506: Strategic Financial Management

Chapter 3: Long Term Strategic Financial Decision

T.Y.B.B.A. (Semester – V)

Sr.No. Content Page No.

1 Investment Decision Process

2 Cost of Project 1

3 Means of Financing 2

4 Risk Evaluation in Capital Budgeting 4

5 Risk Analysis in Project Selection 4

6 Techniques and models in taking decisions under risk and 5

uncertainty

2. Cost of Project

When a company or a promoter intends to set up a new project or undertaking expansion,

diversification, modernization, it is necessary to ascertain the scheme of project i.e. cost of
project and means of finance.

Cost of project is the aggregate of costs estimated to be incurred on various heads for
bringing the project into existence. Establishing cost of project constitutes critical steps in
project planning, on the basis of which means of finance is worked out.

The cost of the project can be broadly classified into the following:

i) Land and Site Development –

It includes the cost of the land, premium payable on leasehold land, cost of levelling the site
and other site development expenses, cost of internal roads, cost of fencing and compound
wall and cost of providing gates etc.

ii) Buildings and Civil Works –

It includes construction cost of main factory building, building for supporting services,
factory administrative building, storehouse, workshops, godowns, warehouses, open yard
facilities, canteen, workers rest rooms, sanitary works, staff quarters etc

iii) Plant and Machinery-

It includes the cost of main plant and machinery, stores and spares, foundation cost, cost of
manufacture and commissioning.
iv) Technical know-how and Engineering Fees –
It includes fees payable to provide the technology, auxiliary equipment, transportation cost,
installation and know-how and travelling expenses payable to technicians and foreign
collaborators etc.

v) Miscellaneous Fixed Assets –

It includes the cost of office furniture and equipment like tables, chairs, air conditioners,
water coolers, miscellaneous stores items etc.

vi) Preliminary and Pre-operative Expenses –

The preliminary expenses include the cost of raising finances like public issue expenses,
commission and fees payable to brokers and consultants in raising term loans, expenses
incurred for incorporation of the company, legal charges, underwriters’ commissions, cost
of advertising the public issue etc. The pre-operative expenses include salaries,
establishment expenses, rent and other miscellaneous expenses incurred before the
commercial production.

vii) Provision for Contingencies–

It includes the provision for meeting the unforeseen expenses and costs not provided in the
other heads of the cost of the project.

viii) Working Capital Margin-

The working capital margin required for the project, which is not being financed by the
banks, will also be included in the cost of project.

3. Means of Financing

There is no ideal pattern concerning means of financing for a project The means of financing
is determined by a variety of factors and considerations like amount of funds required, risk
associated with the enterprise, nature of industry, prevailing taxation, laws, etc.

The following are the sources of finance:

1) Share capital
2) Term Loan
3) Debenture capital
4) Lease Financing
5) Unsecured Loans
6) Public Deposits
7) Deferred Credit
8) Incentive Sources

1) Share Capital:
It is the capital raised by a company by issue of shares. It may take two forms:

a) Equity Share Capital:

It refers to the shares held by the owner of the business. They enjoy the rewards and bear
the risks of ownership of the business. Equity share holders have a voting right but they are
paid dividend only after paying dividend to preference shareholders. Dividend on equity
shares depends upon the amount of profits and financing position of business.

b) Preference Share Capital:

It refers to the shares held by the investors who are not owners of the business. Preference
shareholders do not have any voting rights but they receive dividend at a fixed rate and
before equity shareholders.

2) Term Loan:
Term loans are provided by financial institutions and commercial banks. They represent
secured borrowings for financing new project as well as expansion, modernization and
renovation schemes. They can be of two types:
a) Rupee Term Loans:
They are given for financing land, building, plant and machinery etc.
b) Foreign Currency Term Loan:
They are given to meet foreign currency expenses towards import of machinery, equipment
and technology.

3) Debenture Capital:
Debenture capital is an instrument for raising debt capital. It may be of two types i.e.
Convertible and Non-convertible.
a) Convertible Debentures are convertible, wholly or partly into equity shares after a fixed
period of time.
b) Non-convertible Debentures are straight debt instrument carrying a fixed rate and have a
maturity period of 5 – 9 years. If interest is accumulated, it has to be paid by the company
by liquidation of its assets. It is an economic method of raising fund. Debenture holders do
not have any voting rights and there is no dilution of ownership.

4) Lease Financing:
It is a contract in which the owner of the asset (lessor) gives right to use an asset to the user
(lessee) for an agreed period of time in return of consideration in form of periodic payments
called lease rentals. It is used for expansion projects, since repayment can be done
immediately through cash generated from existing facilities. It is a popular method of
project financing for large machinery, airplane, ship etc.

5) Unsecured Loans:
In case of shortage of funds, the promoter of the business may mobilize funds from family,
friend and relatives in form of unsecured loans to meet such shortage. Lenders may or may
not receive any interest on the amount lend and have no control management and decision
making. In this method of project financing, the borrower does not have to keep any
collateral for the loan therefore unsecured loans are perceived as less risky.

6) Public Deposits:
It refers to funds mobilized from the public and shareholders. These deposits can be taken
for a minimum period of 6 months and maximum period of 36 months. The government of
India has fixed the maximum amount of deposit at 25% of the paid up share capital and free
resources of the company. Only a public limited company is allowed to accept deposits from
the public and a private company cannot do so, however private companies can raise
deposits up to 25% of the share capital from friends, family and relatives.
7) Deferred Credit:
At times suppliers of plant and machinery offer a deferred payment facility under which
payment of plant and machinery can be made after a certain period of time a agreed upon
by the buyer and seller at the time of purchase. In order to get deferred credit, a person has
to furnish bank guarantee and may even have to mortgage certain assets.

8) Incentive Sources:
The government and its agencies may provide financial support inventive to certain types of
promoters for setting up industrial units in certain location. It may take form of:
a) Seed Capital assistance – provided at a nominal rate of interest to enable the promoter
to meet his contribution to the project.
b) Capital Subsidy – to attract industries to certain locations.
c) Tax Deferment or Exemption – particularly from sales tax.

4. Risk Evaluation in Capital Budgeting

Total risk of a company can be broken-down into business risk and financial risk.

1) Business Risk:
A company’s business risk is determined by how it invest its funds i.e., the type of projects
which it undertakes. A company’s competitive position, the industries in which it operates,
the company’s market share, the rate of growth of the market etc all influence business risk.
Business risk measures the variability in operating profits (Earnings Before Interest and
Taxes) due to change in sales. Business risk is the risk to the firm of being unable to cover
fixed operating costs.

2) Financial Risk:
Financial risk is the potential losses incurred by an investor when investing in a business that
uses borrowed money. When a firm uses a large amount of debt, it incurs a significant
interest expenses and obligation to repay principal that makes it more likely to have
financial difficulties if its cash flows declines.
Financial risk is the risk of being unable to cover required financial obligations such as
interest and preference dividends.

5. Risk Analysis in Project Selection

The acceptability of projects depends upon cashflows and risk.

Cashflow is operational cash receipts less operational cash expenditure and investment
outlay.
Risk must be taken into account when estimating the required rate of return on a project.
Risk relates to volatility of the expected outcomes, the dispersion or spread of likely returns
around the expected return. Investors do not like risk and the greater the riskiness of
returns on a project, the greater the return they will require. There is a trade-off between
risk and return which must be reflected in the discount rate applied to investment
opportunities.
Figure shows the risk-return relationship of seven projects:

The best available project is number 2, it is a high return and low risk project and presents
the most and desirable combination of these characteristics.
The least desirable project is number 1, which has a low return and high risk project.
Investment number 3 will always be preferred to investment number 4, because it has
higher return for the same level of risk.
The highest risk project is number 7, but it also has high expectation return.
The project 6 is a zero risk investment with a certain outcome. Such an investment might be
a short dated Government security, where the exact interest rate is known in advance.
If it is assumed that the line joining projects 6,3 and 7 represents the trade-off between risk
and return in the real world. These three projects can be examined further, since these
three projects are on the risk-return line.

6. Techniques and Models in taking decision under Risk and Uncertainty

 Meaning of Risk and Uncertainty

Risk refers to a situation where probability distribution of the cash flow of an investment
proposal is known.
On the other hand, if no information is available to formulate a probability distribution of
the cash flow, the situation is known as uncertainty.

Example:
Expansion of operation allows a decision maker to assign probability to various outcomes
due to some historical data is risk. But in case of diversification or entering into a new
business may not allow to assign probability to the various outcome due to lack of historical
data is an uncertainty.
 Techniques:
1) Sensitivity Analysis
2) Probability Distribution Method
3) Standard Deviation and Coefficient of Variation
4) Decision Tree Approach
5) Risk Adjusted Discounted Rate (RADR) Method
6) Certainty Equivalent (CE) Method

1. Sensitivity Analysis

Sensitivity Analysis is a technique of analyzing the impact of change in each of different

underlying variables such as cash inflows, cash outflows, project life, cost of capital etc on
the project’s NPV (Net Present Value). Sensitivity analysis provides information as to how
sensitive the estimated project parameters, namely, the expected cash flow, the discount
rate and the project life are to estimation errors. The analysis on these lines is important as
the future is always uncertain and there will always be estimation errors. Sensitivity analysis
takes care of estimation errors by using a number of possible outcomes in evaluating a
project. The method adopted under sensitivity analysis is to evaluate a project using a
number of estimated cash flows to provide to the decision maker an insight into the
variability of the outcomes.

The decision makers, while performing the sensitivity analysis, compute the project NPV for
each forecast under three assumptions:
a) Pessimistic (i.e. the worst)
b) Expected and (i.e. most likely)
c) Optimistic (i.e. the best).

Sensitivity analysis answers the question like:

i) What will happen to NPV if cash flows are less than expected?
ii) What will happen to NPV if cash outflows are more than expected?
iii) What will happen to NPV if the project life is less than expected?
iv) What will happen to NPV if discount rate is more than expected?
Hence, whatever there is uncertainty, of whatever type, the sensitivity analysis plays a
crucial role.

Steps:
Sensitivity analysis involves the following three steps:
1. Identification of all those variables having influence on the project's NPV.
2. Definition of the underlying quantitative relationship among the variables.
3. Analysis of the impact of the changes in each of the variables on the NPV of the project.

Merits:
1. It assesses risk in capital budgeting decisions.
2. It shows how different variables are sensitive to NPV and it helps in identifying the
critical variables. After knowing the critical variables, the decision maker can explore the
possibility of how the variability of these critical variables may be controlled.
Demerits:
1. It considers only one variable at time and other variables are kept constant.
2. It does not consider the probability associated with occurrence of different value of
variables.
3. It is not a risk reducing technique.

Format for calculation of NPV in case of Sensitive Analysis

Particulars Years

1 2 3 4
Sales xxx xxx xxx xxx
Less: Variable Cost xxx xxx xxx xxx
Contribution xxx xxx xxx xxx
Less: Fixed Cost xxx xxx xxx xxx
Earning Before Depreciation and Tax (EBDT) xxx xxx xxx xxx
Less: Depreciation xxx xxx xxx xxx
Earning Before Tax (EBT) xxx xxx xxx xxx
Less: Tax xxx xxx xxx xxx
Earning After Tax (EAT) xxx xxx xxx xxx
Plus: Depreciation xxx xxx xxx xxx
Cash Flow After Tax (CFAT) xxx xxx xxx xxx
Plus: Working Capital --- --- --- xxx
Plus: Salvage Value --- --- --- xxx
Cash Flow After Tax (CFAT) xxx xxx xxx xxx
X Present Value Factor (PVF) xxx xxx xxx xxx
Present Value of Cash Flow xxx xxx xxx xxx
Total of Present Value of Cash Flow --- --- --- xxx
Less: Initial Investment --- --- --- xxx
NPV --- --- --- xxx

2. Probability Distribution Approach:

The probability distribution of cash flows over time provides valuable information about the
expected value of return and the dispersion of the probability distribution of possible
returns. On the basis of this information an accept-reject decision can be taken.
The application of probability distribution theory in analyzing risk in capital budgeting
depends upon the behaviour of the cash flows i.e. Independent or Dependent.
The assumption that cash flows are independent over time signifies that future cash flows
are not affected by the cash flows in the preceding or following years. Thus, cash flows in
year 3 are not dependent on cash flows in year 2 and so on. When cash flow in one period
depends upon the cash flow in previous periods, they are referred to as dependent cash
flows.

Merits:
1. It helps in determining the probability of project that whether it provides a net present
value of less than or more than the specified amount.
2. It provides a quantifiable measure of risk.
Demerits:
1. It involves lot of estimation since probabilities for cash flows are estimated for each year
comprised in project.
2. There are lots of tedious calculations involved in it.

3. Standard Deviation and Coefficient of Variation:

In statistical terms, standard deviation is defined as the square root of the mean of the
squared deviation, where deviation is the difference between an outcome and the expected
mean value of all outcomes. Further, to calculate the value of standard deviation, we
provide weights to the square of each deviation by its probability of occurrence.

4. Decision Tree Approach:

The Decision-tree Approach (DT) is another useful alternative for evaluating risky
investment proposals. The outstanding feature of this method is that it takes into account
the impact of all probabilistic estimates of potential outcomes. In other words, every
possible outcome is weighed in probabilistic terms and then evaluated. The DT approach is
especially useful for situations in which decisions at one point of time also affect the
decisions of the firm at some later date. Another useful application of the DT indicates the
approach is for projects which require decisions to be made in sequential parts.

A decision tree is a pictorial representation in tree form which indicates the magnitude,
probability and inter-relationship of all possible outcomes. The format of the exercise of the
investment decision has an appearance of a tree with branches and, therefore, this method
is referred to as the decision-tree method. A decision tree shows the sequential cash flows
and the NPV of the proposed project under different circumstances.

Steps:
1. Calculate joint probability of various alternatives.
2. Calculate NPV of project for each alternative.
3. Calculate expected NPV by multiplying the NPV of each alternative with their
corresponding joint probability.
4. Calculate Standard Deviation.
5. Calculate Co-efficient of Variation.

Merits:
1. It helps in visualizing the different alternative in more graphical presentation.
2. It provides lot of information to decision maker in easily understandable form.

Demerit:
1. This method requires lot of information thus this method becomes very complicated.
Note: In decision tree approach, risk-free rate of interest is used for discounting the cash
flow.

5) Risk Adjusted Discount Rate (RADR) Method:

RADR approach is one of the risk analysis techniques under which risk is incorporated by
discounting the risky cash flows at risk adjusted discount rate. It incorporates the risk by
varying the discount rate depending on the degree of risk of project. Thus, high discount
rates are used for more risky projects and lower discount rates are used for less risky
projects.
Risk Adjusted Discount Rate (RADR) is a sum of Risk Free Rate and Risk Premium Rate
reflecting the investor’s attitude towards risk.
RADR = Risk Free Rate + Risk Premium.
Risk Free Rate is the rate of return on risk-free security. The risk free security is the security
which has no risk of default, example, Government Bonds.
Risk premium is the premium for systematic risk. Systematic risk is the risk which cannot be
eliminated through investing in well-diversified market portfolio; it is also known as market
risk or non-diversifiable risk and measured as Beta (β).
Steps to calculate NPV using RADR Approach:
1) Calculate risk adjusted discount rate. i.e. RADR = Risk free rate + Risk premium.
2) Calculate all the risky cash inflows and cash outflows associated with the project.
3) Calculate NPV using risk adjusted discount rate.

Format:

Year Inflow PV Factor Present Value

1 xxx xxx xxx
2 xxx xxx xxx
3 xxx xxx xxx
Total of PV xxx
Less: Investment xxx
NPV xxx

Accept / Reject Rule:

NPV > 0 = Accept
NPV < 0 = Reject
NPV = 0 = May or may not be accepted.

Merits:
1) It is simple to calculate and easy to understand.
2) It considers time value of money.
3) It incorporates risk by adding risk premium to risk free rate.

Demerits:
1) Determination of risk adjusted discount rate (RADR) is difficult task.
2) It does not adjust the cash flows.
3) Use of discount rate for different projects or for same project over different years
involves subjectivity.

6) Certainty – Equivalent (CE) Approach:

CE approach is one of the risk analysis techniques under which risk is incorporated by
discounting the riskless cash flows at risk free rate. It incorporates the risk by converting the
risky (or uncertain) cash flows into riskless (or certain) cash flows.
Riskless Cash Flows = Risky cash flows X Certainty equivalent co-efficient
Certainty – Equivalent Co-efficient = Riskless Cash Flows / Risky Cash Flow

Steps to calculate NPV using CE Approach:

1) Calculate certain cash flows. i.e. certain cashflows = Risky cash flow x CE co-efficient.
2) Calculate NPV of certain cash flow using risk free discount rate.
Format:

Year CFAT CE Factor Adjusted CFAT Present Value Present

(or) Riskless cash Factor Value of
flow (Riskfree rate) Inflow
1
2
3
Total of PV
Less: Investment
NPV

Accept / Reject Rule:

NPV > 0 = Accept
NPV < 0 = Reject
NPV = 0 = May or may not be accepted.

Merits:
1) It is simple to calculate and easy to understand.
2) It considers time value of money.
3) It incorporates risk by converting risky cash flow into riskless cash flow.
4) Certainty equivalent co-efficient may be different for different years.

Demerits:
1) Determination of certainty equivalent co-efficient is difficult task.
2) Determination of certainty equivalent co-efficient involves subjectivity.

Distinction between Risk Adjusted Discount Rate (RADR) and Certainty-Equivalent (CE)
Approach

Points RADR CE Approach

Incorporation of Risk It incorporates risk by adjusting
discount rate.
Discount Rate It uses risk adjusted discount rate
for discounting cash flow.
Cash Flows It uses risky cash flows.
It incorporates risk by
adjusting cash flows.
It uses risk free rate for
discounting cash flow.
It uses riskless cash flows.