 16
 Consumable Stores per year (Rs.) 2,000 1,000
Repairs & Maintenance per Year 3,000 2,000
(Rs.)
Working Capital (Rs.) 10,000 20,000
Income – Tax Rate 35% 35%

Should the existing machine be replaced? Assume that:

Required arte of return is 10%.
b.) The company uses written down value method of
depreciation @ 25% and it has several machines in the
25% block.

12. Nine Gems Ltd. has installed Machine-R at accost of

Rs.2,00,000. The machine has a five year life with no salvage
value. The annual volume of production is estimated at
1,50,000 units, which can be sold at Rs.6 per unit. Annual
operating costs are estimated at Rs.2,00,000 ( excluding
depreciation ) at this output level. Fixed costs are estimated
at Rs.3 per unit for the same level of production.
Nine Gems Ltd has just come across another model
called Machine-S capable of giving the same output at
an annual operating cost of Rs.1,80,000 (Exclusive of
Depreciation). There will be no change in fixed costs.
Capital costs of this machine is Rs.2,50,000 and the
estimated life is 5 years with no residual value.
The company has an offer for sale of Machine-R at
Rs.1,00,000. The cost of dismantling will be Rs.30,000.
As the company has not commenced its operations it
wants to sell Machine-R and Purchase Machine-S. Nine
Gems Ltd would be a zero tax company for 7 years. The
cost of capital would be 14%.
 a.) Advice the company whether or not to opt
for replacement.
b.) Will there be any change in your view if Machine-R
is not installed and that the company is in the
process of selecting one machine?

Internal Funds as a Source of Finance

Sources of Finance:

1. Equity Shares:
• Initial Issues
• Rights Issue

2. Debentures:
3. Term loans:
• Long term loans
• Working Capital Finance
4. Internal Funds

Internal Funds as a source of Finance:

This is also known in technical terms as Ploughing Back of
Profits.
Instead of distributing the profits earned, the company
reinvests the same in the future activities of the company.
The share holders earn by way of capital accretion.

Merits of ploughing back of profits:

To the company:

1. Economical (Best and Risk Less)

2. Increases the operating efficiency and productivity
3. Increases shareholder faith and confidence
4. enhances creditworthiness and ensures ease in external
financing
5. no financial risk of interest repayment
6. helps expansion and diversification where gestation
period is more.
7. freedom of decision making for the management and
lesser outside intervention
8. meets working capital needs in case of cash crunch.

To the shareholders:

1. Capital accretion due and high price of shares due to

huge reserves
2. regular dividend in the years of crisis
3. banks willing to accept these shares as securities

To the society:

1. Increases capital formation

2. development of industry and provides more job
opportunities due to continued expansion by the
company.
3. cost of product is less as the cost of production would
not include any interest cost and hence products can be
offered at a cheaper rate.

Demerits of ploughing back of profits:

 1. Chances of over-capitalization resulting in wastage of
capital
2. Use of profits to manipulate stock prices at the
exchanges
3. Inefficient use of the earnings by the company
4. Excessive speculation endangering the interest of the
small investors
5. more demands from the employees causing disputes
6. share holder want regular returns

Determinants of internal financing:

1. Total earnings of the company.

2. Taxation policies of the government
3. dividend policy
4. general industry trend
5. economic and social environment in the country

Equity Capital : As a Source of

Finance
Shares:
As per Section 2 Clause 46 of the Indian Companies Act, 1956,
SHARE “ means share in the share capital of the company and
includes staok except where a distinction between stock and
share is expressed or implied ”.

Basic Concepts:
1. Authorised Share Capital
2. Issued Share Capital
3. Subscribed Share Capital
4. Paid – up Share Capital
5. Par Value
6. Market Value
Advantages of Equity Share Capital for the Issuing Company:

1. More or less permanent source of finance

2. No obligation for repayment
3. No fixed commitment to pay dividend
4. Greater freedom for retention of profits in the business
5. Larger equity base means more stability
6. no charge on the assets of the company

Disadvantages of Equity Share Capital for the Issuing

Company:

1. higher cost of capital

2. higher issuing costs involved
3. chance of over-capitalsation

Advantages of Equity Share Capital for the Share holders:

1. Greater rewards for shareholders of stable and

profitable companies
2. equity holder are the ultimate owners and can control th
e management of the company
3. limited liability

Disadvantages of Equity Share Capital for the Share holders:

1. risk bearers
2. no assurance of returns
3. only residual claim in the winding up of the company
4. management controlled only by a few shareholders
having larger stock quantity
5. investment is subject to risk of prices changes in the
stock market prices

Buy Back of Equity Shares:

It is a tool for financial re-engineering of the company. It is a

procedure by which the company goes back to the share
holders and offers to purchase from them the shares which
they hold.
Relevant provision: Section 77A, 77AA, 77B of Companies Act,
1956.

Objectives:

1. Return surplus cash to shareholders as an alternative to

dividend payment or reinvesting.
2. restructuring the capital composition.
3. to increase EPS and NAV. To better the current market
price of the share by reducing the market supply
thereof.
4. to avoid hostile takeovers.

Positive aspects of buy back:

1. share holders have a choice whether to accept the

payout unlike the dividend.
2. company can return excess cash thus providing greater
flexibility in dividend policy.
3. helps the company to achieve a desired capital
structure.

Negative aspects of buyback:

1. fewer growth opportunities as cash resources are

exhausted
2. possible mismanagement may result in paying
exceptionally high price for the shares
3. less certain than annual payment of dividend

Pricing by companies issuing securities:

• A listed company whose equity shares are listed at a

stock exchange, may freely price its equity shares or
any other security which is convertible in to equity
shares at a later date, offered through a public or rights
issue.
• An unlisted company eligible to make a public issue and
desirous of getting its securities listed on a recognized
stock exchange pursuant to the public issue may freely
price its equity shares or any other security which is
convertible in to equity shares at a later date.
• An eligible infrastructure company shall be free to price
its equity shares subject to the compliance with the
 disclosure norms as specified by SEBI from timer to
time.
• The banks ( whether public or private sector ) may
freely price their issue of equity shares equity shares or
any other security which is convertible in to equity
shares at a later date subject to the approval of the
Reserve Bank of India.
• Any listed or unlisted company making a public issue of
equity shares equity shares or any other security which
is convertible in to equity shares at a later date, may
issue such securities to applicants under the firm
allotment category at a price different from the price at
which the net offer to the public has been made
provided that the price at which the security is being
offered to the applicants in firm allotment category is
higher than the price at which the securities are offered
to public.

Dividend Policy and rate of Retention

Determinants of Dividend Policy:

• Liquidity
• Investment Opportunities
• Access to other sources of Finance
• Floatation Costs
• Corporate Control diluted by issuance of further capital
hence retention preferred
 • Investor preference
• Tax
• Dividend Stability

Types of Dividend Policies:

• Constant Dividend Per share or dividend rate
• Constant payout
• Small constant dividend per share plus extra dividend
• Conservative dividend policy
• Stable dividend policy

Types of Dividend:
• Interim Dividend
• Final Dividend

Important ratios:
1. Earning per share
2. Price earning ratio
3. Dividend payout ratio
4. Dividend Yield ratio

Objectives of Financial
Management
• Proper Utilization of Funds
• Maximization of return on investment
• Cash Flow Management
 • Maximization of profits
• Maximising corporate wealth
• Maximizing Shareholder value
• Social acceptability and recognition
• Social wealth

Ratio determining return on investment:

• Return on investment:
ROI = Net Profit Before interest and tax
------------------------------------------ x 100
Proprietor’s funds+Borrowed Funds

• Return on proprietor’s funds:

Formula = Net profit after tax

----------------------- x 100
Proprietor’s funds

• Return on equity capital:

Formula = Post tax net profit – Pref. Dividend

----------------------------------------- x 100
Equity Share Capital

1. The comparative balance sheet and income statement of

Lotus Ltd. has been given below:

Balance sheet (in Crores)

1994 1995 1996 1997 1998

Share Capital 10.0 10.0 15.0 15.0 15.0

0 0 0 0 0
Reserves and surplus 6.50 10.5 9.10 10.6 11.2
 0 0 0
Secured Loans 12.7 13.5 13.2 13.1 14.3
5 0 5 0 0
Unsecured Loans 2.25 2.60 2.40 2.5 6.90
Current Liabilities 7.60 8.50 7.60 8.10 10.5
0
Fixed assets (net) 25.2 28.3 30.4 32.2 33.0
0 0 0 0 0
Investments 1.00 1.00 1.00 1.00 1.00
Other Current Assets 12.1 15.1 15.3 15.6 23.4
0 0 5 0 0
Debtors 6.10 6.90 7.35 7.90 12.8
0
Inventories 6.00 8.20 8.00 7.70 10.6
0
Misc. exps. and losses 0.80 0.70 0.60 0.50 0.50
Total 39.1 45.1 47.3 49.3 57.9
0 0 5 0 0

Income Statement: (in Crores)

1994 1995 1996 1997 1998

Net sales 47.5 54.2 60.5 62.3 70.10

0 0 0 0
Cost of goods sold 35.2 38.0 44.4 47.5 55.20
0 0 0
Gross profit 12.3 16.2 16.1 14.8 14.90
0 0 0 0
Operating expenses 3.50 4.10 4.40 4.90 5.60
Operating Profit 8.80 12.1 11.7 9.90 9.30
0 0
Non operating surplus / 0.40 0.70 0.90 0.60 (0.40
(deficit) )
EBIT 9.20 12.8 12.6 10.5 8.90
0 0 0
Interest 2.00 2.10 2.50 2.20 2.10
PBT 7.20 10.7 10.1 8.30 6.80
0 0
Tax 3.00 4.40 4.20 4.10 3.50
PAT 4.20 6.30 5.90 4.20 3.30
Dividend 2.00 2.30 2.30 2.70 2.70
Retained Earnings 2.20 4.00 3.60 14.5 0.60
0
Prepare the Du-pont chart for the year 1998.

2. The comparative balance sheet and income statement of

Lotus Ltd. has been given below:

Balance sheet (in Crores)

1995 1996 1997 1998 1999

Share Capital 4.30 4.30 6.50 6.50 6.50

Reserves and surplus 4.70 6.70 5.70 7.40 9.30
Long term debt 3.60 3.10 2.30 5.20 3.80
Short term bank 6.50 5.20 5.60 8.30 11.70
borrowing
Current liabilities 2.50 3.20 7.50 6.60 6.70
Total 21.3 22.5 27.6 34.0 38.00
0 0 0 0

Net Fixed assets 10.8 11.9 14.8 19.6 23.20

0 0 0 0
Cash and bank balances 1.20 2.60 0.70 0.60 1.10
Account Receivables 3.10 1.80 2.80 2.90 2.00
Inventories 5.10 4.60 6.20 8.20 9.30
Other current assets 1.10 1.60 3.10 2.70 2.40
Total 21.3 22.5 27.6 34.0 38.00
0 0 0 0

Income statement (in Crores)

1995 1996 1997 1998 1999

Net sales 29.8 34.9 34.6 39.0 57.40

0 0 0 0
Cost of Goods sold 24.5 26.2 26.0 30.5 45.80
0 0 0 0
Gross Profit 5.30 8.70 8.60 8.50 11.60
Operating Expenses 3.70 4.20 4.60 4.90 7.00
Operating Profit 1.60 4.50 4.00 3.60 4.60
Non operating profit / 0.20 0.10 0.20 0.50 0.40
(loss)
EBIT 1.80 4.60 4.20 4.10 5.00
Interest 1.00 0.90 0.80 1.50 2.00
PBT 0.80 3.50 3.40 2.60 3.00
 Tax - 0.60 1.20 - -
PAT 0.80 2.90 2.20 2.60 3.00
Dividend 0.60 0.60 0.90 0.90 1.10
Retained earnings 0.20 2.30 1.30 1.50 1.90

Prepare Du-pont chart for 1999.

Term Loans and Project Appraisal

Types of term loans:

• Short Term Loan: Repayable in 36 months

• Medium Term Loan: Repayable within 72 months
• Long Term Loan: Repayable in more than 72 months

Basic features of Long Term Loans:

1. Maturity period generally 6 to 10 years.

2. Direct Negotiation between the customer and the
financial institution.
3. Formal agreement between the 2 parties.
4. The loans are generally secured specifically by the
assets acquired, by using the said term loans. The loans
may also be secured further by company’s current
assets. This is called as collateral security.
5. Restrictive covenants:
Asset related covenants:
• Borrowing company must maintain minimum asset
base.
• Minimum current ration to be maintained.
• Not to sell fixed assets without lenders approval.
• Refrain from creating any other charge on the
assets.

Liability related covenants:

• Restrain from incurring any other debt.
• Repay existing loans.
• Reduce its debt equity ratio by issuing additional
equity capital.
• Limit the freedom of the promoters by restricting
their freedom to dispose off their holdings.
 Cash-flow related covenants:
• Restrict cash dividends.
• Restrict capital budgeting decisions.
• Restrict salaries and perks to managerial staff.

Control based covenants:

• Broad based board of directors.
• Appointment of nominee directors by the financial
institutions.

6. Option to convert a part of the loan in to

rupee loan.
7. Repayment schedule
8. Interest

Procedure for term loans:

• Submission of loan paper by giving comprehensive
information about the project.
• Initial processing of the loan proposal and preparation
of flash report.
• Appraisal of the proposed project.
• Financial letter of sanction.
• Acceptance of the terms and condition by the board of
directors of the borrowing unit at their meeting and
passing the resolution and conveying the acceptance
within the stipulated period of time.
• Execution of the loan agreement.
• Disbursement of the loans from time to time as per the
progress of the project.
• Creation of security by a first charge on the immovable
properties and hypothecation of movable properties.
• Monitoring the repayment of installments and recovery
of interest at regular intervals.

Type of finance Cost Dilution of Risk Restriction on

control managerial
freedom
Equity finance High Yes Nil No
Retained High No Nil No
earnings
Preference High No Less No
Capital
Debenture Low No High Some
Capital
Term Loans Low No High Moderate

Areas of Project Appraisal:

1. Market Appraisal:
• Examine the reasonableness of demand projections
by using various market survey reports.
• Access the adequacy of marketing infrastructure in
terms of promotional efforts, distribution network,
transport facility, stock levels etc.
• Judge the skill knowledge, skill and competency of
marketing personnel.

2. Technical Appraisal:
• Product mix
• Capacity
• Process of manufacturing
• Engineering know how and technical
projections
• Raw materials and consumables
• Site and location
• Building
• Plant and equipment
• Manpower requirements
• Break-even point

3. Financial Appraisal:
• Reasonableness of the estimates of the capital
costs to ensure that under estimation of costs is avoided,
specification of machinery is proper, proper quotes are
obtained from suppliers, contingencies are provided and
inflation factors are considered.
• Reasonableness of the estimate of working results
based on a realistic market demand forecast, price
quotations for inputs and output are based on the current
rates and inflationary conditions, appropriate time
schedule for capacity utilization, and that bifurcation has
been made in the fixed and he variable costs.
• General norms for the financial desirability in
terms of various ratios like the debt equity ratio, internal
 rate of return o investment, return on investment, debt
service coverage ratio, etc.
• Promoters contribution in the project cost and the
stock exchange requirement in regard to the same.

4. Economic Appraisal:
• Social cost benefit analysis

5. Managerial Appraisal:
• Prior experience of the promoters, their success in
organizing various aspects of the project, skill with
which the project was presented.
• Credibility of the project plan including the
organization structure, the estimated cost, financing
pattern, assessment of various inputs and the
marketing program, etc.

Q.No.1 The following data is made available regarding Jay

textiles Ltd:
1. The company was incorporated in 1982 with
the promoters having an experience of more than 35
years in textile field and is a brand leader in micro
yarn.
2. The company intends to borrow a term loan
under Technology Up-gradation Fund Scheme.
3. The present installed capacity is 10
machines or 6000 TPA or polyester yarn.
4. The additional investment would increase
the capacity by 3600 TPA.
5. The present and the proposed set up is at
Silvassa a backward area and enjoys income tax
holiday fro 5 years. The corporate taxes are 40%.
6. GIIC, GSFC and SBI financed the present
unit. All the accounts are regular.
7. The project will lead to economies of scale,
reduced cost of production, higher production due
to yarn speed being faster. Due to the latest
generation machine, best quality would be
maintained.
8. The expected ROI of the project is 18%.
 9. Depreciation for the project is 400 Lacs per
year.
10. The cost and the means of finance for the
proposed project are as follows:
Proposed Project Rs. In
lacs
Cost of Project
Land and site development 27
Factory Building 155
Plant and Machinery 1,604
Electrical Installations 24
Misc. Fixed Assets 10
Pre-operative expenses 20
Contingencies 67
Margin money for working capital 93
Total 2,000
Means of Finance
Promoters Funds / Additional Equity Funds 300
Internal Cash Accrual 500
Term Loans 1,200
Total 2,000

11.The term lending institution has interest rate of

13% for similar risk project and the loan is repayable
in 5 years with interest and installment repayable at
the end of each year.

The general manager of the financial institution has

requested you to:
• Prepare a flash report from the point of view of the
term lending institution.
• Evaluate the project for profitability in the next 5
years.
• Calculate the debt service coverage ratio for the
term loans.

Solution:

Jay Textiles Ltd.

Incorporated in 1982
Set Up : at Silvassa
Term Loan Under Technology Upgradation Fund Scheme:
Rs.1200 lacs
Capacity : 6,000 TPA + 3,600 TPA = 9,600 TPA of Polyester
Yarn
Strengths: Weakness:
1. Promoters having an experience of more than
35 years in the textile field.
2. Brand Leader in micro yarn
3. Higher production due to higher speed due to
use latest technology
4. Best quality due to modernized machine
5. 40% of the funds can be arranged internally
and only 60% is required as borrowings in the
form of term loan.
6. Economies of Scale : Reduced cost of
production.
Opportunities: Threats:
1. Set-up in backward areas
2. Income tax holidays for 5 years.

Investments : Rs.1,200 lacs

Expected ROI at 18% : Rs.360 lacs
Depreciation for 5 years : Rs.400 lacs (life 5 years)
Term Loan : Rs.1,200 lacs @ 13%

Year Principal + Interest = Repayme

nt
1 240 + 156 = 396.0
2 240 + 124.8 = 364.8
3 240 + 93.6 = 333.6
4 240 + 62.4 = 302.4
5 240 + 31.2 = 371.2

1,200 + 468 = 1,668.0

1 2 3 4 5 Total
Calculation of
interest:
O/s loan at begin 1,200 960 720 480 240 N.A.
Less: yearly 240 240 240 240 240 1,200
repay. 960 720 480 240 0 N.A.
O/s loan at end 156 124.8 93.6 62.4 31.2 468
Interest at 13%

Calculation of
Profits:
PBIT 360 360 360 360 360 1,800
Less: Interest 156 124.8 93.6 62.4 31.2 468
PBT 204 235.2 266.4 297.6 328.8 1332
Less: Tax 0 0 0 0 0 0
PAT 204 235.2 266.4 297.6 328.8 1332

Calculation of
DSCR
PAT 204 235.2 266.4 297.6 328.8 1332
Add: 400 400 400 400 400 2000
Depreciation
Add: Interest 156 124.8 93.6 62.4 31.2 468
Funds Available
for repayment 760 760 760 760 760 3800
(A)
REPAYMENTS:
Loan repaid 240 240 240 240 240 1200
Interest repaid 156 124.8 93.6 62.4 31.2 468
Total int + loan
repaid (B) 396 364.8 333.6 302.4 271.2 1668
DSCR (A/B) 1.90 2.08 2.28 2.51 2.80 2.28

Capital Budgeting (Additional Problems)

Q.No.1) M/s Onward Technologies has short listed two

projects A and B for final consideration. It has to undertake
only one from the two and not both. The investment required
for the project A is Rs.190 lakhs while that fro Project B is
Rs.400 lakhs. The other details related to the project are as
below:

Project A:
Year Depreciatio Profit before Profit after tax
n tax
I 24 78 56
II 20 82 60
III 16 100 74

Project B:
Year Depreciatio Profit before Profit after tax
n tax
 I 78 104 82
II 64 118 92
III 54 260 186

The cost of capital to the company is 14% and the present

value of Re.1 at the end of first, second and third year @14%
rate is 0.8772, 0.7695 and 0.6750 respectively. Using the NPV
analysis recommend which project is to accepted.

Q.No.2) The total available budget for the company is

Rs.20lakhs. The following projects have been ranked as per
their profitability:
Projec Cost (Rs. In Profitability
t Lakhs) Index
M 6 1.50
N 5 1.25
O 7 1.20
P 2 1.15
Q 5 1.10
R 13 1.40

Calculate:
i.) Total Cash inflow from each of the
project.
ii.) Net Present Value of each project
iii.) Which projects must be undertaken by
the company in order to maximize the Net
Present Value under Capital Rationing assuming
that each project is indivisible?

Q.No.3) Modern Electronics Ltd. wants to take up a new

project for manufacture of electronic device, which has good
market. Further details are given below:
Cost of Project:
Land : Rs. 2.00 lakhs
Buildings : Rs. 3.00 lakhs
Machinery : Rs.10.00 lakhs
Working Capital : Rs. 5.00 lakhs
The project would go in to production immediately and would
be operational for 5 years.
The annual working results are as follows:
Sales : Rs.20.00 lakhs
Less : Variable Costs : Rs. 8.00 lakhs
Fixed Cash Costs : Rs. 4.00 lakhs
Depreciation : Rs. 2.00 lakhs
At he end of the 5 years the fixed asset are expected to be
sold at a Profit of Rs.5 lakhs. There are no taxes on capital
gains. The cost of capital to the firm is 10% and the corporate
taxes are 40%. You are required to evaluate the proposal
using the NPV analysis and then list down 5 factors that
should be consider before taking the decision.
The present value of annuity of Re.1 at10% at the end of 5
years is Rs.3.79 and the present value of Re.1 at 10% for year
5 is Re.0.621.

Q.No.4) A product is currently manufactured on a machine that

has a book value Rs.30,000. The machine was originally purchased
for Rs.60,000 ten years ago. The per unit cost of product are:
Direct Labour Rs.8, Direct Materials Rs.10, Variable overheads
Rs.5, fixed overheads Rs.5, and the total cost is Rs.28. In the past
year 6,000 units were produced and were sold for Rs.50 per unit. It
is expected that the old machine can be used ten years in the
future. An equipment manufacturer has offered to accept the old
machine at Rs.20,000 and trade in for a new version of the
machine. The purchase price of the new machine is Rs.1,00,000.
The projected per unit cost associated with the new machine are:
Direct labour Rs.4, direct materials Rs.7, Variable overheads Rs.4,
Fixed Overheads Rs.7 and total cost Rs.22. The management also
expects that if the new machine is purchased, the new working
capital requirement would be less by Rs.10,000. The fixed
overheads include depreciation on equipment. The new machine
has an expected life of ten years with no salvage value. The
company follows straight line method for charging depreciation. It
is also expected that future demand for the product is gong to
remain constant at 6,000 units. Should the machine be acquired?
Present Value of annuity of Re.1 at 10% discount rate for 9 years is
5.759 and the Present Value of Re.1 at 10% discount rate received
at the end of the 10th year is 0.386.