INDEX

S. No Topic Page No
Week 1
1 Fundamentals of Financial Management - Part I 1
2 Fundamentals of Financial Management - Part II 18
3 Fundamentals of Financial Management - Part III 32
4 Fundamentals of Financial Management - Part IV 48
5 Fundamentals of Financial Management - Part V 70
Week 2
6 Financial Planning and Forecasting – Part I 87
7 Financial Planning and Forecasting – Part II 104
8 Financial Planning and Forecasting – Part III 125
9 Financial Planning and Forecasting – Part IV 142
10 Time Value of Money – Part I 155
Week 3
11 Time Value of Money – Part II 170
12 Time Value of Money – Part III 191
13 Time Value of Money – Part IV 209
14 Time Value of Money – Part V 223
15 Time Value of Money – Part VI 236
Week 4
16 Time Value of Money – Part VII 252
17 Capital Budgeting - Part I 272
18 Capital Budgeting - Part II 289
19 Capital Budgeting - Part III 306
20 Capital Budgeting - Part IV 325
Week 5
21 Capital Budgeting - Part V 340
22 Capital Budgeting - Part VI 358
23 Capital Budgeting - Part VII 377
24 Capital Budgeting - Part VIII 394
25 Capital Budgeting - Part IX 408
Week 6
26 Capital Budgeting - Part X 429
27 Capital Budgeting - Part XI 447
28 Capital Budgeting - Part XII 463
29 Estimation of Project Cash Flows - Part I 480
30 Estimation of Project Cash Flows - Part II 496
Week 7
31 Estimation of Project Cash Flows - Part III 512
32 Estimation of Project Cash Flows - Part IV 526
33 Estimation of Project Cash Flows - Part V 544
34 Estimation of Project Cash Flows - Part VI 557
35 Estimation of Project Cash Flows - Part VII 572
Week 8
36 Estimation of Project Cash Flows - Part VIII 585
37 Estimation of Project Cash Flows - Part IX 600
38 Estimation of Project Cash Flows - Part X 616
39 Estimation of Project Cash Flows - Part XI 625
40 Risk Analysis in Capital Budgeting - Part I 636
Week 9
41 Risk Analysis in Capital Budgeting - Part II 649
42 Risk Analysis in Capital Budgeting - Part III 663
43 Risk Analysis in Capital Budgeting - Part IV 680
44 Risk Analysis in Capital Budgeting - Part V 693
45 Risk Analysis in Capital Budgeting - Part VI 709
Week 10
46 Risk Analysis in Capital Budgeting - Part VII 724
47 Cost of Capital - Part I 742
48 Cost of Capital - Part II 758
49 Cost of Capital - Part III 776
50 Cost of Capital - Part IV 793
Week 11
51 Cost of Capital - Part V 817
52 Cost of Capital - Part VI 837
53 Cost of Capital - Part VII 858
54 Capital Structure - Part I 880
55 Capital Structure - Part II 905
Week 12
56 Capital Structure - Part III 927
57 Capital Structure - Part IV 955
58 Capital Structure - Part V 981
59 Dividend Decisions - Part I 1003
60 Dividend Decisions - Part II 1027
 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 01
Fundamentals of Financial Management - Part I

Welcome all; I am Dr. A.K. Sharma, Professor in the Department of Management Studies, IIT
Roorkee. This time I am offering a course Financial Management for Managers. In the past also
have offered some courses through NPTEL like Financial Statement Analysis and Reporting,
Working Capital Management and Management Accounting and this is the next subject in the
row.

This is the next course in the row, Financial Management for Managers, in which we will be
learning about the overall financial management aspects in the firms in the business
organizations and we will learn about that how to arrange the funds for the businesses, how to
properly manage their funds, how to decide the proper financial mix and then finally, say,
utilizing the financial resources in such a manner that the overall value of the firm is maximized.

If you go back in the literature, what is the ultimate purpose of any business? The purpose of any
business is the maximization of the wealth of the shareholders. That is the ultimate purpose of
every business, every organization, when any entrepreneur starts a business, maybe a startup you
can say or a just a sole proprietorship you say, then his ultimate dream is he does not want to end
up with or continue with a sole proprietorship, his ultimate dream is to make it as a transnational
company and to convert a sole proprietorship organization and taking it up to a transnational
company.

It requires hard efforts, it requires different inputs, it requires factors of production, it requires a
meticulous way of managing the resources, all resources including financial and it needs a
professional management approach. So apart from all these things you need, the first and the
foremost thing is that is the finance and the financial resources, if you have sufficient amount of
finance, if you have the ample amount of the finance then the next question arises, how to make
best use of it, how to make best use of it?

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So, in the firms, when you talk about that the finance, what role it plays, what is the importance
of the finance and how to properly manage the finance and what all about we call it as the
financial management. So, many things are involved in this process, that we will learn each and
everything one by one and the answers to all the questions will be say given here over a period of
time, when will we move forward in the discussion and we will try to say discuss different
concepts of the financial management one by one in detail.

I will take you back little before understanding or explaining the say importance of this subject
or this particular course. For example, you think about that you may be any individual who is
after graduating or maybe doing MBA or maybe any other professional program. He has 2
options available. One option available is that he can join any firm, any organization, means
through the placement process or the second option is that he may become entrepreneur.

This question comes in the mind of an individual, a young graduate, that if he feels that whatever
the job profile, he is being offered by any company, any firm and whatever the financial
resources, means he has with him and what is the financial package he is being offered by that
firm, if he is not satisfied with that, he may think about that my price is not this. I am more
capable. I am capable to take more risk.

I am acquainted with the better management skills and techniques. So, for me, any job is not
meant for I will be opening up my own organization, I will be setting up a startup, I will be
starting with an own organization with the business and I will become an entrepreneur. If he
decides this that he would like to become an entrepreneur, then what important things come in
his mind. Because a person who thinks of becoming an entrepreneur, he needs to have many
qualities.

He cannot be a normal human being and the qualities are like say, for example, he should be
visionary, this is the first and the foremost quality of an entrepreneur, that you should be
visionary, you should be means able to see, foresee in the future that what is going to happen in
the time to come, how the business process is going to be there? Which sectors are going to
grow, what are going to be the government policies, what is going to be the customers the
response, what is going to be that other stakeholders’ response in the market and which area of
the business he has to venture into.

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So vision is about most important thing, if the person is visionary enough, then certainly he is
capable of becoming an entrepreneur. Apart from that, another important, say quality of a
entrepreneur is or the person who wants to go up in the startup is that he should be having the
risk taking capacity. Everybody does not have that risk taking capacity and everybody cannot
means take all kinds of the risk, especially the business risk.

So, the people who think of becoming entrepreneurs moving into their own ventures own
startups, they must have the risk taking capacity or the risk taking capability, right. Apart from
these two important qualities of that individual who thinks of becoming a entrepreneur and
starting his own business. Third important requirement is the financial resources, how many
financial resource? How much financial resources you have?

And what is the amount of investment, minimum amount of the investment required which you
plan to say invest in or the business you want to start in how much funds are required to be
invested into that business. Requirement of the financial resources is another important
requirement apart from being visionary, apart from having that risk taking capacity you should
be a person having the ample amount of the financial resources.

With zero amount of the funds in your pocket, you cannot start cannot become an entrepreneur.
So, what we can think about that, what is the idea in my mind how I want to go ahead? And what
is the financial requirement of giving that idea a shape or converting that idea into a business
because mere idea does not this work in any way, this is not going to help you to start any
business.

You need to have the proper required amount or the financial resources, it may be possible that
you need to, for example, invest 1 million rupees, you have only half a million in your pocket,
but you should be capable of that half a million will be available from other sources in the
market and I will be able to say generate a fund of 10 lakh rupees or 1 million.

Next question arises that if you have 1 million rupees now, from different sources from your own
pocket from your parents, from the relatives, from different other sources, if you are able to
generate the requirement of the funds means the required amount of the funds required to have
invested in the business, then how to manage those funds, because management is a very, very
important concept.

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You have to your objective is that you want to magnify with the given amount of the funds with
you if you had the 1 million in your pocket. Your plan should be that next year at the end of the 1
year of the business it should be 1.5 million with me, but it may not be possible because initially
when we start a business, initially we have the gestation period for that.

We incur some losses for the same period of time, initial 2 to 3 to 4 years even sometimes or up
to 3 years you can say any new business can be allowed to incur the losses. We expect that the
losses will be there, but at least at the end of the third year or in the fourth year, the business
must mean be reaching at the breakeven point. And from the say means thereafter onwards, the
business should start earning the profits.

This all will happen only if you know how to manage the financial resources, I am emphasizing
upon the financial resources, because this is the backbone of any business, this is the, this plays
the role of the blood as the means as the blood plays in the human body, this finance plays the
role like a blood because in the human body, if the blood is not there, sufficient amount of the
blood is not there, if you have that lesser amount of blood in the body, we are anemic.

And if you are the more amount of the blood in the body that is also not good for the human
body or for the human beings. Similar is the case with that when you talk about the finances, we
talk in terms of the finances in the business in terms of the capital. So, how much amount of the
capital you require. You have to have that much amount of the capital, because if, if the lesser
requirement of the capital, we are undercapitalized and if you have the more amount of the
capital invested into the business, we are over capitalized and both the situations are not good or
not up to the mark.

So, under this process of learning about the financial management, we will have to learn about
the optimum amount of financial resources to be invested into the business and the proper
management of all those sources of the finances. When you run the business or when you start
the business and you start running the business, you have a number of factors of productions, you
need land, plant, building machinery, material, capital, labor.

So, all these other factors of production depend upon only one factor of production and that is
capital in other way around you can call it as finance. If you have the finance, requirement of the

4
finance then you can have the land also, you can have the say material also, you can have the
labor also and you can generate other fixed and the current assets in the business also.

So, the first and the foremost requirement of any business is having the required amount of
finance. Once you have the required amount of finance, you can proceed further you can
generate other factors of production, you can give your idea a shape in the form of the business
and go ahead with that process and start working with your organization with your business with
the objective that I will now magnify the say my finances, my say resources.

Whatever the investment I have made into the business, I will pass through all the hurdles, I will
make best possible efforts best managed my organization and then I will achieve that means
objective of converting that sole proprietorship into a partnership firm because it is a process.
First when we started the business as a sole proprietor, we then convert that into a partnership
firm, then we convert that into a private limited company and then we convert that into a public
limited company.

And then the public limited company has any level, it may be a national company, it may be an
international company, it may be a multinational company or it may become a transnational
company. So, todays transnational companies if you talk about they were started as a sole
proprietor organization sometime back years back, maybe sometime you can call it as decades
back and today these companies have seen or risen up to a level that they are now say not in one
country or in the one part of that country in which they were started but they have now become
the transnational and they are into every part of the world.

Talk about these Japanese companies, Toyota, Sony or any other means say your Honda, all
these automobile companies, all yours say electronics products, manufacturing companies or the
American companies or the UK based companies. These companies were started by the single
individuals. If you go back in the history of any company, you will find it that somebody started
is at a very small level and today they have become transnational company and they are serving
the needs of the people in the different parts of the world.

This all happens with the better and the proper management of the business, which we start as a
sole proprietorship, which we started you call it as the startup organization and if the idea is well,

5
if the process of managing the resources is well, then certainly we can grow and we can achieve
the dream that we want to reach, right.

So, here, the overall management of the business, I will emphasize upon that if your manager
finances well, in this course, we will learn about different ways, processes and means that if you
manage your finances well, if you manage your resources well, then certainly you are going to
achieve your dream where you wanted to reach at one day or at the one point of time, but if the
financial management of any organization is poor, then certainly whatever the other resources
you have, they are not going to deliver the results, they are not going to deliver the value.

So, managing your finances well, you need to create 2 situations in your firm, in your business,
in your organization. Every organization has 2 important structures; one structure is called as the
operating structure of the firm. Second structure is called as the financial structure of the firm,
right. Under the operating structure of the firm, we talk about the operations part, there if you
talk about in terms of the financial statements, we prepare 2 broad financial statements, one is the
income statement which has the 2 components and the second statement is the say balance sheet.

So, the first statement which is income statement it has 2 components, trading account and the
profit and loss account and the second statement is the balance sheet. In the trading account we
talk about the operations or the operating part of the firm and in the say lower part in the profit
and loss account, which is the second part of the income statement, we talked about the financial
structure of the firm.

So if the operating structure of the firm is good, but the financial structure of the firm is poor it
may be possible that sometimes when we start a new business, we borrow the funds from such
sources which are very-very expensive, the rate of interest we are paying to these sources is very
high and sometimes whatever the revenue we are earning larger part of that is spent only on
servicing the debt or the funds generated from those sources, right.

It may be possible in the beginning because your idea is new, your business is new, your concept
is new, you’re even the firm as a startup is new. Many established financial sources may not be
ready to come forward, you cannot start the equity means you cannot issue the equity capital in
the beginning of your business. Even you go to the bank and you start borrowing or you ask for
borrowing some money from the bank to start your business bank will not take any kind of the

6
risk because you are just a beginner in the business. You have not proven your potential in the
market.

So, you may not get the funds from the bank also. Even you go to your friends, your relatives,
and you ask for the money for that, it may be possible that sometimes they have a doubt in their
mind that this is a new concept, this is new idea, this person is going to start the business for the
first time he is very young. So, it may be possible that the business does not grow well and it
may collapse before it has started growing.

There are kind of that, this kind of apprehensions are there in the mind of everybody. So, your
relatives, your friends, even your parents are not ready to support you, but your conviction and
your faith in yourself it gives you a, say the feeling that I should go ahead. So, there in that case,
you end up generating the funds from the very-very expensive sources. For example, you go to
the venture capitalist or you raise the funds from such other sources maybe from the Angel
investors which are very expensive, sometimes the interest goes up to 40-45% also.

So, what happens when you raise the funds from such kind of very expensive sources, financial
structure of the firm becomes weak. But if your operating structure is good, means if your idea is
good and you know that I am sure about that, if I start generating this service and rendering the
service to the people in the market, certainly there is a market and there will be the buyers for
that or if you start manufacturing some product and start distributing in the market.

You should be sure about that, yes, there will be the that the people who will start liking my
product and certainly I will generate market for my product, then that is your confidence and if
the operating structure means that is a manufacturing process and the product or service, which
we are generating out of it if it is very good and acceptable to the people.

So, you can say your operating structure is very strong means certainly the operating structure of
the firm is very strong and slowly and steadily your weak financial structure that the expensive
financial resources which you have invested in the business, you would be able to replace those
resources with the cheaper and the say affordable financial resources.

So this all depends upon how well we manage our organization, how will we manage the firms
and which direction we give it to because first and the foremost requirement of starting and
growing with any businesses is the finance.

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And the proper financial management is that the beginning of any good business, this is a
prerequisite that you should be knowing that finance is very-very scarce source, I should be
learning about managing it very carefully, meticulously, so that my business grows and the
ultimate objective of maximization of the value of the firm I am able to achieve, right.

(Refer Slide Time: 17:55)

So, now I will take you to the forward this take forward to the towards a formal discussion here
and when we talk about the different important parts that what we are going to learn about in this
subject will be talking about certain things like, say, this beginning is this is the introductory
lecture and I am say just trying to build a foundation about this subject and this particular course,
finance and the financial management.

So, ultimately, we are going to learn about the finance and the financial management as a whole,
which is very important for any business manager or particularly people are dealing in the say a
finance and accounting department of any organization and especially for the CFOs, right. So,
we will start with the basic discussion, the introductory part of this particular course, financial
management, and slowly and steadily build up this pyramid and we will try to means learn about
the different other concepts of financial management.

As we move forward into the discussion we will be learning about the different concepts of
financial management. So, today in this beginning in the introductory lecture, I would like to
give you the overall means a feeling of this course, and the overview of this course that what all

8
we are going to discuss in the say the days to come or maybe in the next subsequent lectures and
what different things we are going to involve in this learning process about this financial
management.

So, we will learn the basics of the financial management which you can call it as the
fundamentals of financial managements. Then, after that I will take you towards the time value
of money, time value of money is a very-very important concept, you all understand, I think to
some extent, that a money or a rupee today in my pocket or with anyone amongst us is more
valuable as compared to a rupee coming after 1 month, right.

So, earlier the value or earlier the money or earning or any resources, financial resources you are
earning, it has more value as compared to the financial resources coming to us at some later point
of time. So, it means we will be then from this basic foundation, I will take you to the time value
of money, from the time value of money then after that, we will start talking about the proper
business finance there we will talk about the say a capital structure of the firms that how to
decide the financial mix for the firms.

Then similarly, we will be talking about the other important components like your cost of capital
and then yours say other important concept like say financial risk management and other
important areas will be discussing. So, means it will be a complete course, that at the end of
means the total discussion of 30 hours you will be able to means very clear, be clear in your
mind that what is the financial management and what is means all about we talk about the
financial management as area of learning.

So, let us start with the foundation and the basics of the financial management and this is the
beginning I have done in this a few slides and if you talk about that, the first thing is the finance
and the financial management, what is finance and what is a financial management? You would
agree with me and you know it I think to some extent because you must have some idea about
the finance and the financial management.

Finance has 2 important components one is called as a money which we all use for our daily
purposes for the daily needs and any individual any human being, if he uses any finance for his
consumption purpose for buying the goods and services for himself or his family or for his other
near and dear that is called as money. Because the benefit of that finance if you are able to enjoy

9
only for once only for the say at one point of time that money was with me, I purchased the
goods and services from the market, I consume that that money is gone benefit I enjoyed, and
that part is over, right.

But the funds which we use in the business which we invest in the business which we use in the
business, they are called as capital, the name of that finance is capital. So, we will be learning
about, that what is that, it is the beginning of the business, how to invest that capital into the
business, how to say appreciate that capital, how to maximize that capital and financial resources
and how to grow with any startup or any say small level of the organization maybe you call it as
the sole proprietorship, right.

So, for example, what I have written here is finance may be defined as the art and science of
managing money, is the art and science of managing money. For example, if I have 100 rupees,
and if I go to market and purchase some goods and services, that 100 rupees is gone, there can be
another guy that he can buy that say, some goods for 100 rupees, he can sell those goods for 150
rupees in the market to some other customers, where they are are not easily available and he can
make it say 50 rupees with the help of that 100 rupee.

So, his 100 rupee becomes 150 rupees. So, this is the art and science of managing the money.
When we are managing it only for one purpose, one single use of the money it is called as
money, but when it is say use for the multiplication for the investment in the business for the
purpose of the business, then it is called as capital and the second part which we are calling as
capital, investing any amount of the money into business and maximizing those financial
resources, we are going to talk about that.

So, difference between the money and the capital is finance is same, the 100 rupees is same, but
the money is that once you go to market you consume that only for once that is called as money,
but if you invest the same 100 rupees into any kind of business and then you grow up with those
funds, you make it 150, 200, 300 rupees, it becomes capital. So, we will have to make our
minimum resources maximum resources and that is how we can do it that is only possible with
the help of learning the concepts of financial management.

Second important point here is financial management is concerned with the duties of the
financial managers in the business firms, duties of the financial managers in the firms. What

10
financial managers do? You would means agree with me that every firm has a different
department, organization maybe a small, big or medium sized organization that is divided into
different departments and every department is doing a different kind of the functions they are
performing different kinds of jobs, different kinds of functions.

We have for example the purchase department, they purchase raw material, different kinds of
raw material, their job is to seek the requirement from the production department and purchase
the best quality of the material at the very competitive prices. So, that is the only function of the
purchase department, they place the orders, they received the materials, they take the material to
the warehouse, and finally the material is available with us all the times.

Then the another department is a production department, production department job is

converting the raw material into finished product and then passing it on to the warehouse and
partly even from the plant some material goes to the market. So, we have the production
department. Once the production is over after that we have the marketing department, marketing
department has 2 broad functions, they have the say advertising function also and they have the
sales and distribution function also.

So, they are largely their major chunk of operations is involved into sales and distribution of the
product, but at the same time, they keep on advertising the product, having the feel of the market,
knowing about the customer requirements and giving the feedback back to the firm or to the
production departments. So that the product and services can be modified as per the requirements
of the customers in the market so that is the job of the marketing department, right.

Then after that, we have the after sale service department. So, means once we sell the product in
the market, it requires after sale service. So, we have the after sale service department in the firm
whose job is to keep the people or our customers satisfied. In between, there is one department
which is called as finance department, accounting and finance department.

There are other departments also for example, human resource department, HR department, they
deal with the total human resources and taking care of all the Human Resources hiring of the
people, properly managing those resources within the firm and then taking care of all their
financial and physical requirements. So there is HR department also, apart from all these
departments.

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Your purchase department, production department, your marketing departments, human resource
department, sales and distribution department after sale service department, we have a very-very
important department which is called us finance department CFO means the firm is the head of
that department, Chief Financial Officer is the, who is in the firm CFO of the firm is the one who
heads their finance and accounting department.

And the job of the finance department is always arranging the funds to be invested in the
business and fulfilling the financial requirements of different departments. Because purchase,
people cannot purchase the material until and unless you give them sufficient amount of funds.
Production people cannot produce if you provide them different inputs and different inputs come
from the market and they need funds. Marketing people cannot go for marketing functions until
and unless they are supported by the financial say requirements or by the finance department.

Similarly, your HR department need funds, your after sale service department need funds
everybody need funds. So, it means when people need funds, it means if you have finance
required amount of the finance in the business, other things can be arranged, but you do not have
the required amount of the finance, other things cannot be arranged. This is the one part, second
part is having the funds is one thing, but properly managing the funds is another important thing.

That is why we remain very careful and we need very good and expert people who know what is
the finance, what is the importance of the finance in the business and how to properly manage
the finance, right? So, here when we are talking about financial management is concerned with
the duties of financial managers in the business firms, that what the financial managers do for the
whole day in the firm that all is called as the financial management.

Then important part is financial managers actively manage the financial affairs of any type of the
business namely financial and non-financial, private and public large and small, profit seeking
and not for profit, any kind of the business you talk about whether we are a profit making
organization. Whether we are not for the profit making organization, whether we are a small
firm, we are a large firm, we are a manufacturing firm, we are a service rendering organization,
everywhere you need the funds.

Everywhere you need finance and proper management of the finance is most important thing. If
you are not managing your finances properly, even a, maybe a firm having the ample amount of

12
the resources may become insolvent or if you are managing your finances properly then even a
firm starting the business from very smallest micro level can become a transnational company.
So, it all depends upon that how well we manage our funds and how well we perform the
financial management functions and how active and professionally managed your finance
department is.

So, we will have to give more importance to the finance because if the finances are properly
managed, nicely managed, then the other departments can automatically be but if the funds are
not managed, then certainly other things cannot happen. So, it means finances equally important
for all kinds of the organizations even for the profit making organizations even for the firms who
are not for profit, right. So, it means you can understand now the slowly and steadily the
importance of finance.

(Refer Slide Time: 29:53)

Now, in this part we are going to talk about financial decision areas. We are going to talk about
financial decision areas, I have laid down here 6 important points and the 6 important financial
decision areas and this all will be talking about till this say end of the discussion for the 30 hours
in this course, right.

And apart from these major 6 financial decision areas, we have some other supportive areas also,
which you call it as the say support, department support areas and you can call it as support also

13
the primary areas and some other related disciplines which support the finance function in any
firm or the financial management in any firms or in any kind of the firms, right.

So, when you talk about the financial decision areas, we have the 6 financial important financial
decision areas, one is the investment analysis. Second is the working capital management, third
one is the sources and the cost of funds. Fourth one is the determination of the capital structure
and then is the dividend policy and then is the analysis of the risk and returns. Because ultimate
purpose of any business is having the maximum returns at the optimum level of risk.

I will not say minimum level of risk, you cannot do that, because there is a direct relationship
between risk and return, there is a direct relationship between risk and return. So, higher the
return risk will also be higher and lesser the return risk can also be lower that is quite possible.
But our job as a good financial manager is that we have to maximize the returns of the firm
because ultimate purpose of any business is the value maximization or the wealth maximization
of the shareholders.

People who provide the finance after performing your purchase function, production function,
marketing function, distribution function after sales service function, HR functions, you have to
run the business in such a manner that ultimately the return on the shareholders’ investment is
maximized and that all is going to happen. If you are managing your finances properly, if we are
providing the required amount of funds to the different departments at the required amount of
time then only you are going to think about that the best results will be available.

If we are not able to do it, means at the right amount of time, it may be possible that the CFO is
not able to look forward into the future and what is happening in that case, sometimes we are
running short of funds, sometimes we have the ample amount of the funds, even you are running
short of the funds, you are undercapitalized, you will not be able to fulfill the requirements of all
the departments on time and there are obstructions in the business, if you have the more than
required amount of the funds that is also not good for the business.

So, what we have to learn here is we have to have the optimum amount of the funds, so that the
businesses optimally capitalized, we are optimally fulfilling the requirements of all of our
departments and we are optimally managing our financial resources by taking the optimum

14
amount of the risk and maximizing the returns on whatever the investment we are making in the
market.

So, this all will depend upon if your overall financial management functions are properly
performed in the organization. So, now we will talk about the 6 decision areas, financial decision
areas. First thing is the investment analysis. Spend more time, maximum time on the investment
analysis, spend maximum time on the investment analysis, because if the analysis is better, we
understand that when we are going to take any investment decision in the business, if we have
properly analyzed it from the different angles, then certainly the end result is going to be better.

But sometime any decision which is taken in the haste that is going to mess up with the things,
going to create problems for the managers for the stakeholders of the business and it may be
possible that overall idea of making investment in the business may not means come out with the
desired results, it may be possible that, that investment may prove to be a bad investment and we
are not able to generate sufficient returns out of it.

And sometimes it becomes a loss making business and losses are so, high that you are not able to
convert that business into profit within the given amount of time and finally, we take a decision
that a business has to be closed down, right. So, it means investment analysis is the most
important thing and for the investment analysis, but we do, first of all we have an idea in our
mind and that idea when we think of converting that into a business, first question comes up.

That the product which I will say generate or the service which I will generate out of this entire
business means putting all these factors of production into the job and then say converting that
into that idea into the business and then business will start producing the product or generating
the services who will buy that product or service from my organization, is there sufficient market
available?

Proper market analysis is required to be done. Market and demand analysis is the backbone of
the success or failure of any business, if you have the market, if you think that you will be able to
have the market, sufficient market in the initial years of your business, then there is no issue at
all there is no problem at all. But if the market is not there or the market analysis has not been
properly done in that case, what happens.

15
That we manufacture the product and when we go with that product in the market, we do not find
the buyers in the market. We do not find sufficient buyers in the market and if the buyers are not
there in the market, then sufficiently means the sufficient buyers are not there in the market for
whom you are manufacturing the product then, you generate a service and no, means buyer of
that or subscriber to that service is available in the market.

Then for whom you are going to means have that service. So, it means what you have to do is
you have to have the ample amount of the market for your product and that you have to see
beforehand that you have to see beforehand that when you start manufacturing the product, you
have to think about that is there sufficient market for that? So, every investment analysis starts
with the market and demand analysis, right.

Similarly, then the other analysis is there apart from the market and demand analysis, then you
go for the technical analysis, right, that okay market is there, demand is there, because my
product is new, my concept is new, my idea is good, right? And it is acceptable to the people, we
can conduct a survey and we can get good results.

But apart from that, you have to go for the second set of analysis, which is technical analysis.
What kind of inputs are required, what kind of technologies required, what kind of machines are
required, what kind of other things are required and you have to say go for the technical analysis
in detail then you have to go for the financial analysis. Financial analysis means that from where
the funds will come? How much funds are required to be invested?

What is going to be the cost of the funds? And if I make this required amount of the investment,
then at what price I will be able to sell my product? What will be the profitability state in the first
year? How much loss will be there, second year, third year, you have to create the dummy
financial statements projected financial statements for the next 10 years.

So, financial analysis is also very-very important. Profitability analysis also very-very important,
risk analysis also very-very important. So all these analysis means a proper investment analysis
if it is done before starting any business or giving any shape to the business, then certainly the
end result is going to be the best and the beautiful, but if we are not means doing sufficient
homework and if the properly investment analysis is not done, then certainly the end result is not
going to be the, the one which is desirable or which is going to be supportive for the business.

16
So, similarly, apart from this investment analysis, we will talk about the another important
decision area also and then slowly we will take forward this discussion to the another important
relevant concept. So this all I will discuss with you in the next class. Thank you very much!

17
 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 02
Fundamentals of Financial Management Part II

Welcome all. So, we have started learning about the Financial Management and the basic
concepts of financial management or the fundamentals of financial management. So, in the
previous class, in the first class I just tried to build up the foundation of this particular concept,
this particular area and we discuss some basics of financial management or some fundamental
requirements of the financial management. So, now I will take you forward in the process and in
the end of the previous class we were talking about the investment analysis.

So, I told you in the previous class also that investment analysis, a proper investment analysis is
very very important. If your investment analysis is not important even these days what happens,
that when we start say even for the existing firms also if they want to start a new product, they
want to launch a new product, new product or new service self is considered as a full-fledged
project.

For the existing firms I am talking about, even if it is a multinational company want to start a
new product or any new service, it is a new project for them, they create a full-fledged sub
division for that and they supported completely like a new organization, new firm, new business.
And every analysis is done for the success of that product or that service and as I told you in the
previous class that analysis begins with the market and demand analysis.

Because there is a back bone of the success or failure of any product, if you can manufacture any
product, you can manufacture any products for example I was reading sometimes back some say
something some written some in some magazine, that general motor’s you have heard about, its
say American car manufacturing company they had said that any person in the world can think
having any kind of the car, any kind of the car.

You think of the features in the car you want to have it and tell us that I want a car, price is not
the limitation I am ready to pay any price for that but these these features should be there in my

18
car. You think about that, give the design of your car to us within 15 days we will hand you over
the keys of the car.

What does it mean to say? Means in today's global competitive scenario manufacturing of any
product or rendering of any service is not a challenge. The challenge is accepting the product by
the people, by your customers in the market. And if the product is accepted in the market, your
business is successful. With the product is rejected in the market, your business is a failure.

I tell you the story of one very very important product, that product was fruit beer, anchor group
you have heard about, anchor group is basically at their time now today it is a taken over group
by the Panasonic but earlier it was an anchor. They used to manufacture the electrical products
switches, wire and all that.

They thought of that after liberalization of Indian economy they thought of diversification and
they thought because now in the electrical segment when the multinationals will some to India or
may be the when the sector is open for any global competition and when the multinational
companies will some to India certainly the electrical products a segment may become very very
competitive for them. It may be possible that they may not be able to compete with the
multinationals or the transnational companies into the area of the business in which the anchor is
already.

Anchor was a leader in the market when it was a closed economy, but anchor had to face the
challenges when the economy is open for the global competition and they were preparing for
success being successful in the market. So, they thought of that for example if any challenge
comes up in the electrical product segment then we must start or start thinking of diversification
and we must start to diversifying other areas.

And when they consulted the people in the market, the experts in the market that if you want to
diversify from the electrical products segment to some other areas, what are the important other
areas they can diversify to? They got the answer form many experts and many research and
analysis agenesis that see this is a very large country in terms of population. We are 1.2 billion
people; at that time, it was today we are grown up to 1.3 or 5 billion people but at that time I am
talking about the late 90’s.

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So, we are this country, large country of 1.2 billion people has minimum to eat something. So, if
you want to diversify today, you diversify towards the consumer products, anything which you
manufacture if it is related to the consumer area or the human consumption area then certainly
the chances of success are more as compared to if you move to any industrial product or any
other product where the chances of the success may be not as good as there in the consumer
segment or the consumer area or in the consumer market.

They considered one product which is called as fruit beer. Fruit beer is a very common product
which is non alcoholic everybody knows it. Everybody can drink it, even the say kids, even the
women, anybody can take it and it is a very common product in the other countries in US, in
Europe, even in some advance countries in Asia.

Fruit beer is a very common product. They got some advice after some analysis in the market
that yes if they manufacture in a start, means say introduce this product in the market, in the
countries market in India’s market they will become the pioneer in this area number one and the
product will be very very successful.

They read all market and demand analysis, everything. The response was very good and finally
they started giving shape to the concept, to the idea and they created a plant near Gurgaon for
manufacturing the fruit beer they invested 350 crores at that time, in the late 90’s I am talking
about. And they started manufacturing the product.

When they manufactured the product they started distributing it initially free of cost. Because
every company at the time of the launch of the new product they manufacture and they start
distributing it to the people free of cost sometimes so that people know about what the product is,
what are the properties of the product, what is the taste of the product, how they feel it, so that
now after sometimes they start buying about it.

They started distributing it and finally people rejected the product, product failed, 350 crores of
investment made in the market, product failed, people rejected the product. Now, you can means
raise a question here that after so much of the detailed analysis about that particular product,
about that particular concept, about that product which is very successful in the other countries
market, why that product was not successful in India?

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Company lost, anchor lost 350 crores of the scarce resources and finally that means proved to be
a flop show, so they lost that money that money went down in the drain. That was a company the
anchor which was in the market for so many years, they could sustain that big loss and that big
shock, the financial shock in the market, they could sustain but later on also means their all
operations could not be sustain and finally that company had to acquired by some other company
in the market.

Now, the anchor is acquired with the Panasonic and it known anchor by the Panasonic now, they
could not sustain independently, that have to sell of their business in the market but you see why
I am discussing this story that when you are talking about the investment analysis, their financial
management comes into the picture and that starts, that analysis starts with the market and
demand analysis.

If the market is good, if the demand for the product is good, if it is verified in the market then
only your business can sustain. Now, why their fruit beer failed in the market? Because later on
when they got the feedback from the market, they came to know that in India people use beer as
the product for intoxication not for any other purpose.

Fruit beer cannot be used in India as the say you can call it as a supplement or the substitute for
tea, coffee, juice or any cold drink or even for the plain water. No it is not possible because price
was almost kept as of the same product which is in normal beer in the market which has the say
alcoholic content in the beer.

The price of the fruit beer was fixed by the anchor almost the same as there is the price of the
normal alcoholic beer in the market. In India the purpose of taking the beer is different, people
take the beer for the intoxication not for the relaxation purpose, so the product finally failed. At
the time of survey market and demand analysis, when they did the survey in the market, people
said yes the product is going to acceptable to them but later on when the product was
manufactured and distributed to the people in the people in the market, people rejected it.

So, detailed analysis is required to be done. For the beginners I would like to caution here that if
you want to start means as a startup or at the small level you do a proper market and demand
analysis. If for example you do not have the funds for that then you do what you say so many
people who became very established entrepreneurs and who have converted their sole

21
proprietorship firms into the now the national companies or international companies, you learn
from their experiences.

For example, you talk about nirma, nirma is the name in the market now which is into the
manufacturing, which is into the services sectors both. Nirma was started long back in 1982 by
Karsanbhai, a person who started the business by simply converting the caustic soda into the
washing powder and you look at, at that time though he was very sure about the success of his
product but still he did not take much risk.

He did not means immediately converted that into a big manufacturing organization, started
manufacturing the product, invested huge amount of resources and started distributing the
product at a larger scale, No, he did not do like this, his strategy of moving into the market was,
he started manufacturing the product and started distributing it to his near and dears.

First his distributed to the locality, people in the locality where he himself was residing, then he
started giving it to his relative and people, friends and other near and dears. And when the
response was very good form the market then he scaled up his operations. And today you see that
means it is a nirma, the product which became the first important a competitive product for a
company like HUL, Hindustan Unilever Limited and at that time their two product were coming
in the market, one was the surf and second was the sunlight.

And sunlight was comparable to the, means surf was for the premium segment people and
sunlight was for the low segment people and at that time people were not even able to afford to
buy even sunlight. So, when this new product came in the market, number one he added very
good attributes, good qualities in the product which fulfilled the basic requirement of washing
the clothes by the people and second thing he kept in the mind was the price of the product. In
1982 he started selling 1 kg of the washing powder for 10 rupees a Kg.

And that was the success of because the product was fulfilling the basic need of the people, it
was very much within the reach of the people and the response became tremendous, response
became alarming and then finally you see that the growth, the spectacular growth of the nirma,
today that company which started as a sole proprietorship organization that this company has its
presence in many areas now both in manufacturing and services sector.

22
So, I am emphasizing upon that better financial management will depend upon or beginning of
the better financial management depends upon the best investment analysis. You do the proper
analysis how much investment I am required to make here or my company is required to make
here, how much time will be required which is known as the gestation period and what will be
the overall investment requirements.

My proper financial usage requirement and then how would I manage the finances. So, that they
magnify the grow up at the desired pace and ultimately the objective of the value maximization
of my firm is attained, this is the first requirement in the financial decision areas, detailed
financial analysis investment analysis.

Second is the working capital management, normally what happens when we start thinking of
say going into the business we only think of say giving a shape to the organization that we will
require this much amount of land, plant, building, machinery, furniture or some other say assets
like vehicles.

We sometimes forget about the finance which is called as working capital management, if you
have the plant, if you have the building, if you have the machines, they need raw material to
convert the raw material into the finished product. They need human resources to work on those
machines they need human resources to manufacture the products, to take your product from
another place of production to place of consumption.

So, you need to pay them, you need raw material, you need human resources, you need the other
inputs like power, water other inputs lubricants fuels and for that we need the working capital.
So, you need two type of the sources of the funds in any business one is the long term funds for
creating the fixed assets, second is the short term funds for creating the short term assets or for
fulfilling your working capital requirement.

Short term financial requirement for buying of raw material, you can buy some of the material on
credit but even getting the credit from the market requires some presence in the market,
reputation in the market, creditability in the market. Form the first day onwards nobody will start
giving you the raw material on credit.

23
Human resources can wait for paying for their salaries for 30 days, it is a virtual credit available
from the market, but after 30 days you have to pay to them, power supply companies can wait for
30 days or 60 days but they have to be paid at the end of this period. Water supply companies
can wait for some time but they have to be paid at the end of that period. So, that all requires the
working capital. We make the proper estimates and some times for the long term funds
investments requirements, but we sometime make either we underestimate the working capital
requirements or simply we forget to make the proper estimates for the working capital.

So, proper mix of the funds of for the long terms requirements and for the short terms
requirements has to be there, so that you can create a balanced organization and all sort of the
requirements of any firm can be easily met. So, working capital is the important part. Working
capital means that for running the day to day operations of the business, the amount or the funds
required is called as the working capital.

So, you need the long term investment for the land, plant, building, machinery, furniture,
vehicles. You need the funds for materials, employees, electricity, water, oils, lubricants fuels
and that is called as working capitals. So, you have to create a proper mix of these two sources
and these two are independent areas of learning. Investment analysis a full-fledged area of
learning and decision making. Working capital management is also a full-fledged area of
learning and decision making, you need to be very careful about both these areas, right.

Next thing is the sourcing and the cost of funds. From where the funds will come, what are the
sources? You wanted to be entrepreneurs, you wanted to after doing your MBA, you wanted to
have a started up, form where the funds will come, your investment analysis has given you
answer to the question that yes my product is very good, my idea is very good, my concept is
good, I am going to be very successful in the market and I need 1 million rupees just in the
beginning to invest into my business.

In your pocket there must be only 100 thousand, your maximum can arrange 100 thousand from
your own saving, from your parents and from other sources only 100 thousand. One tenth of the
requirement, remaining nine tenth of the requirement will come from where? You have to now
think about that, and here the financial mix requires to carefully decide about the cost of the
funds, because if you go to the banks, they will not give you money because you are a new into

24
the business, if you go to the say shareholders, you cannot come out with an IPO or equity
capital or nothing like that.

You have only options available either you discuss your idea with some of your friends or
likeminded people and ask them that see this is my product, this is my idea, this is my concept or
this service I want to generate if you join hands with me, we can join together three, four people
and we can start our own business and then we can grow with this organization rather than
starting working for some other organization.

So, this is a one option available, but for example you are the four friends and you get 400
thousand rupees, still we require 600 thousand rupees more, more than half a million, investment
is more required now. From where the funds will come? You have only one option, to go to the
venture capitalist, and if you go to the venture capitalist you discuss your idea with him, your
project proposal with him, your investment analysis with him, they may agree, that the project is
good, the idea is good, concept is good.

They may it is very it is quiet unlikely that they become your partner in the progress through
private equity. Sometimes they give you the venture capital and when they give you the venture
capital it is a sort of loan to the firm and the rate of interest is very high 40-45 percent. Later on
when it starts working well they may convert that into a private equity or the rate of interest may
come down.

But initially to save the business from the very high cost of financing, you have to be very
careful about that what is the total requirement of my investment, what is the total investment
requirement, from where the funds will come, and what is the cost of those funds? I can tell you
that even sometimes a better operating structure, but a very poor financial structure can create the
problem for the organization.

Your operating structure is very good but your financial structure is so heavy, the cost of funds is
so high that whatever the profits you are generating, whatever the revenue you are generating by
selling their products or service in the market, larger part of that you are using in servicing that
debt. So, even sometimes a well functioning organization or a business which are expected to
start earning the profits at the much earlier stage they become the loss making businesses.

25
(Refer Slide Time: 20:20)

So, be careful this is very very important third area of decision, sources and cost of funds. Then
is the determination of capital structure, another important question, we will discuss all these
concepts in detail one by one but today I am just building the foundation and just I am say
clarifying the fundamentals so that what we are going to discuss in this course in the time to
come you should be very clear about that.

(Refer Slide Time: 21:00)

So, determination of the capital structure, you have funds, you have different options of the funds
available and when you talk about the capital structure, the capital structure talks in terms of that

26
the capital structure of a form is, when you talk about the capital structure you can see here that,
capital structure means, having the mix of the funds from different sources and what are the
different sources? Here are the different sources which are called as equity plus debt, this is
equity and debt, this is called as the two sources and now in the capital structure you have to
decide the mix of these equity and debt.

So, equity means because it is a new firm, new organization even for the existing firms also in
the beginning equity is not allowed to be raised from the market by selling the stocks in the
market or may be coming out with any IP or anything. Initially the firm has to prove its potential
and be successful with the business in the initial years later on then they can supplement the
existing financial resources with the new financial resources and the equity issues may come in
the market with the help of the initial public offers.

So, if the equity from the public cannot be arranged, cannot be generated then you have two
options, that whatever the equity as entrepreneurs, the people who are the initial beginners or the
initial investors in the market they have to invest from your pocket. For example, I was talking to
you if the one person tries to become entrepreneur he has 100 thousand in his pocket,
requirement is plus debt will be 9 lacs 900 thousand and if you take this debt because the
business is new and 900 thousand you are arranging and the rate of interest is for example even if
it 30 percent per annum, the cost of funds is going to be very high.

So, what you can do here is, you can try to find out that from say this source, equity is
considered as that it is not the say risky source of funds because equity, the person who gives the
equity or invest into the equity of any firm, they are not means say supposed to be paid the return
every time every year. It all depends upon when there are sufficient returns available they can be
paid by the dividend if there is no profitability in the business or required amount of the profit in
the business no dividend has to be returned back to them.

So, say this is going to be very very risky proposition that 1 lac and 9 lacs is the borrowing from
the market. Whatever you earn with the help of this 10 lacs rupees, larger part of that will be
spent on servicing this jet so this option is not workable. So, what can you do is, you can try to
minimize this amount. 9 lacs have to be minimize if you because your investment requirement is
all 1 million 10 lakh rupees. So, you want to minimize this, it means if you want to minimize

27
this, you have to maximize this, so you can bring people like minded people in the market for
example you say that four people join hands and they invest 1 lac rupees each.

So, it means total amount becomes, how much? This amount becomes 400 thousand, so if this
becomes 400 thousand so it means our borrowing requirement has come down to 600 thousand,
at least not 900 thousand. We have now brought it down to 600 thousand. So, 600 thousand and
into 30 percent of that is still lesser as compared to you are paying the interest for 9 lac rupees
you are borrowing.

So, it means your debt equity ratio, it means capital structure is that capital structure creates a
something that once you decide any capital structure you are going to have something which is
called as debt equity ratio. Debt equity ratio, debt equity ratio means standard debt equity ratio is
2 is to 1 for the existing firms, existing organizations. 2 is to 1 means if you invest 1 rupee from
your pocket you have the right to borrow 2 rupees from the market.

So, this ratio becomes 2 is to 1. Either business is doing well then the lender can lend you any
amount of money then this ratio can be even 9 is to 1. This ratio can be 8 is to 1, it can be 8 is to
1, it can be 10 is to 1, that depends upon the borrower and the lender but normally the standard
ratio for any solvent and optimally managed business is considered as the optimum ratio is the
ratio the dept equity ratio has to be 2 is to 1.

So, it means as per this ratio if the business has not proven its potential in the market it is a new
business, so it means if you invest 1 lack rupees from your pocket, you are allowed to borrow 2
lack rupee from the market but 2 lac rupees means at a normal rate of interest, normal market
rate of interest. For example, we talk about borrowing from the banks or other financial
institutions but since here borrowing requirement is very high here that is 4 lacs 4 people have in
their pocket.

Total investment requirement is 10 lacs, so 6 lacs you have to borrow from the market and
normally because debt equity ratio allows only maximum is how much that you can borrow 8 lac
rupees sorry 4 lacs rupees from the market but that only happens for the, or may be 2 is to 1 ratio
so you can have 8 lac rupees borrowing from the market but that will happen only for the
businesses which have proven their potential in the markets.

28
Since yours is a new business nobody will be ready to give you this say 8 lacs rupees of the
investment or 6 lac rupees of investment at the normal ratio of interest, so for this you have to
look for some avenues of investment which charge higher rate of interest and they are called as
venture capital.

They are called as venture capitalist and you have to go to the venture capitalist, there are the
two sources. One is called as private equity and second is called as venture capital, venture
capital is basically the one which comes into being into the business in the beginning of any big
business provided when we go to the venture capitalist they ask us to explain the concept of the
business, the product which we are going to manufacture, the service which we are going to
render out of its business and how it is going to be a successful concept, is a successful idea and
what are going to be the financials of the business.

You have to explain them everything that from today to next 10 years, what is going to happen
with this product in the market, how the financials will behave and from the day 1 till the last day
of the 10 year where you will start working from, where you will arrive at, so if they like the
idea, the venture capitalist like the idea that yes idea is very good and if we make sufficient
investment in this particular concept in this particular idea then certainly means this idea can
become a very good business tomorrow.

So, they may agree, they may say that yes you have 4 lac rupees in your pocket we will give you
4 lac rupees but over rate of interest is 30 percent, so you have to agree you have no other choice
so in this case what will happen? Your financial structure become very heavy will become poor
but I am again emphasizing upon if you are operating structure is going to be very strong, if your
product or service which you are going to manufacture or render is going to be very strong then
certainly you can take this risk and go ahead.

Because part of the risk is already you have transport to the venture capitalist and venture capital
funds their people are so smart they can easily find out whether this product or ideas is going to
be successful in the market or not. They do not take the decision of investment until and unless
they are sure about that whatever you are talking about is going to be the real thing tomorrow in
the market. So, initially till the time we are not into the profit or we do not reach at the break-
even situation, you accept this and then finally once we have started earning the profits then

29
there is arrangements that this funds will remain or will continue supporting for this much
number or years.

After that it depends upon that it if they want to continue, then this venture capital can be
converted into private equity or if they want to withdraw, they can withdraw and since now the
business has started earning the profits so any other source will be able to jump into the business,
even you go to the banks any other financial institutions tell them we are a business
manufacturing this product, this is our balance sheet for the past 3 to 4 years, we have crossed
the break-even point now or we have reached the break-even point, we have crossed the loss
making area, we are at the break-even point and now are we have started making the profits.

Anybody will venture into, so the venture capitalist will move out and you will replace that very
very expensive financial resource of 30, 35 or 40 percent, with a very nominal 15 to 18 percent
or 18 to 20 percent and then the financial structure of the firm can also be improved because
operating structure was good so it is helping now to improve the financial structure also.

(Refer Slide Time: 29:58)

So, in this case what we have to do is, you have to decide about the determination of the capital
structure. Capital structure is basically the mix of the debt and equity, equity is the owned funds
by the owners of the business, and debt is the borrowed capital form the market. So, as per as the
owned funds are concerned there is no problem at all.

30
Because maximum risks to owned funds is that if the business does not work well, your
maximum risk that whatever the investment you have made in the business that will go down in
the drain, you will lose that, all 4 people, all 4 friends they invested 1 lac rupees each and
business has not responded well.

So, after 2-3 years they tried their luck but they thought that this business is not working we have
to close it down so you lost 1 lac rupees each. Fine but the question is that if the component of
debt is very high and that debt is hypothecated against the assets of the firm and if the assets of
the firm are not sufficient sometimes then sometimes it can create a problem that the personal
assets which are given as a guarantee by the owners of the business, they can also be attached
and the financial institutions can do anything for recovering their debt.

So, apart from the business becoming insolvent even sometime the owners of the business also
become insolvent. So, you have to become very very careful while deciding the capital structure
of the firm. If the capital structure is fine, balanced capital structure in the initial years of the
business more funds should come from your own pocket. Borrowed composition of the borrowed
funds you should be as low as possible.

So, if you invest least amount of the borrower funds then certainly you can expect the better
performance otherwise you can say that the chance of risk is very high. So, I would caution you
that to be a better financial manager component or the magnitude or extend of the borrowed
capital in the business should be as low as possible until unless it starts making the profits.

You can start borrowing from the market later on when we have the proven potential and we are
sure of profitability of the business. Until and unless that is means assured we should depend as
less as possible on the borrowed capital so very carefully we have to take the fourth decision in
the business about deciding its capital structure. Other important decision areas like dividend
policies and analysis of the risk and returns and other supportive areas. I will discuss in detail
with you but that two in the next class. I will stop here, thank you very much!

31
 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 03
Fundamental of Financial Management Part III

Welcome all. So, we are in the process of learning about the basics of the financial
management or fundamentals of the financial management. And in the previous class we
learned about some of the important decisions areas of financial management, where we
discussed about the importance of investment analysis, working capital management, sources
and cost of funds and determination of the capital structure. Now, there two more decision
areas like dividend policy and analysis of the risks and returns.

(Refer Slide Time: 00:56)

These are the two further more important decision areas of the say financial management.
Here the financial manager has to play a very very important role. In terms of say for
example, fifth decision areas, the dividend policy. Now, when you talk about the dividend,
dividend is the something like that, when you prepare the profit and loss account and when
we calculate the profit, say for example here we have the profit and loss account and
whatever the profit comes up here, this is our profit and loss account.

32
(Refer Slide Time: 01:27)

So, we call it as the income statement. This is the income statement and it has two parts. First
part is called as the trading account, trading we call it as a trading and profit and loss account,
trading and profit and loss account.

So, it has two parts. Upper part is called as the trading account where we talk about the direct
revenue is coming from sales, by sales and then it is by closing stock and then it comes as a
to material costs, then to labour cost, then to other overheads cost.

These three costs we take and this, these two we take here and then finally we try to find out
that what is the net result here is. And for example, if the sales are more than the cost so the
net result here is the to gross profit, this is a gross profit.

So, gross profit is basically we calculate with the help of the trading account where we have
the two sources of the revenue that is the sales and closing stock, and this side we have the
cost and then with the differences called a gross profit. Then we bring this gross profit here
by gross profit.

And by other incomes, by other incomes we call it as other indirect incomes we added up
here and then, to other indirect cost we take here the other indirect cost we subtract here we
total it up here again and then you talk it about here is the difference becomes is the to net
profit, net operating profit after tax. After adjusting for the tax and everything you get this net
operating profit after tax. This is a very summarized view of your profit and loss account or
the income statement.

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Now dividend policy, when we are talking about that this profit when we have earned about
is net operating profit after tax, how these profits will be distributed?
We have the two options available here. One option here is that we can distribute larger part
of this. For example, 90 percent of this is distributed as a dividend, and 10 percent of this is
invested reinvested in the business. This is called as reinvested in the business. 10 percent is
reinvested in the business.

So, it means what is happening, the dividend policy of the form is that larger part of the
profit, net operating profit after tax, which is up reward of the business operations that profit,
larger part of that profits will be distributed among us the shareholders and only very nominal
part of this profit will be reinvested back into the business. So, what will happen in this case?

That if for example, if the dividend, the part of the profit we are earning from the internal
sources, if the larger part of that we are distributing as dividend, it means that for our own
investment requirements we have to go out in search of the funds and there may be so many
problems that when we go out in search of the funds that first of all you have to decide which
one is the best source available because cost of capital is a very important thing to be taken
care of we have decided in that other decision area that is a determination of the capital
structure and in the previous part we have talked about is the cost of capital.

So, if you reinvest your internal funds, the profit which we have earned, larger part of the
profit if it is reinvested back into the business, so it means there are so many say means
facilitating points are here. That funds that internally available. We have not to go out in
search of the funds.

Cost of the funds is within control because that is our only opportunity cost and says other
administrative and transaction costs can be saved because we are generating the funds largely
we are generating the funds internally.

But when you go out in search of the funds you have to pass through so many hassles.
Sometimes the funds may not be available and it raises the important say point here also and
it raises many eyebrows also, that when 90 percent because if the firm does not require the
funds internally within the firm, then it is means is justifiable that larger part of your profit
you distribute as dividends because firm is optimally capitalized.

But if you are requiring the funds for your internal operations, internal investments and for
that you are going out in search of the funds, you are going out in the market, you are

34
searching with the financial institutions, you are face searching with a say FPOs, IPOs and
FPOs or you are searching with the other revenues of the funds and where as your internal
funds are available. You are distributing that as a dividend to the shareholders that does not
make a sense.

So, if you want to maximize the value of the firm, your dividend policy has to be very clear.
That what do you want to do? If the internal funds are available and the businesses is for
example, is on the growth path and more funds that are required internally for the internal
investments, then our dividend policy has to be the financial manager has to take stand.

CFO of the company has to take a stand that we should that clear minimum amount as
dividend, maybe 10 percent, 20 percent of the profit can be distributed as dividend to the
shareholders whereas 80 to 90 percent of the funds should be reinvested back into the
business. So that our own investment requirements can be met internally.

And it makes sense also that if you have the surplus funds available why to distribute as
dividend? Because if the shareholders are not satisfied because you have not declaring
dividend, they have every option to sell off their stock in the stock market in this country
market and get rid of the stock.

If shareholders are satisfied with that whether we are getting the dividend or we are not
getting the dividend, we are getting the say value maximization of our investment in that case
it is better to invest the larger amount of the profit back into the business and not say
distribute it as a dividend.

Only shareholders who want dividend if they are have bought the shares of the company for
the want of dividends, they are the free because secondary market is there, stock market is
there, you can sell of the shares in the stock market and you look for the shares of the
companies who are declaring the liberal dividends.

So, dividend policy has to be very very clear. Dividend policy has to make clear, CFO has to
contribute, Chief Financial Officer has to contribute in designing the dividend policy of the
firm that if in any case the firm requires a funds internally, for the internal operations, for the
development and growth of the internal operations, certainly we would not declare dividend
or we will declare dividend as the minimum amount.

35
But if the funds are not required internally only in that case the dividend will be declared. So,
ratio will be either 90, 10 or 10, 90 that depends upon the internet requirement of the funds.
So, here financial manager has to play a very very critical role, very very important role
helping the management to decide, helping the board of directors of the company to decide
about the dividend policy.

If you are not retaining the funds generated internally, then you have no right even to look for
the funds from the external revenues and that may create the problem of the funds for the
firm. Many and in many cases, in many cases, what happens?

That for example, that when the firms go out in search of the funds for the additional
investment, the sources of the funds they also look back and they also try to analyse the
balance sheets of the firms who are seeking the funds from outside, avenues that what you are
doing with your internal funds.

If you are a profit making company, you are generating sufficient funds internally, why are
you not investing your own funds back into the business? Why are you distributing that as
dividend? It means your intention is not clear.

Your intention is not to continue with the business for the longer duration. And in that case,
the external sources of the funds also do not come out in support of the firms and they face
the say capital problem or the capitalization problem and it becomes very difficult for the
firms to raise the funds from the external sources.

And in many cases, even the businesses have failed, there the intentions of the shareholders
were something like that they wanted to close down the business. That is why their internal
funds they distributed as dividends and for their own requirements they went out in search of
the funds.

For example, if we talk about those Kingfisher and other companies owned by Vijay Mallya,
many banks were lending him money 9000 crores was lent by SBI and the other banks, they
never even looked for that what these companies are doing from their internal funds.

When the internal funds, internal profitability, they are distributing as a dividend to the
shareholders and for their own investment requirements, they are coming to the financial
institutions to the banks. It means their intention is not fair. They do not want to continue

36
with the business. There is something going to be fishy and this business and other funds,
other say lending may also be at risk.

So what we have to do is, we have to be very very careful. Or second thing is for example, in
this case for example, if you want to lend any external sources of the funds want to lend the
funds to any of these companies. So, it means they have to ask for the long term collateral or
the proper collateral, proper security of their funds and even if you are not asking for the
collateral or the security of the funds, it means rest assured your funds are going to be at risk
and do not expect your funds will come back smoothly.

In case of the Kingfisher and the other companies held by Vijay Mallya and that associated
group that, there was no physical collateral, there was no appropriate collateral ask by the
banks while extending the loans to the Kingfisher and other related companies.

And when they were asked, when the banks were asked by the different interest groups that
how could you lend 9000 crores to a person who has nothing to give us a security. So, they
said that only the brand name was a security with us. So, it means dividend policy plays very
very important role.

What you are going to do with your own profits and how much are your internal financial
requirements? Be clear about that. If you need more funds for internal investment, do not
declare liberal dividends. Sometime you cannot declare any dividend and total amount of the
profit can be reinvested back into the business.

People who want to support to genuinely and who have the long term investment needs, they
will continue with the company. Others will have the option to sell off their stocks in this
secondary market and look for the stocks who are going them immediate dividends or the
immediate liquidity.

So, dividend policy deciding the dividend policy financial manager has to take very important
decision. CFO has to take very important decision and they have to assist the board of
directors of the company, that since we require a larger amount of the funds within the firm,
so whatever the profit we are earning that profit rather than distributing as a dividend should
be reinvested back into that business.

37
(Refer Slide Time: 13:13)

Next financial decision area is analysis of the risk and returns, analysis of risk and returns.
That is a very very important this criterion analysis of risk and returns. Because every
decision when we take, we have to be very careful about that, how much is the return
available for the given amount of the risk we are taking in the business?

How much is the return available for the given amount of the risk? It is very clear that when
you are into the business, you are going to take risk. But you want the reward for that risk. I
was giving you example in the previous classes that when a person graduates or he does his
MBA, he has option two options is in his hands. One option is to go for the placement and
join a job and become an employee with some existing organization.

There what he is doing? He is taking the minimum risk. He is not investing his own funds. He
is only going to render his services and for those services the firm is going to pay the price
and that price is called as the pay package. So, it means whatever the work is assigned to him,
he will go to the office, he will do that work come evening home, next morning again will go.

At the end of the month, he will be paid for that. If he has the second option in his hand and if
he exercises that, that he rather than becoming an employee to some existing firms, if he
prefers to become the entrepreneur, so he is going to manages all resources by himself or by
his team it means there can be success also, there can be failure also.

So, he is going to take the huge risk by becoming entrepreneur and when you are taking the
huge risk by becoming an entrepreneur, you are not satisfied with the salary or that amount as
you are getting it as a salary from some company when you are an employee. You want more

38
return and that return has to be number one is a return for your efforts, second one the returns
for your risk. So, it means analysis of risk and return is always important.

Another important example here can be for example we have. For example, I have 100 rupees
available with me? I can give that hundred rupee to the bank simply deposit in the bank, rest
assured, I will be getting 3.5 percent of the saving bank rate of interest and I am going to get
that nobody can stop that and that 100 rupee will become 103 rupees and 50 Paisa after 1
year.

But I have another option that I can buy the stock of a company for a 100 rupees, one share of
the company for a 100 rupees if it is available. And I can say think of that rather than making
a 100 rupees 103.5 rupees at the end of one year, I would like to make it 110 rupees.

It means I am going to the stock market, I am taking more risk and if I am taking more risks,
I want that more reward for that. I need to be compensated for that. So, analysis of risk and
return goes hand in hand in every business decision, in every business decision analysis of
risk and returns goes hand in hand.

Whatever the business decision you are going to take, you first think in terms of the returns
available and at the same time you think of that for this much amount of the returns, this
much amount of the risk I have to take and it may be possible that I get the desired return, it
may be possible that do not get the desire return, it may be possible that I get 0 return,
whatever the investment I am making that goes down in the drain. Anything is possible, but if
I want higher returns I have to take risk.

So, every decision we have to take in that perspective of the risk and return. I give you the
example in the previous class of that, fruit beer project of the anchor industries or the anchor
India limited. In that case also because they thought of diversification from their say
conventional business of the electrical products.

They thought of diversifying to the consumer products and they thought that fruit beer is a
product, which is going to be a new in India and the anchor may be the pioneer in that area or
in that product or in that field.

As the product is a welcome product in the Europe, US and the other some advanced
countries. It may be a welcome product in India also. So, they invested 350 crores into this

39
project, into this particular area. So, their intention was to maximize the returns because they
thought that we will be pioneers, we will be the pioneers in this area.

So, when you are pioneers, you are the first mover in the market, so you take some risk also
but the returns are also equally high. But in that case only it was a risk, no return was
available because product finally failed.

Similarly, you talk about the Karsanbhai story Nirma. When you talk about the Nirma in
Nirma’s case, Karsanbhai why did not take say uncalculated risk? This is the one important
advice I would like to give you here is that, any risk you want to take because we should take
risk. That means for sure.

That if we want to grow in the life, whatever the decision you take, whether it is the
investment decision, business decision, entrepreneurship decision or any decision, you have
to take risk in the life. If you are take risk in the life, certainly the turns will be higher. But
there can be the things happening other way around also. So, but if you want to take risk,
always take that calculated risk. Warren Buffett also says that when you take risk, take risk.
Nobody can means earn anything extra without taking the risk.

But always take the calculated risk. And then Karsanbhai moved into the market with the
Nirma washing powder, he did not take much risk. He manufactured the product, he started
distributing it free of cost. So, what is risk was? Initially investment into the factors of
production and producing that product at a very small scale.

He distributed it free of cost to his neighbours or people living in his vicinity, then to his
relatives, then to others. So, whatever that investment he made during that manufacturing and
free sales of the product, he took that risk that if my product is acceptable to the people, I will
go for a manufacturing it at that larger scale.

But if my product is not acceptable to the people, I lost some a few thousand rupees and in
1982 few thousand rupees was also a big amount. So, means he took the calculated risk and
finally the product was huge success. So, whatever that say free distribution he did, he could
recover that total amount back.

So, here when you talk about the analysis of risk and return in every business decision, when
you think of earning the good return on your investment as a true financial manager, you
have to always think about that risk always goes hand in hand with the returns and we have to

40
be very careful in every business decision. It may be a decision of buying a machine, single
machine, replacing the older technology with the new technology or maybe sometimes hiring
some specialized skilled workers and say replacing the old workers with the new workers.

Whatever the decision you take every decision is going to come with the risk and you have to
think about that if the risk is means outweighed by the returns, then certainly we are going to
be in a win win situation. Otherwise sometimes we lose also in the business.

So, the see because of that risk, sometime your returns are not up to the mark so there is
nothing to worry about. So these are that six business decision area. I am discussing this all in
a very summarized form investment analysis.

We will discuss in detail working capital management is itself an independent area of

learning. I have offered another course specialized on the working capital management,
which is already going on. If you want to have a detailed knowledge about the working
capital management, you can join that course. Then you will be learning in detail in this
course about sourcing and cost of the funds and about the decision making in this area.

Determination of capital structure is a very very important decision. I gave you just flare off
that in the morning that what component of the total fund should come as a debt, what should
come as an equity and what should be the mix of debt and equity. So, that all will be learning
in detail.

Dividend policy I just discussed with you that dividend policy has to be very clear if you
need the funds internally first, reinvest the funds back, distribute the minimum amount of the
profit as dividend. Otherwise the firm will have bad name, bad repetition and last is the
analysis of risk and returns very important decision because every business decision goes
with the risk.

If you take a risk only, then you can have that higher amount of the returns. So, finally if we
look at this arrow, this arrow says that if you take these 6 proper business decision in the
proper manner, then the result will be the shareholder's wealth maximization and there is an
ultimate objective that why we are starting the business, why we are into the business because
we want to maximize the shareholder's wealth.

We want to maximize the shareholder's investment. If people buy the stocks of the
companies, why they buy the stocks of the companies in the wake of that, they will be able to

41
maximize their returns on their investment. It may be possible that sometime when you buy
share from the market, the price of the share may go down. It may be possible that sometimes
you lose investment in the market also or sometime investor increases.

But not at the desire place or sometime overnight the, your means 100 rupees’ investment
becomes an investment of 1000 rupees. So, everything is possible but ultimately when we are
into the business, ultimate purpose of every business is to maximize the shareholder's wealth.

So, that the shareholders, promoters of the firm when they start a business and when at any
later stage when the business is closed. There has to be the difference in that initial capital
and the capital of the firm at the time of the dissolution or the closer of the firm. So, whatever
the decision you take here right from the first to the sixth decision ultimately that is going to
be in terms of the maximization of the shareholder's wealth and that is going to be the
reflection of the better financial management.

Now, we moved to the other areas that to have the better financial management of any
organization, any company. You have to have the other supportive areas, also supportive
disciplines also and you have to carefully means manage those areas also because every
supportive discipline can be translated in terms of finance. For example, the primary
disciplines are which go hand in hand with the finance are accounting, macroeconomics and
the microeconomics.

Accounting and finance is the one department in the companies with the help of accounting,
you get to know that whatever the investment be made in the business, what is the end result
of that? Because whatever their sources of the say finance we invest into the firms, we
convert that into the financial statements and financial statements are possible to be created
with the help of accounting.

At the end of the year, one accounting period of 12 months, you come to know whether the
business has ended up with the profit or the loss and that all becomes possible if you know
accounting or you convert that raw information into the profit and loss account.

Similarly, we prepare the balance sheet, balance sheet tells us about the financial position of
the business on the last day of the year or the last day of the accounting period, and that also
becomes possible with the help of accounting. So, accounting is the one important say, basic
discipline, which is the prerequisite for the efficient management of the funds or the finances

42
in the organizations. And accounting helps in the reporting of the firms’ operations and the
business results.

Similarly, the other disciplines are macroeconomics. It tells you about the trade position in
the market, tells you about the supply and demand position in the market sorry, that is in the
microeconomics but to the government policies, government budgets then as international
environment, everything is the part of the macroeconomics and every firm these days is
subject to the all these external factors, government policies, government budgets,
international environments, foreign exchange, all of these things and largely they are the part
of macroeconomics. Microeconomics, demand and supply functions are the most important
functions, money, market, capital markets.

All these are related to the microeconomics and without money market, without demand
supply functions, you cannot run any business and there every at every step you need the help
of the microeconomics. Then we have the other related areas like marketing, production, then
your quantitative methods. For example, marketing without finance marketing is not possible,
without finance marketing is not possible.

Why you go for marketing? Because you want to maximize the sales of your product or the
service in the market and why you want to maximize the sales? Because you want to have the
maximized revenue and maximized revenue means maximized profits and maximized profits
means the maximum is return to the shareholders.

Similarly, the production why you want go for the production? Without finance production is
not possible at every step you need finance. So, if you want to have the proper well managed
production function, you first have to discipline yourself in terms of finance. If you do not
have the required amount of finance, then you do not have the required amount of the
material.

You do not have the required amount of the people, so who will run your plant. So, these are
related areas supportive areas. And in nutshell, you can say that finance is such a diverse area
that with the help of other areas, whether it is accounting, economics, both macro and micro
marketing, production, distribution, human resource management, these all functions are
facilitated by the finance and then finance becomes the backbone of the business that is why I
started in the morning.

43
The discussion in the previous class when I started the discussion, I told you finance plays the
roll off a blood as the blood plays, the role in the human body that if the blood is equally
being supplied to the different organs of the body, then all organs remain healthy, all organs
remains working, all organs keep on responding and a human being remains a perfect human
being, a healthy human being.

But if there is a shortage of the blood in the human body, in overall person becomes anaemic.
If the blood circulation is not proper in any part of the body or sub part of the body, that part
also stops functioning or sometimes they are come serious problems.

So, if the finances flowing property properly within the organization and the financial
requirements of the different units and subunits of the firm are being taken care of properly,
you can see the firm is growing just to delivering value and ultimately the ultimate purpose of
the business is going to be attained and the final objective of the maximization of the
shareholder's wealth or the value maximization of the firm is going to be attained.

So, we have to learn to manage the funds, the finances in the best possible manner. So, that
within the minimum financial resources we can have the maximum and the best possible
results. Now, we go ahead with the next part. Scope of the financial management, what it
involves.

When we talk about the financial management, what it involves, what are the different
decision areas. Which show that they are the 6 decision areas, but in the scope when we talk
about the scope we in a very crisp manner, we can say that in the scope of the financial
management.

44
(Refer Slide Time: 29:33)

We have three important decisions to take, we have three important decisions to take one
decision is the investment this decision, second decision we have to take her is the financing
decision and third decision we have to take here is as a dividend policy decision. Three
important decisions we have to take here investment decision, financing decision and then is
the dividend policy decision. Now, investment decision.

What is investment decision? Investment decision can be that in two possible ways the
decision can be taken or then the two different situations the decision can be taken. As I told
you to that fresh entrepreneur if he went to a fresh management graduate or any graduate he
thinks off that rather than joining a job in any company, I will become entrepreneur.

45
Why he will become an entrepreneur because he is visionary. He has the risk taking
capability. And third important thing is he has got very good idea in his mind. If he means,
implement that idea in the business, he can create a very good product or a very good service
and if it goes with that product or service in the market that will be accepted by the people in
the market. So, this is the investment decision.

Now, whether to go for that he cannot blind fully say that I have conceived this product and I
will manufacture and people will out rightly buy it or they will accept a product that is not
going to happen.

He has to go for the detailed investment analysis for that and I told you in the previous class
also that analysis starts with the market and demand analysis. You have to first try to explore
that if you manufactured this product or start generating this service. Is there any market for
that or not?

Similarly, if the market response is very good, similarly you have to take the input decision.
This yes output if it is done, it is acceptable to the people in the market, but what about the
input? How can I manufacture this product and then finally he has to make input output
analysis to have the one unit of output, how much input is required, and what is the total cost
benefit analysis? This is in case of the new entrepreneur, single entrepreneur. If he wants to
become a businessman and invest his funds into the business and try his luck by becoming an
entrepreneur by moving into the business.

Second situation can be that an existing firm who is already having manufacturing four
products and successfully selling them in the market, they want to introduce a new product in
the market, the fifth part of the sixth product into the market. They want to check that and
they want to take that investment decision. Again, they have to follow the entire process as in
case of the anchor industries I told you that anchor was already existing in the market.

But means, just because of the fear of the liberalization, globalization of Indian economy,
they thought that their conventional business of the electrical products may not be as safe as it
was when India was a closed economy. So, now they have to look for some other areas and
we have to start to diversify.

And then when they went for say taking this decision under diversification and started means,
thinking about introducing this product, the fruit beer, they did a thorough analysis
investment analysis. And finally they decided that yes, we should go for this investment.

46
And finally we should, means make this investment and manufacture this product and come
out with this product in the market. Finally, the product did not work well, they lost their total
investment. That’s a different story, but first decision, whether you are a new entrepreneur or
you are an existing business, proper investment decisions have to be taken.

So, furthermore what is required in the investment decisions and what are the other
prerequisites of the investment decisions, these plus financing decisions and the dividend
policy decisions. I will discuss with you in the next class. I will stop here. Thank you very
much!

47
 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 04
Fundamentals of Financial Management Part IV

Welcome all, so in the process of learning about the Basics of Financial Management, we
were discussing about the investment decisions and in the investment decisions, I told about
you that a thorough analysis of the, say proposed investment decision has to be done with
regard to the market and demand technical analysis means the input, output analysis,
possibility of selling the product in the market, then the cost and benefit analysis everything.

Even including the projected financial statements for the next 10 years minimum. So, that we
are sure about, that how many years the product will take to reach at the break-even point and
then after that in the next ten years, out of the 10 years’ periods of time, how many years
there will be a profit and how many years will be there be a loss and when the product will
reach at the break-even point.

(Refer Slide Time: 01:25)

Now in this case the investment decision, when we take it has two broad components, first
component is the long term investment related decisions which we call in the short term or in
the technical manner the capital budgeting decision and second is the short term or the
current asset decisions.

So, long term investment decision and short term investment decision. Both the investments
we are required to make, when we think about the long term investment decisions, we call

48
them as a capital budgeting decisions and when we talk about the short term investment
decisions, we call them walking capital decisions.

So, capital budgeting decisions and working capital management decisions both the decisions
we have to take. In the previous class, sometime I told you that, to make the proper utilization
of the long term investment made into the fixed assets, land, plant, building, machinery,
furniture, vehicles, you need sufficient amount of the working capital, short term funds.

Your plant your machinery is of no use, until and unless there is a sufficient amount of the
people working on the plant, sufficient amount of the raw material available with us,
sufficient amount of the other inputs like power, water, other lubricants, oils, lubs other
things.

So, when you are taking the decisions about plant and machinery, land, building, plant and
machinery, it is a long term decision, it the capital budgeting related decision. But to make
the proper utilization of those long term fixed assets to have the working capital and to have
the short term or the current assets like, this material like human resources, like other things
you need to make short term investment decisions working capital decisions.

So, how much investment is required as a long term investment, how much investment is
required as short term investment, you have to pre assess it in a proper and efficient manner.
Then we have to proceed further. So, if your investment decision says yes, if the answer after
the thorough and the detailed analysis, we get the answer that yes, this is the profitable
investment, we can make this investment and if we make this investment we are going to
attain the ultimate objective of the value maximization of the firm or the wealth maximization
of the shareholders.

We are manufacturing four products, if we add up the fifth product in the row in the total say
you can call it as the product mix rather than manufacturing 4, now we start manufacturing 5
or 6. We are going to increase the overall sales of the firm, overall profitability of the firm,
overall value maximization we are going to attain. Certainly the investment decision is
positive and we have analysed it from every angle.

So, once that investment decision is approved by the different stakeholders, like the
management of the firm, different consultants, board of directors and finally it got it got
approved in the annual general meeting, the final approval of the shareholders is obtained by

49
the board of directors. It means that investment decision gets the green signal and support of
that investment decision is the detailed background analysis.

After this, once this decision has been taken, the next decision we have to take is now the
financing decisions. I told you different type of the investments to be made, into the long
term assets into the short term assets, capital budgeting and the working capital management
both. So, now from where the funds will come?

I told you largely, there are three sources of the finance, one is the long term sources of the
funds, short term sources of the funds and third one is a spontaneous finance. Long term
sources of the funds have to be used only, or largely for having the long term assets in the
firm like land, plant, building, machinery.

Short term funds have to be used for the creation of the short term assets, like inventory,
credit sales, prepaid expenses, advance deposits and keeping cash. And then is the
spontaneous finance. So, when we start making use of it, if you talk about the long term
investment decisions only long term sources we should normally make use of. And for the
long-term funds you have the different sources, you can go, if it is the existing firm we can
come out with an IPO.

So, we can have the sufficient equity and we can issue the equity share, we can issue the
preference shares. So, by way of equity, we can generate the funds or if you do not want to
generate all the funds through equity then partially we can generate the funds through equity,
partially through that, by say borrowing funds from the financial institutions or coming out
with the bonds issue, debenture issue or simply if we do not want to come out with the bond
or debenture you can borrow funds from the financial institutions.

So, you can have a proper mix of debt and equity as far as the long term investment is
concerned. For the short term investment, you have to start with spontaneous finance and
then you are to move towards the short term finance and anyhow if the working capital needs
are not fulfilled from spontaneous finance and the short term sources, then only we have to
resort to the part of the long term sources.

So, long term investment only from the long term sources, short term investment, working
capital investment, first from spontaneous finance, then from the short term sources of the
funds and then from the, if still the need is there, part of the long term funds can be used for
the short term requirements.

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(Refer Slide Time: 07:20)

So, what is written here? The second major decision involved in financial management is the
financing decision. The investment decision is broadly concerned with the asset mix or the
composition of the assets of the firm. How much you want to have the long term assets? How
much you want to have the short term assets land, plant, building machinery and then short
term asset inventory, credit sales, advance payments, paid amount, cash in hand, cash at bank
all these things.

The concern of financing decision is with financing mix or the capital structure or leverage. I
told you what is the capital structure? That is a mix of the different sources of the funds,
borrowed funds and owned funds borrowed funds means debt, owned funds means equity.
There are two aspects of the financing decision, there are two aspects of financing decisions,
first the theory of capital structure, which shows the theoretical relationship between the
employment of the debt and the return to the shareholders.

Second aspect of financing decision is the determination of the, an appropriate capital

structure given the fact of a particular case. Thus, the financing decision covers two
interrelated aspects the capital structure theory and the capital structure decision. Capital
structure we will discuss in detail at the later stage but capital structure theory what it says
there are different theories of the capital structure. We have the net income approach, we
have the net operating income approach, we have the Modigliani Miller approach.

We have number of other theories of capital structure. So, first we will learn about those
theories, but in literature all these theories talk about or suggest, the firms to have the capital
structure like and in the practical sense how the capital structure of the firm has to be decided.

51
Because the major difference in the debt and equity is, people say debt become means comes
up as a cheaper source of finance as against the equity because it is tax deductible, because it
is tax deductible, because whatever the cost of the funds you pay as debt means you must
understand here that whatever the cost of funds we pay here as debt.

(Refer Slide Time: 09:35)

For example, you are preparing here this profit and loss account. So, in this profit and loss
account after preparing the trading account, you show one cost is that is called as the interest
on loan and when you show this is an expense here. So, when you calculate the two net
operating profit after tax, it means this profit will come, for example this interest figure is
10,000 and your profit is 90,000.

52
So, if this borrowing is not there this interest on the loan will also not be there. So, what will
happen this interest will not be paid on that, because entire amount of the fund has come from
equity. So, what will happen this amount will be added in this, it will become 10,000 your
profit will become 1 lakh rupees and if the tax rate is at 30 percent.

So, it means your tax will become how much 30,000 rupees. So, it means your profit in your
hands will be, that left out profit will be how much rupees 70,000. But, if you paying this
interest to the say, the suppliers of the long term funds in the form of the debt, we have
borrowed this funds it means 10,000 rupees paid as interest. So, now this profit will now be 1
lakh rupees, but this profit will be something like your 90,000 rupees.

So, it means if it is 90,000 rupees, so at the rate of 30 percent, what will be your tax,
component? The tax component will become 27,000 rupees. So, your 3000 rupees saving is
there if you are boring the funds paying the cost of the funds as interest and that interest is we
are showing as the financial cost in the profit and loss account, which is tax deductible.

But the funds, if I have come from the equity then no interest is paid on the equity because on
the equity capital, we never pay any interest, we pay only dividend in the event of
profitability and that dividend is not the part of the profit and loss account. So, it means that
does not appear here that does not come here, it means you have to, your profit will become 1
lakh rupee, you have to pay 30,000 rupees as a tax.

In this case, you have to pay 27,000 rupees as a tax. It means whatever the loan we are
paying, means actually this interest on the loan we are paying is actually, we are paying 7000
rupees, because 3000 rupees we are saving as tax. So, people say that, debt comes as a
cheaper, say as a cost of funds, it is lesser than the cost of equity. Because of the first feature
is that it is tax deductible, equity is not tax deductible and second thing is that the cost of the
debt remains fixed.

For example, the rate of interest of that loan is for example 18 percent. So, if the firms profit
is for example very high that 50 percent of the investment is a profit of the firm. In that case,
if the funds have come in the form of the debt only you have to pay 18 percent as interest that
is the cost is fixed, remaining whatever the balance amount is that belongs to the equity
shareholders.

So, to the firm the cost of funds is restricted up to 18 percent which we know in advance. But
in case of equity, because higher the amount of the profit, higher the amount of, amount will

53
be of the dividend. So, some time the amount of dividend can go up to 40 percent also, 30
percent also, 35 percent also, 45 percent also. So, the cost of funds it is not known in advance
in case of equity. So, in the event of the higher profit, there profit has to be shared with the
shareholders. If we not required that profit internally within the firm.

So, cost of the funds goes up, so that does not happen in case of the debt and furthermore the
debt is tax deductible, equity is not tax deductible. So, in the capital structure of the firms in
the financing decision of the firm. We have to create a proper balanced capital structure. First
we have to understand the theories of capital structure therefore deciding the capital structure
of a firm but net income approach says, but net operating income approach says what your
Modigliani Miller approach says and finally for deciding the capital structure of the firms
what finally we have to do what to do, what finally we have to do.

And then once the financing decision is taken two decisions are over. One decision is the
investment decision, we clear that yes we will go for this investment because we see that this
investment is going to be profitable investment, once that decision is ok taken. Second
decision is financing decision, we have decided on certain basis that out of the total
investment requirements 80 percent will be equity, only 20 percent will be debt or vice versa
or 50 percent will be debt 50 percent will be the equity.

So, we have to take this next decision which is called as the financing decision and largely
this decision is also taken by the CFO with the help of the other important functionaries in the
organisation in the firm.

(Refer Slide Time: 14:53)

54
Then we talk about the dividend policy decisions, what should be the dividend policy of the
firm, here it is written the dividend decision should analysed in relation to the financing
decision of the firm. Two alternatives are available in dealing with the profits of the firm after
the profits is earned we have the two alternatives here.

They can be distributed to the shareholders in the form of dividends as I told in the previous
class. Second is they can be retained in the business itself the decision has two or decision as
to which course should be followed depends largely on the significant element in the
dividend decisions.

The dividend pay-out ratio that is what portion of the net profit should be paid out to the
shareholders and this dividend policy decision is always taken in the light of investment
requirements of the firm. If the internal investment requirements of the firm are high then
CFO has to play a very role here, convincing the board of directors, convincing the
shareholders in the annual general meeting that let us have a policy, that whatever the profit
be earned larger chunk of that profit is reinvested back into the business because the business
is on the growth trajectory.

If the business is on the growth path certainly we need more funds rather than going out in
search of the funds, why not to reinvest the profit back into the business. So that we can
maximize the capitalisation base of the firm, the capital base of the firm, investment base of
the firm and very few needs are fulfilled from external sources, larger investment come from
the internal sources only and we do not distribute our profits as dividends liberally.

If shareholders permit for this, it means the dividend policy is, now say you can call it as, in
is in favour of say reinvesting the profits back and not paying it as a dividend to the
shareholders in the liberal manner, but if the other way round is decided that investment
requirements are not very high internally of the firm, firm is optimally capitalised. So,
whatever the profit earned now that larger part of that will be distributed as the dividend.

So, that depends upon the stage of the business, if the business is on the inception or the
growth stage then certainly more amount of the profit has to be re-invested back into the
business. So, dividend has to be reinvested back, no dividend is to be paid or very nominal
amount of dividend is to be paid and profit has to be reinvested back into the business, but if
the business is on the saturation level and no further funds requirements is there, in that case
you can decide that yes further investment requirements are low in the business.

55
So, whatever the profits, we earn that will be distributed as dividend. So, this is a very
important third decision as the financial department or the head of the financial department or
the finance department, the CFO has to take. So, three important decisions, investment
decision then is the, your financing decision and third one is a dividend policy decision.

(Refer Slide Time: 18:02)

Now finally we talk about the relationship of all these decisions with the risk and return and
the market value of the frim, ultimate objective is this. The market value of the firm we want
to maximize the market value of this firm. When you want to maximize the market value of
the firm, when the market value of the firm will be maximized when the total all decisions
when you are taking they are in the interest of the organization.

Market value for example, you talk about, say there are the two kind of the values of the
firms, one is the book value of the firm second is the market value of the firm. Book value of
the firm is calculated by way of summing up all the assets of the firm at the book value at
which they are acquired and then we try to find out from the asset side of the balance sheet.

What is the book value of the firm? Market value of the firm is basically, means if you talk in
the true sense of the market capitalisation, then we say that total number of outstanding
shares in the market, multiplied by the price of the one share. So, that is known as the amount
of the capitalisation you can calculate.

56
(Refer Slide Time: 19:05)

So, it means the market capitalisation is, the market capitalisation of the firm will be, if you
want to calculate the market capitalisation, then in that case how to calculate the market
value, this is the process you can easily calculate that total number of, total number of the
shares outstanding, total number of the shares outstanding multiplied by the market price of
one share.

So, it means that is called as a market capitalisation. Total number of shares outstanding
multiplied by the market price of the one share, that is known as the market capitalization and
though the market value of the firm, the capital, market capitalization of the firm is not same
as the book value of the firm, but even the market value of the firm is also influenced by the
book value of the firm.

57
If for example, if the firm is making the best utilisation of his fixed assets, best utilisation of
its current assets and maximizing the overall profitability of the firm. So, that reflects its best
performance in the market and that news spread out in the market that this is a best managed
companies, the profits of the company are very high and on the basis of that best news
spreading in the market price, people are ready to pay the very high price for the shares
trading in the stock market.

Though they are not means reflecting the true value because there is a different in the market
value of the share and book value of the share. But if you, or the book value or the intrinsic
value of the share or the fair price of the share. But market capitalization or the market value
of the shares which is largely the reflection of the traded price of the share. But that is also
equally supported by the physical performance of the firm and physical performance of the
firm largely depends upon your capital budgeting decision.

How means, honestly we are taking the investment decisions how robust our analysis is while
deciding over the investment analysis how robust our total analysis is. How we have decided
our capital structure. How we have decided our dividend decisions and how we are managing
our working capital everywhere there the two aspects, one is the risk and another is a return,
then you are taking the capital budgeting decision, both aspects are important.

When you taking capital structure decision both the aspects are important. When you are
taking the dividend decision both risk and return are important. When you are taking the
working capital decision both the aspects are important and finally, if you are able to
maximize the returns of the firm for a given amount of the risk by virtue of taking all these
four decision in a very professional manner, then what will happen?

You will be able to achieve this final objective of maximization of the market value of the
firm and if the market value of the firm is maximized it means the objective of the wealth
maximization of the shareholders will be achieved.

So, we have to learn this, in this due course that how to achieve this target by managing your
financial resources in the best possible manner. One more important dimension of the
financial management is goal of financial management, where you want to go with the best
management of your financial resources. What you want to do?

58
(Refer Slide Time: 22:44)

So, here what is written here first read that. Finance theory rests on the premise that manager
should manage their firm’s resources with the objective of enhancing the firms market value.
Market perceptions and how the market perceptions increase when your physical
performance of the firm goes up.

When your profit and loss account is reporting profit and profit is means every year it is
going up. So, it means whatever the price for the share in the market we are paying, we are
able to expect the better returns because firm physically is also performing though there is a
difference in the market price of the share and the book value of the share, there is a
difference.

Because traded price is different and the book value the intrinsic value is different that is
there. But if the book value is increasing, automatically the market value will increase. And if
you want to increase the market value of the firm that is why the, say market price existing
market price per share and the total outstanding number of the shares.

In that case, what will happen your overall value of the firm will be maximized in the market.
Market capitalization will be very high of that company. So, goal of the financial
management is to use your financial resources which are scarce in nature in such a manner
that by managing the given amount of risk, in the best possible manner, the return of the firm
is maximized.

The cost of our value drives scarce resources to their, most productive uses and their most
efficient users. The more effectively resources are deployed, the more robust will be the

59
economic growth and the rate of improvement in our standard of living. Finally, Adam
Smith’s invisible hand is at work when investor’s private gain is a public value.

Physically you are growing, the firm is growing your profit is growing. Your sales are
growing your revenue is growing, your expenses are within the control. So, the difference
between the revenue and the cost is maximizing. So, ultimately your profit is maximizing,
when the profit is maximizing you are getting the maximum amount of the dividend back as
the shareholder and when the dividend amount is increasing, certainly the market value of the
share of the company is also increasing.

That perception about the market value of the firm is increasing and the firms that value
maximization objective is getting say attained. So, private gain is a public value, means
whatever amount to the increase, whatever amount of the increase in terms of the dividend
the firm is making by getting the maximum out of the dividend from the firm because of the
increased profitability.

Same reflection is there in the market value or in the market price of the shares of the
companies also. So, because the physical values increasing, intrinsic value is increasing, fair
values increasing, certainly the market value of the share is also increasing. So, the private
gain is becoming the public value.

(Refer Slide Time: 25:53)

So, we have to achieve this objective of the goal of financial management and apart from the
goal the objective is that, apart from that we have certain other objectives also apart from the
value maximization of the shares of the company, we have some other objectives also and the
other objectives of the company are or the financial management are.

60
Let us read what is written here, the goal of financial manager is to maximize the owners or
shareholders’ wealth as reflected in the share price rather than profits or EPS maximization,
because the latter ignores the timing of returns does not directly consider the cash flows and
ignores risk. So, what is written here, the goal of the financial manager is to maximize the
owner’s wealth, as reflected in the share price that is ultimate objective.

(Refer Slide Time: 26:45)

That is it is written here also, that the private gain is the public value. Private gain is in terms
of the dividend and dividend in terms of cash. When the profit increases, then the dividend
increases. So when the profit increases dividend should also increase and dividend should be
passed on to the shareholders. And when that happens then what happens it is reflected in the
increased price of the share, because it is the real.

61
The dividend is the real, if the dividend is passed on to the shareholders that is passed on, in
terms of the cash and cash is more real as compared to the profits. So, it means the ultimate
objective is to increase the market value of the firm by increasing the profitability and by
increasing the dividend to the shareholders.

As key determinants of the share price, both return and risk must be assessed by the financial
managers when evaluating decisions alternatives. Right from the investment analysis till the
dividend policy decision, everything is important for us. The economic value added is a
popular measure to determine whether an investment positively contributes to the owner’s
wealth.

Next thing is, however the wealth maximization action of the finance, finance managers
should be consistent with the preservation of wealth of stakeholders that is groups such as
employees, customer, suppliers, creditors, owners and others who have a direct link to the
firm, till the end of means say corporate India paid scant attention to the goal of the
shareholders’ wealth maximization till the end of 80s.

In the post liberalization era, it has emerged as the centre stage of the corporate financial
practices. The contributory factors being greater dependence on the capital market, growing
importance of the institutional investors and the foreign exposure. Because of the increased
say competition in the market. Because now the capital market has become very, very
important for us.

Large amount of the funds is coming from the capital market to the businesses, shareholders
are subscribing to the shares of the companies, awareness level has increased the investor
participation in the stock market has increased, your stock market has become say means you
can call it as like a world market, and efficient as the world markets are.

So, since the role of the shareholders has increased many folds. So, like other important
stakeholders, shareholders’ welfare is another important objective and that ultimate objective
can be achieved by the increasing the market value of the shares, because people will
subscribe to the shares of the companies, whether it is through IPOs or through the secondary
sale.

They would subscribe to the shares of those companies only, where the value maximization
function is attained. So, ultimate goal of the financial management is the value maximization

62
of the firm and if that is attained, then the major objective of the better financial management
is that we are able to give the better returns to the shareholders, who make investment in the
market by way of subscribing to the shares of the companies.

So, important objective apart from the goals of financial management, important objective of
the firm is that, like your important, say stakeholders like customers, suppliers, creditors
owners and others we have to have, means very important and respected position to give to
the shareholders also, who are the suppliers of the blood, lifeblood to the companies and if
the funds are coming in the liberal manner to the companies then ultimate objective of wealth
maximization can be achieved because you have the best input in terms of material, in terms
of employees, in terms of the final product to the customers.

So, if all interest group are satisfied, return on the firm’s investment will be maximized and
ultimately this will be reflected in the increased share price of the company because physical
performance of the company has increased because of the increased profitability, increased
revenue, increase profitability increased sales and ultimately the maximum returns we are
able to give back to the shareholders. So, objectives and goals of the financial management is
maximization of the firm’s value and second thing is maximizing shareholder’s wealth.

(Refer Slide Time: 31:23)

Now, the other important things, when you talk about here is that, means before we close the
discussion for today. I would like to discuss this structure with you the fundamental principle
of finance, means what we have been discussing just now that what should shareholders give
it to you or to the firms and what the firms return back to shareholders. This structure, this
relationship goals something like this.

63
Now, look at this, the fundamental principle of finance, the fundamental principle of finance
speaks here is a business proposal regardless of whether it is in new investment or acquisition
of an, another company or restructuring initiative. New investment may be by an
entrepreneur or maybe by the existing company into the new product new service or new
division.

Whatever it is or acquisition of another company again investment decision or restructuring

initiative in the existing company, again investment decision raises the value of the firm, only
if the present value of the future stream of the net cash benefits expected from the proposal is
greater than the initial cash outlays required to implement proposal.

You invested 100 rupees today, in whatever manner maybe as entrepreneur, may be as your
say adding the new product into the adjusting product mix or by acquiring a new company or
by restructuring the existing business operations. Because of that investment of 100 rupees,
that 100 rupees has to be magnified and the future value of that 100 rupees, the benefits
which are arising out of this investment must be more than that 100 rupees.

If we are able to achieve that target, means finally when you calculate the net present value of
any investment. We calculate the present value and the net present value of any investment
which we will discuss at the later state in the capital budgeting decisions. So, when you
calculate the net present value of any investment decision, we try to find out that we make a
relationship between the, or analysis between the outflows of the funds and inflow of the
funds.

Outflow is when the investment is made, funds outflow from the firm, from the business to its
operations. When we move into the operations, product is produced or service is generated
that goes to market then by way of virtue of the sales revenue comes in. So, funds start
flowing in time and then we make a time say value of money analysis and because of that
time value of money analysis, we see that whatever the investment we made in today's period
in the current period that is equal to the 100 percent.

But the inflows are coming over the future period of time. So, we adjust them against the
time value of money and then we compare it that, what was the total present value of the
outflows of the funds which we invested in the business?

64
What is now the present value of the funds coming back to us in the form of the inflows over
the future period of time and then we make a comparison of the two and the minimum
decision making criteria is that the present value of the outflow must be equal to the present
value of the inflows and the NPV should be 0.

If this is the decision we can say yes, we can think of going into that investments, if the
decision is otherwise means outcome is otherwise, that for example the present value of the
outflows is more than the present value of the inflows, then the NPV is negative, there is no
point going for this kind of the investment decision and if the reverses happens that the
present value of the inflows is more than the present value of the outflows then certainly we
are into the say win-win situation.

And that situation occurs only that finally, what we invest and what we get back in return if
there is a difference, positive difference that investment is lesser than the inflow coming back
to us then certainly we would say we are able to provide the reward back to the investors or
to the shareholders.

So, this structure says that investors are who they are the two kind of investors in the firms
one is the shareholders, second are the lenders and what they do is investors provide the
initial cash required to finance the business proposal. They provide the initial finance to say
finance the business proposals and that cash goes to the business in the form of the outflows.

And then whatever that business takes place after selling, manufacturing and selling the
product and services in the market. Whatever the revenue comes back after adjusting for all
the expense and everything the proposal generates a cash returns to the investors and that
again is coming back to them in the form of inflows.

So, we make a outflow inflow analysis or inflow outflow analysis and we adjust these inflows
and outflows against the time value of money. And finally, we say that, that a business
proposal regardless of whether it is in new investment or acquisition or another of another
company or a restructuring initiative, raises a value of the firm only, if the present value of
the future stream of the net cash benefits, present value of the net cash flows occurring to the
firm in future.

Expected from the proposal is greater than the initial outlay required to implement the
proposal. If you invested 100 rupees today and after means total 5 years’ cash inflows

65
annually, means in the first year also we are getting something, second year we are getting
something, third year we are getting something, fourth year we are getting something, fifth
year we are getting something.

So, sum total of the 5 years’ cash flows if they are discounted against the time value of the
money. For example, we invested 100 rupees which is equal to the 100 rupees today and after
5 years, we are getting the inflows back and present value of that when converted equal to
the, say today's value comparing the inflows with the outflows and for example that value
works out as 200 rupees discounted value of all the future cash inflows works out to be 200
rupees. So, what will happen?

Your cash flow is 100 rupees; your inflows present value is 200 rupees. So, net present value
is 100 rupees. It means, they are able to give some reward back to the shareholders to the
lenders who provided the funds to the business and ultimate objective of the wealth
maximization of the shareholders and the value maximization of the firm is attained. So,
when you talk about this comparison between the outflows and inflows. So, when you are
making the investment of 100 rupees.

(Refer Slide Time: 38:03)

For example, I will explain it to you, that for example when you are investing the 100 rupees.
So, we invested in the 100 rupees in the year 1. So, these 100 rupees is equal to 100 rupees,
because the present value of the 100 rupees is 100 rupees. And we run this business for the
next say 5 years. So, we will call it is as the present year is the 0 year and the first year,
second year, third year, fourth year and fifth year, we have the 5 years now.

66
For this investment the life of this investment is 5 years. In the first year we got the return is
50 rupees, then we again got the return of 50 rupees again we are getting the return of 50
rupees, then we got return of 100 rupees’ cash inflow and then this is a cash inflow of the 100
rupees. So, to have the net present value of any investment proposal or any project.

We need to have a say cash flows and cash flows are basically of the two types, one is the
cash outflow and another is the cash inflows. So, cash outflow is basically the investment
which we make and that investment is normally made in the current period and that current
period is called as the 0 period here this period is called as a 0 period and if you take this
investment 0 period.

So, for example in this case we have invested 100 rupees, this is called as a cash outflow.
And when we are going to now start the project and the commissioning of the project and the
production will start coming up and output will start coming up and we start selling it in the
market.

So, after that finally the cash flow which comes back to us that is called as a cash inflow and
the cash inflow here is for example in the first year we get this 50 rupees, in the second year
we get 50 rupees, third year we get 50 rupees, fourth we get 100 rupees and fifth year we get
100 rupees.

So, what we have to do is to calculate the net present value, we have to now subtract the say
the cash outflow from the cash inflow. But see, we have to calculate the present value of
these cash inflows and the cash outflow also. So, if you look at the cash outflows, cash
outflow for example this 100 hundred rupees which we are making, that is in the current
period.

So that is, I have signified it as the 0 period. So, 100 is equal to 100 in the current period and
whatever these inflows are coming us, they are coming back to us at the end of the year, they
are coming back to us in the end of the year. For example, this, in the say first year we are
getting 50 rupees.

So, 50 rupees coming back at the end of the first year. So, it means there is a time lag of the
12 months, 1 year. So, it means 100 rupees in the current period and 50 rupee coming back
to us, after 12 months is not equal to 50 rupees but something less than that. Similarly, next
50 rupees coming back to us after 2 years at the end of the second year, this 50 rupees coming

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back at the end of the third year, this is coming back at the end of the fourth year and this 100
is coming back at the end of the fifth year.

So, it means now, we have to sum it up, and if you sum it up, so what becomes it. For
example, this 100 is equal to 100. But this amount has, they will become how much? This
amount will be come 350 rupees. But these 350 rupees is the value which is a non-discounted
value, once you discount it by using some discount factor to calculate the time value of
money to calculate the time value of money.

So, time value of money means you have to discount these future cash flows against some
discount factor to calculate the present value and if you sum it up this works out as 350
rupees and if you discount it again some factor. For example, say 10 percent or maybe it is
called as 12 percent or it is called as 15 percent. So, how we have these discount factors, I
will discuss with you later on. But you understand that this moment that this future cash
flows, cash inflows have to be discounted again some discount factor.

For calculating the present value, so that you can apply the concept of the time value of
money. And for example if you discount it against this 12 percent. So, what will become this
discounted value of this for example 350 becomes a 200 rupees. This 350 is equal to 200
rupees because 350 coming after means over a period of 5 years will be if it is discounted and
to compare with the today investment.

So, it means this becomes discounted value of 350 becomes 200 rupees. So, it means for
calculating NPV Net Present Value, this what you will do is inflow present value of inflow
minus the present value of outflow and NPV will be how much? 100 rupees, this is called as
100 rupees NPV.

So, Net Present Value will be 100 rupees. So, we have to apply the concept of the time value
of money, we have to calculate the time value of money. So, that the net present value of any
investment proposal can be worked out. So, in the current period 1 rupee is equal to 1 rupee.
So, similarly 100 rupees is equal to 100 rupees.

But when the cash inflows are coming to us, they are coming us over the period of time and
every year they are not coming in the beginning of the year, also there at the end of the year.
So, even in the first year this 50 rupees coming, they are not equal to 50 rupees if you
compare it in the today's terms, it will be something less than that.

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So, you have to discount it by applying some discount factor 10 percent 12 percent or 15
percent and then once you discount it. So, for example discounted value of 350 becomes,
200. So, the present value of inflows, total inflows is 200, present value of the outflow is 100.
So, the NPV of the project is 100. So, since the NPV is positive, so you can take up the
project and the investment proposal can be approved can be, can be taken up and we can go
ahead with this investment proposal.

(Refer Slide Time: 43:43)

The objective of the business which I was saying here that the value of the firm only, means
it raises the value of the firm only, if the present value of the future stream of the net cash
benefits expected from the proposal is greater which is 150 then the initial cash outlay
required to implement the proposal which is 100.

So, it means ultimate purpose of the business is attained because we are able to maximize the
wealth of the shareholders and lenders and against investment of 100 rupees. We are able to
get them back 150 rupees.

So, this is the fundamental principle of the finance that when you make any, whenever you
make any investment that investment must be appreciated over a period of time and the
discounted value of that means outcome of that investment, must be either equal to the
investment or greater than that.

So, I will stop here, this is just the beginning of the basics of the fundamentals of financial
management in the due course, we will discuss the some other related and advanced concepts
of financial management. Thank you very much!

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 05
Fundamentals of Financial Management Part V

Welcome all, so in the process of learning about the Fundamentals of Financial Management,
in the previous class we discussed about that what is the Principle of Finance, that whatever
the investment, we make in any kind of the business in or in any kind of the business
organizations in any kind of the business firms.

The return from that business should be more than the initial cash we have invested. There is
ultimate purpose because reward for that investment where we mean invest the funds of our
surplus funds and we take the risk of moving in to the business. So, the reward has to be
certainly more than what we have invested in the beginning.

So, I told you in the previous class, that in the form of investors, that whether it is a
shareholder or as a lender whatever the investment people make in the businesses is or
whatever the cash, they provide to the business that is the, say invest in the business forms,
the ultimate return has to be more than that.

If the return is more than that for example, we are investing 100 rupees and the return at the
end of the year or end of the period is 150 rupees then certainly we are generating some
value. Otherwise there is no purpose moving into the business and here one important point
we born in mind is that, what return we should be satisfied with? Should we have satisfied
with the cost of the capital? Then what is my cost of the capital? Or something more or
something less than that.

Because say I have, two options available with me, one option is that I have got 100 rupees
and I can go to the bank deposit that 100 rupees in the bank and at the end of the year, I will
be given, if it is a saving bank account 3.5 percent rate of interest and if it is a fixed deposit, I
will get somewhere around 6 percent rate of interest and that is sure.

I am not taking any kind of risk, I am not involved into any kind of the uncertainty and I am
sure that I am giving my money to the bank and that 100 rupees are going to be 103 rupees 50
paisa, if it is deposited in the saving bank account and 100 and 6 rupees, if it is deposited into
the fixed deposits account. So, it means 0 risks and assured appreciation.

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But, if I am moving into the business, I am not satisfied with that 103 rupees or 106 rupees. I
want 150 rupees, it means I am not giving my money to the bank and I am not risk averse.
When you move to the bank risk averse. So, when you are not risk averse, you are risk pro or
you are risk neutral.

In that case, we want higher rate of return on our investment whether I am a shareholder in
the business or I am the lender in the business. I want the higher rate of return and for that
higher rate of return, what I had to do is, I am moving into the business. I can do it in two
ways directly moving into the business or indirectly moving into the business.

If I directly moving into the business, I become entrepreneur, I start the business, I establish
the business or I become the part of the business which is going to be established. So, I
become the part of the initial promoter team. But, if I want to move to the business indirectly.

Then I can subscribe to the shares of the companies, which are trading in the secondary
market or the stock market, I can buy the shares in the stock market and I am into the stock
market, I am going into the stock market, because I am risk neutral, I know that I want the
higher rate of a return.

So, it means at the same time when I am expecting a higher rate of return, I am going to take
a higher amount of risk also. So, if am taking the higher amount of the risk, so cost of capital
cannot be the desired rate of return my desire rate of return has to be, or my return on
investment has to be cost of capital plus some premium for the risk I am taking and that is
why I am expecting that my 100 rupees should become 150 rupees.

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(Refer Slide Time: 04:32)

So, this is what we discussed, in the previous class that is the Fundamental Principle of
Finance where we have concluded is, a business proposal regardless of, whether it is a new
investment or acquisition of another company or the restructuring initiative. Raises the value
of the firm only, if the present value of the future stream of the net cash benefits expected
from the proposal is greater than initial cash outlay required to implement the proposal.

I am giving 100 rupees, I am getting back and that is a discounted value mind it. That is a
discounted value, we will discuss after this, I will talk to you the financial planning and after
financial planning I will take you to the next level of the time value of money and in the time
value of money, what we will discuss is that a rupee earned today is not equal to the rupee
earned after one year, a rupee earned after one year is less than, what the rupee I am earning
today.

So, we have to discount that value of that earning which is coming to us, in the future period
of time, to make it equal to the present level of the earning or the present amount of the
earning. So, there we apply the different discount rates and the principle of the time value of
money is applied there. So, I will discuss there, so when you are making investments you are
making investments, today in the 0 period. Current period we call it as the 0 period.

So, your outflow of the 100 rupees in the 0 period and your inflow is coming first inflow. For
example, you are making investments for the 4 years, first inflow comes after one year. So,
that inflows come of the 50 rupees and that 50 rupees’ inflow of coming after one year is not
equal to 50 rupees you are earning today. So, you have to discount it against that time value
of money. So, it will not be 50 rupees earned one year, hence, it will be less than that.

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So, we will have to discount it with the help of some discount rate and then we will have to,
means sum it up that first year at the end of the first year how much earned? What is the
discounted value as per the today’s value?

Second year, third year, fourth year sum it up and then see that today’s 100 rupees, value is
100 rupees and next 4 years’ cash inflows discounted value has to be and summed up and
discounted value has to be more than 100 rupees and that more than 100 rupees has to be my
expected return on my investment which includes both, my cost of capital also or opportunity
cost of capital also and the risk I am going to take the premium for that risk.

So, this is the principle of finance that appreciation of the money, appreciation of your
investment, has to be attained and if you are able to do that, we are going to achieve, means
attain the principle of the maximization of the value of the firm or the maximization of the
wealth of the shareholders.

I think you must be clear now, that what is the principle, say fundamental of finance or you
can call it as the major fundamental of finance, that where you talk about the financial
management you talk about the best utilization of your scarce resources and appreciation
growth of your scarce resources and that will happen only if we are managing our funds in a
best possible manner in the professional manner, in the desired manner.

So, that the desired rate of return can be earned and we have different revenues the amount of
risk, you take the amount of return you can expect minimum is the bank investment, you give
your money to the bank take 0 risk, and then the return is also 3.5 percent or 6 percent move
to the business directly become entrepreneur, you can have a 100 percent return also.

Or you move to the stock market, so there you take risk but certainly the return is more than
what you are earning from the bank investment that is you can call it as the risk-free
investment. If you are moving to the stock market, you are taking certain amount of the risk
certain your returns are expected to be higher than what is going to be the amount of the
return at the level when the level of the risk is 0 or negligible.

So, risk and return go hand-in-hand and ultimately we will have to manage the risk, grow
with our funds and whatever is our outflow, the inflow discounted value of the inflow has to
be certainly more than that. So, this is the fundamental principle of finance everywhere in the
subsequent discussions in the subsequent lectures. We will take this principle along, so that
we learn about that best management of the funds requires appreciation of your funds, growth

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of your investment and multiplication of your savings or multiplication of your funds. Now,
next thing this is for this this class only.

(Refer Slide Time: 09:14)

I will be concluding this class with some important observations about the changing role of
the financial managers. We must discuss this, very important component, changing role of the
financial managers and say what challenges we have been seeing in the past, in the recent
past especially after globalization. There are so many challenges which have come in front of
the financial managers.

Today's financial manager is not the same as it was before 1991. Managing finance was much
easier before 1991 but managing finance today is very, very complex because risk has gone
up in the market, complexity has gone up in the market, competition has gone up in the
market, uncertainty has gone up in the market.

So, with all these new features in the overall business, say field or in the business
management, the job of the financial manager, CFO has also has become very, very complex.
So, what are the important say requirements of say, of being a good financial manager. Let us
discuss some of the important points here.

First part is performing financial analysis and planning. This is a continuous job means, if
you want to manage your finances well in the best possible manner then financial analysis
and planning is a continuous process. It is a never-ending process at every point of time you
have to plan. Even you are investing 10 rupees, you have to be careful that were this
investment is going. How much return I am expecting back out of it and whether I am able to
add value to my shareholders or not.

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So, in this case, the concern of the financial analysis and planning is with. Number one
transforming financial data into a firm that can be used to monitor the financial conditions.
You have got for example sales value; you have got different cost means figures input
figures. Like raw material cost is there, labour cost is there your interest cost is there
depreciation is there, so many costs are there.

So, you have to now convert that into the financial statements and then simply preparing the
financial statement that is a profit and loss account and balance sheet does not serve the
purpose these days. You have to analyse these financial statements. It may be possible that,
the CFO when he gets the financial statements prepared from his department and they present
a copy of the balance sheet and profit and loss account before the CMD of the company or
CEO of the company, he may not be the finest guy.

He must not be knowing what this balance sheet is all about. He must be operation’s guy. He
must be the marketing guy. He does not understand what this all is about. So, what you have
to do is, your job is to simplify those financial statements. So, you have to prepare the
financial statements in the one hand on the other hand. You have to analyse them with the
help of some very, very useful ratios.

Or maybe you have going to convert that into the cash flow analysis, or you have to convert
that into the common size of the comparative statements. So, that if you explain with the help
of the analytical values to the CEO or maybe the board members who certainly might not be
carrying the finance background then you need to means make it simpler for them. So, again
the job of the CFO is very, very complex.

(b) Evaluating the need for increased or reduced productive capacity and determining the
additional or reduce financing requirements. Financing requirements in the firms keep on
changing, because market response keep on changing. We require the amount of the funds to
be invested especially in the short term funds, depending upon the demand for the product in
the market. Whatever the product we are going to sell in the market. It may be possible that
for example in one market there are the four players already operating.

So, our sales, our market share till the end of the current year is 25 percent, but it may be
possible that now the next year, two more players have entered into the market and now our
market share has gone down. Your market share has gone down, I agree with you that fix
assets investment will remain fixed but the current assets investment, the working capital will
change.

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So, you have to assess, that how much is going to be the impact on my sales? How much is
going to impact on my working capital? How I have to, means reduce my working capital
requirements? In what proportion you have to reduce my working capital requirement and
how I have to arrange for the, means the funds if additional funds are required and if my
surplus funds are going to be available with me where I have to invest them.

So, that I have the desired rate of return available with me. Now, for example you think about
Jio came in the market two three years back, before that, Airtel was in the market, Idea was in
the market, Vodafone was in the market in the mobile telephony for example we talk about.
These three companies never had thought about that Jio as a fourth player come in the
market, they will slash down the, say the prices of the mobile services, so means to a level to
such a level that were the sustenance of the other players will become a question mark.

You might have seen there is a joint venture now formed by Vodafone and Idea. Idea was
independently operating in the market. Vodaphone was independently operating in the market
but the moment Jio entered in the market. There was a total turmoil in the market means the
customer base was totally shaken and most of the customers of the Airtel, of the Idea, of the
Vodafone, they shifted from their existing service providers to the new service provider
because of the innovation in the services and pricing offered by Jio.

So, in this case, it came a big challenge to the CFO because the cash collection of Airtel, cash
collection of Idea, cash collection of Vodafone went down. So, it is again a challenge who
thought about it that Jio will come to the market and they will perform start performing in
such a manner that now the new things will start happening in the market.

So, any time there might be the increase funds requirement. There might be the reduced funds
requirement. You have to change it, with the change in the demand for the funds. There is not
a problem in the fixed assets of the long-term investments, all base problem comes, challenge
comes with a short-term investment with the short term say investment in the current assets.

So, it means you every time you have to keep on planning and performing the financial
analysis. Planning job is, that how to deal with the future, financial requirements? And
analysis means how best possibly we are utilizing our current amount of the funds or the
finance available with us.

Next important challenge is the making investment decisions. Many a times, we have to make
the investment decisions. I discuss with you, this anchor story, fruit beer story. They made a

76
proper analysis thorough analysis. But still the product failed, 350 crores of the very scarce
resource went down in the drain.

Everybody had made analysis and everybody had means tried at that level, Anchor had
involved the, say market and demand analyst also. Research agencies also, best consultants
also. The product was means say thought well about that whether it is an expectable product
in the Indian market or not and even some customer service was conducted and all these
precautions were taken but despite that when the shape was given when the product was
brought into the market it failed, miserably failed in the market.

So, what can you do? Means ultimately this disaster happen to anchor and they have to go
with it. And finally means, it means disturbed the total financial position of the company and
this kind of the situation comes everyday or sometimes, not in case of the long term funds but
in case of the short funds the problem comes. So, the market is volatile, market is means
uncertain. So, you have to be very careful and CFO has to be always on his toes, that how to
mange a long term as well as the short term funds.

And then third one is the making financing decisions, once you identify a new product, new
area, may be it is a restructuring process or entering in the new market or may be adding a
new product in the adjusting product line or it may be the horizontal integration. It can be the
vertical integration everywhere you need new funds. If any investment, new investment
decision has been conceived, and if is been found that yes firm will go for the new
investment, best investment in the market.

So, in that case once the investment is oked, by the different comities, by the different
experts. Now, the next challenge to CFO is from where to arrange the funds. Because he has
to create a finance mix, where the composition of the total you say finance mix is such that
both equity and debt are involved in a balance proportion. The approach here should be that
most of the amount of the fund should come from the internal sources and dependence on the
external sources should be as low as possible.

Because every firm would like to keep its borrowing capacity intact, if you borrow to much
from the market it becomes sometimes risky. So, deciding the financing mix, I have
discussed at length in the previous classes also and here I am just referring it back to as a duty
of the finance manager, it is a very, very complex job that making of the say investment
decisions, investment decision still may be a joint exercise, because so many people are
involved.

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May be the people for the other departments are involved within the firm consultants are
involved, financial institutions are involved, financial experts are involved. So, if the say
investment decision when we arrive at, it is a joint exercise, it is a you can call it as the joint
exercise of the many people it is a combined exercise of many people, many trust groups.

But as far as the financing decision is concerned, finance department and CFO has to take the
decision that how to now, say bring the funds in, in what proportion that, in what proportion
equity? How much internal funds we have available from different sources? We have to
manage and look for every kind of the say funds available and decide a very, very judicious
financing mix. So, another challenge is there, so the role is very, very you can call it as very,
very active, proactive rather we would say and then it is a challenging also.

(Refer Slide Time: 19:43)

Now, I will take you the next important some important points which are concerning the
CFO’s duties or changes to the CFO’s duties, emerging role of the financial manager in India.
Why I am just discussing this slide? I though it is important to discuss with you, it is written
here the job of financial manager in India has become more important, complex and
demanding, due to the following factors, due to the following factors.

Now, these actors had been made the simple and state job of the CFO of the company which
was till 1991. Now, after 1991, especially in the 21st century it has become more complexed,
2000 onwards it has become more complex. Why? Because of this factors liberalization,
globalization, technological development, volatile financial prices, economic uncertainty, tax
law changes, ethical concerns over financial dealings and shareholder activism. These are
some demanding points from CFO, liberalization and globalization.

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(Refer Slide Time: 20:53)

The major change that happened because of the liberalization and globalization is that India
has now move towards the, term structure of interest rates. What we call it as, term structure
of interest rates. What is the term structure of interest rates? Term structure of interest rates is
that, interest rates on any kind of the borrowing or any kind of the investments in India.

Now we, related to it is term and it is a maturity period and term structure of interest rates
moves something like this, it is the maturity period and this is the interest rate this is the
interest rate and this goes something like this you can say that term structure of interest rate
moves like this.

It is going up, if your maturity period of any investment is increasing from this to this then
your interest rate is also going up from this to this and after some period time at this point it is
becoming saturated and this is started coming down after this. So, it means this is the term
structure of interest rates.

Now, if you borrow the funds for the longer duration your cost of the funds is going to
increase, your cost of the funds is going to increase and this has happened largely after the
liberalization of Indian economy. Sometime, in the past there was a reverse of the term
structure of interest rates also this was something like this. What is the term structure of
interest rates? If you borrow for the shorter duration, you have to pay the higher rate of
interest.

If you borrow for the longer duration, you have to pay the lesser rate of interest, but now we
have aligned with the rest of the world and aligning with the rest of the world means, that we
have now started following the term structure of interest rate and when you are following the

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term structure of interest rate, it means if you are borrowing the funds for the longer duration
your interest rate is going to increase. If you are borrowing the funds for the shorter duration
your interest rate is going to decrease, you are going to be lesser.

So, now the bigger challenge here is that, we have two kinds of the assets, one is the long
term assets, others are the short term assets. Long term assets are fixed assets, short terms
assets are the current assets and current assets investment requirement are fulfilled through
working capital, should be fulfilled through working capital, because rate of return on the
current assets is much less as compared to the rate of return on the long-term assets.

So, sometimes what happens, when we invest the long term funds for the short-term
requirement or in the current assets. So, the long-term funds are very, very expensive because
of the term structure of interest rates and if we invest these funds into the current assets which
are less productive. So, there is a mismatch between the cost and returns. And that effects the
profitability of the business.

So, it means this after liberalization, the term structure of interest rates introduction has made
the life of the CFO challenging one. Second thing is till liberalization the firms in India, never
bothered about the financing cost, means if you talk about the, for preparing your profit and
loss account.

(Refer Slide Time: 24:08)

For example, when you are preparing profit and loss account. This is the lower part of your
financial statement, this is a trading account upper part. This is a trading account and this is a
profit and loss account, lower part is profit and loss account in, now some total we call it as,
income statement, this statement is called as income statements.

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And it has two parts, in this part we had one cost, these days we have now is the interest cost,
interest on loan. This is the interest cost, interest on the loan. So, when you are preparing now
the cost sheet, interest cost or the financial cost has become a very, very important
component of the cost.

Earlier this cost, was never recognized by the CFOs, or maybe while calculating the total cost
of the product, the finance cost was not very, very important. Because in India, we had the
reverse of the term structure interest rate, if you are borrowing the amount of the funds in
bulk from the financial institutions and for the longer duration the interest rate which you are
paying is comparatively lower, as compared to when you are borrowing in the small amount
and for the shorter durations.

So, now the interest rate has gone up because you are borrowing the funds for the longer
duration because of the term structure of interest rate you end up paying higher rate of
interest. So, when the interest rates are now going, have gone up in the market, the interest
cost has overall, not rates but the cost has gone up in the market. So, what is happening that
your financial cost has become very, very important.

So, in the total cost of production, after liberalization one important cost we have added is the
financial cost and we have to be very careful that our financial cost must be under control.
So, the challenges of the liberalization are the one like the introduction of the term structure
of interest rate in India. Second thing is the, say you call it as increasing financial cost to be
kept under control this is another challenge that is because of the liberalization and the
globalization in India.

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(Refer Slide Time: 26:15)

And another important factor, which has come up in the market because of the liberalization,
globalization is the international competition and competition in terms of the cost of
production. Multinational companies always focus upon that their total cost of production has
to be under control. So, Indian companies also have to, means match their cost of production
with their multinational counterpart, and if their financial cost is rising which was never
recognise as a cost in the past.

So, overall cost of production will increase and your product will become less competitive in
the market. So, in this situation because of the, in the wake of the increase competitive
situation in the market, you have to keep your cost of the funds under control, cost of the
product under control and this is another challenge not to the production manager not to the
marketing distribution and purchase manager but to the finance manager also.

If you are investing the expensive funds for the say manufacturing of your product or buying
of raw material certainly your overall cost of production is going to increase. So, the pressure
on the CFO also has increased. Technological developments, technology is changing very
fast, technology is changing very fast.

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(Refer Slide Time: 27:28)

So, in this case, how it creates a problem one thing you add up here the depreciation.
Depreciation though it is a non-cash cost but it is a cost, it is a part of the cost sheet, it is part
of the total cost of production it is a part of the total cost we are showing, we are debiting in
the profit and loss account.

So, when the technology is changing very fast, your depreciation rate is also very high. For
example, there is one IT system which we have, say put in place in the firm. For managing
our finances and we know that software’s life is only 3 years. After 3 years’ new software
will come, better efficient software will come in the market and the software’s price is for
example 100,000 rupees. So, that 100,000 rupees you have to recover in the period of 3 years
only. So, it means 33.33000 rupees’ depreciation you have to provide every year.

Had it been the another way around, that for example you are means this technological
advancement are not very, very fast. So, you can use that software for the next 6 years. So,
depreciation amount will become just half and the moment your depreciation cost increases
or depreciation as a cost increases the total cost of production increases.

So, this is the problem with the CFO also finance people also, because of the technological
advancements you have to change your technology very fastly, you need the fund and
whatever the funds are invested into adjusting technology, they need to be recovered at the
faster pace. Volatile financial prices, marketile financial market, your stock market has
become highly volatile. Predicting the prices is not so easy these days, there is a presence of
the financial this, institution named as foreign institution investors.

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There is a presence of more now shareholders in the stock market, more people in the stock
market. So, when the more people are into the market, market has become active more people
presence is there in the market, volatility in the market has increased. So, again it is a
challenge and if you want to make an investment of your surplus funds in the market even
then it is a challenge.

If you want to monitor your own company’s stock in the market, even then it is challenge.
Because it is very difficult to predict at what price the investment will be available in the
market and at what price our company share will be trading in the market. So, again there is a
big challenge.

Economic uncertainty, these days now for example, India is passing through recessionary
phase. Every sector is suffering from the recessionary problems. So, it means we have to deal
with that and it is a challenge to CFOs also. Tax Laws emergence of GST, emergence of
GST. 2 years back when the GST came to the market everything has become now become
fragile.

(Refer Slide Time: 30:14)

Similarly talk about the ethical concerns over financial dealings that whatever you do the
financial dealing it has to be very crystal clear neat and clean, borrowing, lending, investment
in the market, everything has to be with a proper record and with the proper say, the
documentary evidence and shareholders’ activism.

Shareholders were not as that active as they are today, in annual general meeting shareholders
are asking CFO they are asking the management of the companies that how the company has
performed in the past 1 year and what is appreciation of our investment. So, because

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enlightenment and activism of the shareholders have put forward the, another challenges to
the CFOs. Lastly, so it means when you talk about the emerging role of the financial manager
in the wake of the challenges.

(Refer Slide Time: 31:05)

So, you can say, here you can understand that, reflecting the emerging economic and the
financial environment in post liberalization era, since the early nineties, the role oblique job
of the finance manager in India has become more important complex and demanding the key
challenges are in the areas of financial structure, deciding about the capital structure of the
firm that tend equity in what proportion we have to have.

Foreign exchange management, because now we are dealing with the foreign, we are making
the foreign exchange transactions. So, rupees fully convertible on the current account. So, it
means you, foreign exchange has come into the picture treasury operations, day to day
operations. You need to borrow money form the market, you need to invest surplus funds in
the market, so your working capital even the long terms funds investment has become
challenging, investor communication is very important thing.

At the end of general meeting you need to communicate to the investors or you need to
communicate to the financial institutions who are our lenders, that how we are performing in
the market and how is overall financial performance of the firm. Similarly, the management
control and investment planning these have become continuous of years, these have become
continuous of years.

So, it means you can understand that now the say, the job of the financial manager is very
complex is very, very demanding and we have to spend lot of time in managing the affairs of

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the firm. So, that finally we can deliver the value to the shareholders and we can try to say,
manage the business in such a manner where it creates a win-win situation for all and where
the shareholders stand gain, customers stand gain.

The suppliers are also in a benefiting position. The even the government authorities, the taxes
also, sufficient taxes we returning back to the government and overall means we are working
as per the existing regulatory environment of the country. So, this is something beginning the
foundation of this your financial management this course, this particular say, the subject
which I introduce this time.

So, whatever I could means discuss or I could share with you for building the foundation or
just discussing the conceptual part with you, I did at this point of time and for the further
reading, if you want to go for the further reading, if you want to know all these things in
detail or the fundamentals or basics of the financial management in detail.

I would request you to refer to the book that is the financial management by Prasanna
Chandra. Some of the concepts most of the material I have also taken from that book. So, you
can refer to that book for your detailed reading for the detailed reference. A very good book,
it is easily available in the market. It is a Tata McGraw, it is a McGraw Hill Publication and
you can make use of that. It is not Tata McGraw Hill but it is McGraw hill publication.

So, you can means refer to the book for the further readings, but currently but I could discuss
with you as the fundamentals or the basics of the financial management we have done that.
So, I am stopping here with regard to the fundamental and in the next class will be talking
about something more interesting, a next area next topic and that is financial planning till
then, thank you very much!

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 06
Financial Planning and Forecasting Part 1

Welcome all, so now next part of our discussion is the Financial Planning and Forecasting. The
next thing after talking about the fundamentals of finance of the financial management or the
role of CFOs or the financial managers. Next thing we will be learning about is, that is the
financial planning and forecasting.

Financial planning and forecasting is a very, very you can call it as demanding area in the
financial management because financial planning and forecasting is a continuous process, it is a
regular process, it is a continuous process and whatever the financial requirements of any
business forms are, they depend upon this planning and forecasting process.

If we are not properly planning, if we are not properly estimating how much funds are required
over a period of time then, we are going to put our self in trouble and a price is going to be paid
by firm also. So, you must think here about, that when we are talking about the financial
planning and forecasting, how much investment we are going to make?

Normally, just to means plan for it and just to means estimate the financial requirements. We
divide that requirement into two parts. Because whatever the investment we make in the
business, that we make in the two kind of the assets.

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(Refer Slide Time: 01:53)

They are the fixed assets and they are the current assets. So, whatever the funds we generate
from the market we invest them into the fixed assets we invest them into the current assets. So,
the total capital coming to us here in the firm is total capital, maybe the total funds you would
say capital/funds, they are coming to us from the all the sources whether they are owned sources
like share capital or they are coming from the borrowed sources like loans, from or you call it as
the loans from financial institutions or normally which we call it as the long term loans coming
from the financial institutions. These total funds have to be properly invested properly managed.
So, that the ultimate objective of the value maximization of the firm can be attained.

So, you must be wondering that when we have decided the fixed assets level, we have already
made the investment into the land, plant, building machinery, furniture, vehicles all the fixed
assets. Can we change it next year? No, we cannot change this investment next year. You have
made this investment, so it all depends upon if we are going to make the desired amount of
production and sales in the market you can say that we are going to make the best utilization of
our plant and machinery, building plant and machinery.

But if the sales are more than the level of the assets and if it is only temporary phenomena we try
to means carry on the process with the overtime or with the excessive means usage of the
machines and the plant. But if it is going to be a regular phenomenon, then certainly we need to
make additional investment and then we think in that way and then we mean think of

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restructuring the whole our manufacturing process and we add up the new manufacturing
capacity.

So, that we will look forward for the new financial planning into the long term say requirement
of the firm and say thinking of investing long term funds into the fixed assets. But if everything
remains fixed, your sales are also as they are in the say past years, your level of production is
also the same. So, there is no need to think of changing any kind of the fixed assets or say
changing the investment into the fixed assets. But the investment in the current assets is a day to
day affair.

Current assets like, when you talk about the current assets, current assets arise out of your
manufacturing and selling process in the market. Current assets like we have the one current
asset is the inventory, then you have the say your another current asset are the credit sales which
you call it as coming out of the credit sales and they call it as the sundry debtors.

Then you have the, another current asset is the advanced deposits with the suppliers, different
kind of the suppliers. We have another kind of the say current assets in the, in the form of yours
say cash even you can call it as cash at bank, we want to keep the cash at bank and we want to
keep the cash in hand. So, all these are the assets which are called as the current assets.

You have the sundry debtor, similarly there can be another asset which is called as accounts
receivables, there is another current asset. So, this current asset part short term investments,
current investments they need the regular planning and forecasting process. Because your
inventory depends upon the sales, your credit sales depend upon the total sales, your advance
deposits to the suppliers depend upon the quantity of the material we are going to buy from them.
Similarly, the amount of the cash we are going to keep in hand and keep it in the bank that also
largely depends upon the sales.

So, I would agree with you or means normally with everyone that yes, when you are talking
about the financial planning and forecasting in the normal course, we do not disturb our long
terms assets or the fixed assets or the long-term investments. But as far as the short-term current
investments are concerned there we have to means perform this function almost on the say
monthly, daily, weekly or yearly basis.

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You have to manage it for example, I am saying daily means if you have the surplus cash and our
budgeting horizon is on the weekly basis and we know that in this week we have means, we are
requiring certain amount of the cash and we know that this cash is going to available easily
available with us.

So, that surplus amount of the cash is going to be available that we have to invest somewhere in
the market and these days because investment avenues have means come up in the market like,
in the money market like that where you can invest your surplus cash even for 24 hours, even for
24 hours and you have surplus cash today you give it to some body he will make use of it return
you after 24 hours with some interest or with some appreciation on it.

So, what you have to do is, you have to means plan and forecast on the daily basis, on the weekly
basis, on the monthly basis, on the annual basis. So, it means because ultimate purpose is
attaining the overall goals of the firm, overall performance of the firm. What is a target we have
set for this current year, target you can set in terms of your total sales, cash sales, credit sales,
profitability, cash position?

All these targets we set and for achieving those targets, your continuous financial planning is
most important because as I told you finance is a life blood of any organization. So, if the funds
are available in the right proportion, in the right quantity at the right time, then certainly other
things are going to respond.

If you are not able to give the funds to purchase department to production department to
marketing department, then what kind of the performance you are expecting. If the blood is not
going equally to my hands, to my say eyes, ears, body other parts of the body, my legs then
means some part, when there is a problem in the blood circulation that part of the body starts
getting effected.

So, it means I have to be very careful that how much food I have to take, how much walk I have
to do, how much other, if medicine any required if how much medicine I have to take and how
much work I have to do, how much sleep I have to take.

Same is a case with the business organizations that it also has the different organs. It is like a we
call the business as the artificial human being, it is an artificial person and it also has the same
structure as the human body has and the finance is its life blood.

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(Refer Slide Time: 08:52)

So, when you talk about the planning for example, now this is an entire planning system. We are
starting with this this planning system is the top of the planning system is its goals. What is goal
of the firm, if you talk about the strategic long term goals it can be that for example some say
group of the three friends they started a sole proprietorship today, or maybe not a sole
proprietorship, but a partnership firm and their goal is that within next 10 years, we want to
convert that into a say not at least international but a national level company.

Think about the Infosys, those several friends when they created the Infosys, Narayana Murthy
and his other friends when they created this company initially, they created it at very with the
means started their business operations at very very small level. But today the share of the
Infosys is listed even in NASDAQ. So, the growth is very very spectacular and that is the long
term strategic goal.

But here we fix up the goals as per the, say the different durations of the companies and the
normal duration of the company is one year. Company’s performance is one year that in the next
one year how much we are going to manufacture? How much we are going to sell in the market?
How much is going to be our profitability? How much is going to we are going to return to
shareholders as dividend? And how much we are going to reinvest in the business?

At what rate we are going to grow in the market in the next one year or if our sales level is for
example for say currently we are selling for half a million rupees, then next year we should be

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selling for the 6,00,000 rupees in the market. So, that goal we have to set in the market. So, the
financial planning the system requires that goals, when you set the goals to achieve those goals
you form the strategies.

That to my, means achieve, that ultimate goal of my increased sales, increased profitability,
increased return to the shareholders, increased sales, increased market growth, I have to have
some strategy, I have to make some strategy and that strategy when you frame or you make you
make that strategy not only with regard to finance department, you make the strategy with regard
to all the departments.

Say for example R and D is the one, where we start thinking about say improving the product
first we design the product take it to the market, see the customer response, we get back to the
lab than we again modify the product and then we again perform the R and D operations.

Then second is, once the product is ready we have to do, go for the marketing of the product. So,
we have to have the marketing policy, production policy, personal policy and apart from that
above all is a financial policy. Because everywhere you need to provide the funds everywhere we
have to give the funds R and D is not possible without the R and D budget and providing the
sufficient required amount of the funds for the R and D operations.

Your marketing is not possible, marketing activities are not possible until & unless you provide
the required amount of the funds for the marketing of your product. Similarly, your production is
not possible if the production budget is not their sufficient amount of the funds are not provided
by the finance department. Similarly, is the personal department or HR department and finally
we talk about the say making long term investment in terms of the long term asset.

So, we need the say capital budgeting operations and everything if you put it in a nutshell and
you translate it into the financial terms, so you call it as financial plan. Financial plan total
investment to be made in any business firm in the different departments and finally we will start
with the R and D operations, we will end up with taking the product to the market and taking
selling the product to the people and giving the after sale service to them and means making all
these investments.

Ultimately what we are going to do we are going to manufacture, we are going to sell, we are
going to get the revenue, we are going to recover the cost, we are going to have the profits and

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we are going to reinvest the profits back into the business and we are going to increase the scale
of operations.

So, the ultimately this goal strategy where we have the different departmental budgets and
strategies then finally we end with the financial plan. That too, achieve this goal at the top level
how much funds are required to be invested in the business because there are the financial
requirements of all these departments. So, finally we convert these financial estimates into our
projected financial statements.

Financial planning means, we start thinking in the form of the budgets all kind of the budgets we
prepare and these budgets then converted into the production and sales estimates and then finally
we convert those estimates into the projected financial statements and when you prepare the
projected financial statements you prepare the profit and loss account projected profit and loss
account for the, if you are already into the business, if the business have already started be keep
on preparing for the next year’s projected financial statement.

But if the business is at the conception stage, I told you in the previous class also that if as new
entrepreneur if you want to start a new business and we seek the investment from the different
sources, different avenues we have to go and tell them our strategy our plan, our project report,
we have to get prepared a DPFR, Detailed Project Feasibility Report and with that DPFR we
have to go to different financial sources including venture capitalists and we have to give them a
presentation and they would like to means, know about that what is about the financial
projections.

So, you have to prepare the projected financial statements for the next almost 10 years your
income statement balance sheet, cash flow statement. Show them that this is the, my financial
projections and this is how my business is going to respond over a period of 10 years. But we are
already into the business the if the firm is already adjusting at least for the next 1-year planning,
we have to do and we have to create the projected financial statements for the, current year we
are already into the business we will manufacture sell we are doing that.

We will prepare a real financial statements at the end of the accounting period or that financial
year. But for the next year also at the same time we keep on preparing the projector financial
statements which are three, projected income statement which has two parts trading and profit

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and loss account. Then you have the projected balance sheet and the projected cash flow
statement. So, this all becomes possible because of a very meticulous and very say thought about
financial planning.

(Refer Slide Time: 15:33)

Strategic plan, strategic plan when you talk about is, it means I was just talking to you about it is
a very long-term goal. Today we are starting this firm as a partnership 3 people are joining hands
and they are starting any firm for example xyz limited or maybe a xyz partnership firm and they
are planning, that 10 years down the line we will take it up to the national level, where our
presence will be at the national level and we will be competing the large bigger companies, who
are in the market for the years to means years in the past.

Talk about say for example, Nirma story, I was discussing with you. Karsanbhai when created
Nirma in 1982. He also must have that dream in his mind or I can say that he must have not
thought about that the growth of this company will be so spectacular that in the say in 1982 and
today where we are means just how many about 35 years back or 37 years means back this
company was started, today they are into in multi, in many areas and it is a full-fledged company
at the national level. Even, Nirma products are not only selling in India other say neighboring
countries also I have seen these products are selling.

So, it means if you are manufacturing in India and selling in the other countries at least you can
be called as an international company. So, that is called as, where you are starting from where

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you want to see yourself at the end of 10 years in future that is called as a strategic plan, long
term plan and that has the important components. What is the corporate purpose you want to
grow what is your scope, how you want to grow, what different activities you want to perform,
and within that scope you want to grow and reach at a point where you want to reach after 10
years, corporate objectives you have to decide and then the corporate strategies you have to
decide?

So, strategic plan has to be bifurcated into the annual plans and when you plan in the light of
your enemies plan, your competitors plan, they are called as the strategic plans and these days
planning is not a simple planning, because there is not even a single sector, where you can see
that your competitors are not adjusting, wherever you think of moving into your competitors are
already there in the market, when your competitors are there in the market, it means you have to
beat the competition. So, it means you have to strategically plan and your simple planning has to
be called as the strategic plan.

So, long term planning, very long term planning is a strategic plan and then corporate strategies
you have to make. So, what is your purpose where you have started where you want to reach
what different kind of the product or services you want to manufacture or create and what are the
different objectives you want to, you have the growth objectives or you have the short term
profitability objectives and to achieve those objectives you have to now go for the say forming
the corporate strategies.

So, that on the annual basis the plan, the strategic plan that you make, that is called as the
corporate strategy. So, this is a part of the entire financial planning process. Components of
financial plan, when you talk about the components of financial plan you start thinking about the
means your firm and the area in which your firm is operating at the national level. Economic
environment in the country, economic assumptions economic environment in the country is
going to behave how in the next one year.

One indication we can get is from the budget documents of the government every year when the
government presents the budget on the first of the February. That budget of the government gives
a direction to the industry, to the different sectors that how the government policies are going to
be in the next one year which sectors are going to be the priority sectors, which sectors are going

95
to be the more favored sectors, which sectors are going to be the commonly means accepted
sectors and were the government attention is not much.

So, those means, say those directions, those say initiative or you can call it as an indication from
the budget, that budget document that is number 1, second thing is the general economic
environment in the country and impact upon the general economic environment in the country of
the international economic environment. So, all these things we have to keep in mind while
framing the policies for the next one year.

So, on the basis of that, once you know that how the market is going to behave in that sector in
which the firm, for which we are planning is going to means be how much we are currently
selling in the market? How much we are expected to sell in coming year in the market? What is
our current market share? Whether it is going to remain static? It is going to grow, at least it
should not decline, if it is going to increase at what rate it is going to increase? We have to be
careful about that.

So, sales forecasting is the basis after just having the economic assumptions, economic say you
can call it as idea in your mind you have to now start thinking about that keeping in view this
environment globally and its impact on upon India, on our country and that to on our, say our
industry as well as the company.

(Refer Slide Time: 20:52)

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So, what we have to do is you have to do sought of one analysis, which we call is as this EIC
analysis. This is called as EIC analysis, E means economy then this is economy you call it as I as
industry and C is the company. So, you have to do this analysis continuously because planning
and control they are based upon the regular analysis.

So, economy, industry and company analysis we have to do and on the basis of this analysis, you
have to then think about that whatever the economic environment is building around us. How
much sales we are going to make in the next one year. That is the beginning point of your
financial planning.

Sale forecasting, sale forecasting is your beginning point of the financial planning and keeping
the sales as the common denominator, then you have to start back tracking that for attaining this
much level of the sales, how much is going to my cost of production.

Whether the right amount of the inputs is available with me or not, how much is going to be cost
of production and then if this is a total sales revenue available. This is my cost of production is
going to be then finally how much is going to be the gross profit available with me.

Then after maybe adding into the operating income, the non-operating income from different
sources and subtracting the non-operating expenses, how much net operating profit before tax I
am going to have and subtracting the tax amount from this, how much net operating profit after
tax I am going have.

So, with the help of these different components of financial planning you have to read the
economic environment globally at the country level, do the EIC analysis, forecast the sales for
you, prepare the pro forma financial statement, pro forma financial statements in projected
financial statements for the next 1 year, that is a planning horizon currently you are doing your
business. So, it means you are into the actual business and you will prepare the real financial
statements along with that you will prepare the projected financial statements for the next one
year.

So, that before we move into the first day of the next year, we already have something in our
hand the planning document in our hand the budget in our hand and we know that what is our
planned target of manufacturing and selling in the market. How much cost of production is
expected to be there, what is the level of gross profit then the say net operating profit before tax

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and after tax this all is means the planned document is available with us. And finally that pro
forma financial statements will be used as a guide while we move for the real performance in the
market from the next year onwards or for the next whole of the year.

Similarly, there might me a possibility that sometimes when there is a means, say more than
normal change in the sales is expected in the market. So, we can say if change is going to stay
forever, then we have to increase the production capacity, so we have to add up some more long
term assets.

Or sometime we can think about our productions will remain the same, but your sales will come
down, when the sales will come down your inventory will increase, your inventory is another
current asset. So, to accommodate that increase inventory what you should do?

So, you have to plan for everything in the beginning and to have that required amount of
productions sales, revenue and cost you have to have the proper financing plan. How much funds
we required for, means giving shape to our plan and how much funds are available internally
how much we have to borrow from the outside sources and finally you have to convert that in
into the cash budget.

Because only funds will not serve the purpose estimates will not serve the purpose you need to
prepare the cash budget in the first year in the first month or in the first operating cycle how
much investment is it required is it to be made how much cash is required into invested into it.
For example, we are talking about say the part of the raw material will be available as say the
spontaneous finance, by the suppliers’ credit and 30 days we need not to pay to the labor, 30
days we need not pay to our employees, 30 days we need not to pay to this power and water
suppling companies and others.

So, after 30 days we have to we have to pay. So, proper cash budget you have to prepare, so that
you know that how much is my cash investment requirement, how much cash I have and from
where that cash has to come. So, total starting at the macro level and going up to the minute level
that is a cash budget. So, giving the shape and calculating the cash requirements availability of
the cash working out the cash shortfall.

So, that when we know in advance that we are going to be cash surplus at the end of the first
moth of next year or we are going to be the cash short, we are going to be cash surplus you

98
should do it advance were that surplus cash has to be invested in the market and if you are going
to be cash short from where that cash will be arranged. So, that all will be possible will be
facilitated if you know the process of financial planning properly.

(Refer Slide Time: 25:53)

Now, first thing is that different things we have discussed here, one by one in the summarized
form I will discuss with you, in this part of this class and the next class also. That what is we
mean by the sales forecast?

(Refer Slide Time: 26:01)

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When you talk about the sales forecasting, sale forecasting is a back bone of the efficient
budgeting, if you know at least annual budgeting, if you know the sales correctly or near about
the correct figure of the sales other things becomes very easy because keeping it as a common
denominator you have to then start backtracking that now if this is we are going to sell in the
market it means how much we are going to produce, sales minus profit is a cost of production.

How much we are going to produce in the market? How much is our input requirements in terms
of quantity and in terms of finance? So, all these things we can workout. So, the sales forecast is
typically the starting point of the financial forecasting exercise, it is written here. Sales
forecasting technique fall into 3 broad categories it falls into 3 broad categories qualitative
techniques, time series projection method and Causal models.

Qualitative techniques are just means it is observation by the experts who are the part of the say
you can call it is as the sales forecasting team, they can just look at the data available with them
or sometime they can visit the market and they can see the competitor products and the other
features the competitors are adding into their products and they can just means by just studying
the qualitative say features of our own companies products and the other products adjusting in
the market they can make out that how the sales are going to behave in the time to come.

Whether we are going to have more challenges in terms of adding more features to our products
or the sales we are going to make in the market. How the sales are going to behave? Are we
going to sale the same amount? Or are we going to increase our sales or sales are going to go
down in the market?

So, the qualitative analysis can be done but this is not the job of a layman, this is the job of the
experts, how are experts in planning and just planning for the sales, they are very good
consultants, they are very good.

That are just by looking at the adjusting data and adjusting say presence and the structure of the
market, number of competitors in the market the company whose sales we are forecasting there
share in the market everything means they know, they can tell on the base of data and some time
by visiting the market and looking at the competitors’ products that the sales of your company
are going to be means going to remain static going to grow in the market or going to come down.
So, this is one technique, second is the time series projections method.

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(Refer Slide Time: 28:33)

If you plot your sales, your company sales on a paper for the past, or for the next number of
years. For example, we are having number of years 1, 2, 3, 4, 5, 6, 7, 8, 9 and 10 years we have
the past 10 years’ data. We are going to plan for the 11th year. So, you have got this you have
got the sales of 10, then it is 12, then it is again 12, then it is 13, then it is 13, then it is 14, then it
is 16, then it is say you call it as again 16, again 16 and last year we have sold for the 17 hundred
thousand. This is a total amount of sales. This is a 17,00,000 we have sold in the market in this
year.

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On the basis, of this past year 10 years say time series data you can work out this trend and easily
you can find out how much we are going to sell in the 11 th year. Same, I am not talking about
any other companies’ comparison our own company comparison we can make out that our sales
were how much in the past 10 year on the basis of the past 10.

You can talk about the year to come that how we are going to means behave or at this time
maximum if you want to improve this one more thing you can do is you can do you can
supplement your time series data with the cross sectional analysis.

You can do the cross sectional analysis; you can do the cross sectional analysis also. So, if you
do the cross sectional analysis with the help of this means cross sectional analysis when you talk
about what we include in the cross sectional analysis, the comparison of our company sales with
our competitors in the market.

So, you can find out that how much we are say are selling for the past 10 years. So, on the basis
of that you are going to say forecast for the eleventh year and at the same time, you can
supplement this data with the cross sectional analysis, how your competitors are performing in
the market and then you can say in the eleventh year how much we are going to sell.

Then the causal methods, causal methods are like sale of in one say product because of
increasing the sale of one product because of the other products. As the number of mobile
subscribers is increasing in the market, number of mobile handsets will also go up in the market.
So, this is the causal relationship. When the need for the one thing increases, need for the,
automatically the another thing also increases.

So, just by establishing a causal effect relationship, you can say that for example we have the
data of the mobile subscribers. If we are in mobile manufacturing company, we are the mobile
phone manufacturing company and we want to find out that in the next 2020, how much say
mobile sets will be required in total in the market and what fraction of that will come to us.

So, you can simply there are number of ways but one way is that you can have the data from
TRAI or maybe from other sources that at what rate your telecom, this mobile subscriber is
increasing in the market.

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On the basis of that, you can make out that what will be the demand for the handsets in the
market and existing number of sets we are selling in the market how many new sets we will be
selling in the market. So, cause and effect relationship is another. So, I would cation you here,
not one technique, is sufficient in say isolation. You have to have the mix of the techniques and
then go for the sales forecasting. Sales forecasting is the backbone, if the sale forecasting is
correct then everything is going to be means nearer to the correct figures.

But if the sales forecasting is wrong, your means the wrong sales forecasting has even got the
capacity to kill the well-functioning organization. If your sale forecasting what happened in case
of the say anchor industries fruit bear project. Sales forecasting went wrong, they thought that
there will be ampled demand in the market, sufficient sales the company will be able to make in
the market and nobody purchased the product, all 350 crores went down in the vain.

Means why this Idea and Vodafone joint venture was created, they must have planned that next
year we will be having this much of the subscriber, adding to our subscribers list. They must not
even have thought of that Jio will come into the market and when Jio came in the market what to
talk of increasing the sales. Even say means the protecting their existing sales became a
challenge to them.

It became a challenge for the leader Airtel into the market, it became a challenge to Idea and
Vodafone, they had to join hands. So, all these economic environment changes at the global level
or the national level, they created the problem. So, assessment of forecasting of the right amount
of the sales is the beginning of the right kind of the financial planning and always be careful
about that if your sales forecasting is correct, other things will fall in the line. So, I will stop here
for this financial planning and remaining part of the discussion on the financial planning, I will
discuss with you in the next class. Thank you very much!

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 Financial Management for Manager
Professor Anil K. Sharma
Department of Management Studies.
Indian Institute of Technology Roorkee
Lecture 07
Financial Planning and Forecasting Part II

Welcome all. So, we are in the process of learning about the financial planning and in the
previous class I discuss with you that in the financial planning what are the important steps
involved and we were talking about that apart from yours say or after say assessing about the
economic assumptions or the economic environment revealing at the international and the
national level. And similarly means assessing or forecasting the sales. Next thing is preparing
the pro forma financial statements.

(Refer Slide Time: 00:58)

For example, this is one financial statement which is profit and loss account you can say pro
forma income statement. Different methods are there for forecasting the financial statements.
So, on the basis of the previous data on the basis of the previous 1, 2, or 3 years of the data
you can predict about what is going to happen in the next year to come, you can forecast
about that, what is going to happen? How much sales we are going to make in the year to
come or in the say next one year that will depend upon your historical data.

And on the basis of that you can extrapolate that what we are going to do in the market. For
example, we are talking about here is, therefore example this is a, these are the two past years
one year is this and second year is this, and here we have the now the say projection for the

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next year. So, it means in the year 2000 say 1 say we did this 2002 we did this and what we
are going to do in the 2003 or 2013 or 2023, what we are going to do?

So, we are taking the common denominator as I told you is the sales. What is the methods?
Name is percentage of the sales method. So, first of all what we need is the forecasting of the
true figure of the sales. If you have the true figure of the sales or the, you can call it as the
best acceptable figure of the sales.

In that case you are going to now means have the other estimates also same way means as the
sales are correct fore casters sales are nearer about the correct sales same you thing are going
to have the other estimates also.

For example, your cost of goods sold, your gross profit, your selling expenses, your general
and administrative expenses, your depreciation, your operating profit, operating profit will
depend upon the say how correct your sales for casting is. So, as a percentage of the sales you
can take as a percentage of the individual years there what was our percentage in the say in
2001 or 2011 or 2021. How it was in the previous years that is in the 2012.

So, if you look at the proportion say for example the sales bar 1200, and here it is 1280. So,
this increases there from the 2011 to 2012 and proportionately or cost has also change, cost of
goods sold also has changed. So, if you calculate this percentage this normally remains sales
checking it as a 100 percent, your cost of goods sold is 65 percent gross profit is the 35
percent. Then the selling expenses you can convert them into percentages and when you
extrapolate for the future period.

That is for the next year when you go for the forecasting of your sales and preparing your
income statement profit and loss account, you can use this previous year’s sales figure. You
can take the individual year sales figure and on the basis of the percentage of the sales
method you can start back tracking now and when you now back track you know it that if the
sales are 100 percent what is the cost of good sold of the sale, what is the gross profit, what is
the selling expenses, what is general and administrative expenses, what is depreciation
operating profit and all that?

So, means these are the projected financial statements this is a projected income statement
where we are going to find out that what is going to be my, this projected PAT-profit after
tax. This is very, very important figure for me, because if the profit you are able to estimate

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means exactly properly or correctly then certainly you can think about, how much dividend I
will be able to pay to share holder?

How much retained earnings I will have with me and I will be able to means provide the
funds for the reinvestment purpose in the organisation. So, all this is quantifiable possible and
we are converting over theoretical estimates of sales forecasting into the pro forma financial
statements and then we know it that if this financial statement is already in my hands on in
our finance department hand they can circulate it to the others and then we can put this kind
of the restrictions that our sale has to be minimum this much.

Our cost of production has to be controlled and this much has to be there we want to earn this
much of the gross profit. So, when the targets are communicated to all your performance
remains means revolving around these targets which is very, very important for attaining the
overall goal of the maximisation of the financial say you can call it as health achieving the
financial health or the maximisation of the shareholder’s wealth in the organization. Other
method could be that you can take the average you can take the combined sales.

(Refer Slide Time: 05:31)

For example, we are talking about pro forma profit and loss account combined method or the
combination method. So, you can take you can combine the sets of the sales of the past two
years take the average of that you convert that into the average percentages and on the basis
of the average percentages wherever the percentages are possible to be worked out you
calculate those percentages otherwise you can estimate them and then you can say convert

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them into figures for the next year for which we are going to project or you are going to
prepare the projector financial statements.

So, like income statement we can prepare the projected balance sheet also. In the balance
sheet many things not change because when you talk about the balance sheet you prepare the
balance sheet for example.

(Refer Slide Time: 06:15)

And we have the two kind of the, say components or the parts of the balance sheet if we
divide this balance sheet into this part, we have the upper part where you talk about the say
long term funds you talked about the capital, or the long term funds when you talk about the
long term loans here are the long term loans and here talk about the fixed assets.

So, when you are talking about the long term loans you are talking about the share capital you
are talking about the fixed assets you are means these changes are not going to take place
every year.

They are not on the annual basis must be invest the share capital in the business we invest
these funds in the business that we have given these funds forever and these funds will come
back to us as a promotor when the firm will be liquidated. Talk about the long term loans
when you borrow the funds as a long term loans you do not borrow for 1 or 2 years. You
borrow for the next 10 and 15 years, or minimum 10 years’ period of time.

So, no need to spend time on this particular part upper part of the balance sheet but the lower
part of the balance sheet which talks about the current liabilities and here you talk about the

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current assets. This is the most important thing current liabilities and current assets this is the
most important thing because in the current this is the, first is inventory then it is calling we
calling it as a sundry debtor. We are calling it as a bill are receivables then we are going to
talk it about the say prepaid expenses, prepaid expenses.

Then you are going to talk about the cash in hand and cash at bank all and then you are
talking about the current liabilities. So, here you are talking about the in the current liabilities
is sundry creditors then you are talking about the expense creditors. So, all these creditors we
have to estimate here and these current assets and current liabilities keep on changing when
you are current assets and current liabilities are fluctuating current assets and current
liabilities.

Some part of it remains permanent but large part of these current assets and current liabilities
are fluctuating because the maximum life of these current assets current liabilities is 1 year,
maximum 12 months. So, it means what was the level of current assets in the previous years
that is not expected to be same in the next year. What was the level of current liabilities in the
previous year or in the current year that is not going to be same in next year?

So, you have to spend more time on managing the lower part of the balance sheet and
preparing the projected balance sheet where more time will be spent on the lower part of the
balance sheet not on the upper part of the balance sheet. And in today’s time CFOs most of
the time is spent on managing the lower part of the balance sheet arranging for the funds from
the spontaneous sources and the short term sources and making the optimum investment into
the inventory, into the sundry debtors, into bills receivables, into the prepaid expenses, or into
the your keeping certain amount of cash.

Because if you make more investment into the current assets you arrange lesser amount funds
from the current liabilities. So, what is going to happen here cost of funds is going to increase
yours say availability of the funds from the almost free sources is going to be non-adjusted in
the firm.

So, there is going to a miss match between the cost and revenue and ultimate it is going to
affect the profitability of the firm. So, we have to create a projected balance sheet for the
coming year like the projected income statement as we are talking about here we have to like
this projected income statement.

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(Refer Slide Time: 09:46)

We have to convert means the adjusting the balance sheet the real balance sheet of the
previous year in the current years into the projected balance sheet for the next year. So, pro
forma financial statements are important and you have to say make use of this pro forma
financial statements for the proper financial planning then we talked about the asset
requirements.

(Refer Slide Time: 10:08)

Then we talk about the assets requirement, asset requirement when we are talking about this
we are going to do in the balance sheet and when we are going to talk about the assets
requirement. We are not going to talk about the long term assets or the fixed assets because
your land plant, building, machinery, furniture, vehicle they are not changing every day every
year.

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Once we add up any manufacturing capacity that remains the same for the next 5, 10 years
but as far as the current assets are there you have to be very, very careful and meticulous
because in case of the current assets if you keep more amount of inventory.

(Refer Slide Time: 10:39)

For example, here we are talking about inventory if you keep high amount of inventory you
are going to end up with the more cost less benefits. If you are selling more, larger part of
your production on credit and lesser part of this on this cash certainly there is going to be a
negative result of it. Do not keep higher amount of the cash as cash because cash does not
earn anything for us.

It only has a cost nothing else and here generate maximum funds from the short term sources
from the current liabilities. So, projected balance sheet and estimation of the assets is the one
important requirement. So, asset requirement has to be assessed. Next thing is, now we will
talk about is the say financial planning. In the financial planning now we are going to talk
about the growth and the external financial requirements.

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(Refer Slide Time: 11:27)

Growth of the firm and the external financial requirements. Now, we have decided what do
we mean by growth? Because growth here if you talk about the growth think about this
particular model I would like to explain you the concept of the growth when we are talking
about the growth, growth of the firm as a whole g, g is the function of growth.

So, g when you have to decide that growth at what level we are going to grow if you know
that growth level because with the help of sales forecasting we can find out in advance that
what was our sales level in the previous year?

What is going to be the sales level in the current year? What is going to be the sales level in
the future next one year? So, that we know the growth rate when the growth rate is there
because with the changed amount of the volume of sales, your other inputs are also going to
change. There certainly going to be change in the inputs. So, we have to know think in terms
of the growth and there is if any growth expected in the sales certainly your external financial
requirements are also expected to increase.

Your external financial requirements are of, because we have the internal funds to a certain
extent. First towards the initial capital which is given by the promotors or for example if it
says we are public limited company, we have raise the funds with the help of IPO, Initial
Public Offer and that is also fully exhausted.

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Now, for the further growth funding the further growth operations you have number one
sources apart from equity, promoters’ contribution and the general equity a next thing is the
retained earnings.

So, whatever the profits we are earning but part of that we are in reinvesting back into the
business that is only the internal source. So, for example you need 100 rupees to be invested
in the next year into the firm to attain the target of the increased sales grown up sales, we
have 50 rupees available from the retained earnings it means another 50 rupees has to come
from the external source.

So, how much you are going to borrow in the next one year to support your selling process or
sales forecasted sales with the help of this model we can assess the external financial
requirements and there is always a need for assessing the external financial requirements not
for the internal.

Internal we know that how much profit we are generally earning in the previous years in the
current year and how much reinvestment out of that profit we are going to make that we
know, and in any case we have to reduce the amount of dividend to be paid to shareholders.

We have to increase that say component of the retained earnings to be made into that say the
investment process of the company yes that is in our hands only thing which is beyond our
control is the external financial sources. So, we should be knowing in advance in the next
year.

How much are our increased financial enhanced the financial requirements of that how much
is available with us from the internal sources that is known and how much is more required to
be borrowed from the market if it is known to us in advance we are the better financial
planners.

Otherwise we are going to port everything means in the confusing state we will going to
make the mess of the situation that we will require the funds for the increased purchase of
inventory increase workers more input requirements we not have the funds we have not
arrange the funds, we have not planned in the beginning.

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So, we do not have the funds for that. So, this model will help you out for example look at
EFR, EFR means External Financial Requirements which we can assess for the next 1 or 2 or
3 years’ period of time.

With the help of this model which is A/S and multiplied by delta sales minus that is the L/S
delta sales multiplied by delta sales minus M multiplied by S1 multiply (1-D). So, what this
all mean? This model stands for, EFR means External Financial Requirement. A/S means
total assets, current assets and fixed assets as a proportion of sales. Total assets are going to
be affected.

Higher the amount of sales higher the amount of the total assets will be there because fixed
assets will remain fixed but the current assets will change as the amount of sales increases
your inventory increases, your credit sales increase, your cash level increase. So, total assets
will increase and when your inventory level will increase your credit sale will increase, your
cash level will increase, your investment requirement will automatically increase.

Now, how much is going to the increased investment requirement 1. Second thing out of that
increased requirement how much you can arrange from the short term sources that is the L/S
current liabilities and provisions as a proportion of the sales because total requirement is
going to be how much?

(Refer Slide Time: 16:33)

Total our assets level we are going to build up is because of the increased sales, our increased
investment in the assets especially in the current asset is going to be 100. So, total change in
assets is going to be 100 rupees. This is 100 rupees and if from the current liabilities, current

113
liabilities mean the spontaneous finance and the provisions. Spontaneous finance is normally
the supplier’s credit then we by the raw material. Supplier gives us a credit and that raw
material comes to the firm on a credit period of certain number of days in India the credit
period is 45 to 60 days.

So, for example we know that out of this 100, 50 percent will be available from this current
asset or the total assets we are going to increase and current liabilities are going to give a 50
rupees. So, it means finally EFR, External Financial Requirement is going to be of 50 rupees
which you have assessed in advance. If you have done this exercise beforehand then we are at
a very comfortable position. Otherwise in the lack of financial planning the firm is going to
be in a very difficult situation. So, what this model says external financial requirement.

(Refer Slide Time: 17:39)

So, as a proportion of increased sales how much level of increased assets is going to be there,
what is expected change in the sales is going to be there and as a proportion of the increased
sales what is going to be the magnitude of the current liabilities and the provisions. Then M is
the profit margin then S1 is the projected total sales for the next year and D is the dividend
pay-out ratio.

Because external financial requirement to a larger extent will depend upon the profits and the
dividend pay-out ratio. Higher the profit but higher the dividend pay-out ratio the funds left
for the reinvestment will be very less. So, you have to depend more and more on the external
financing requirements but if the higher the profit and he dividend pay-out ratio is very low

114
then larger part of the funds generated internally are available for the investment within the
firm.

So, it means we are in a comfortable position. So, this model will help us to say assess in
advance that in the next 1-year period of time what is going to be the sales level and as per
the sales level the total investment requirement as they are going to change, how much funds
are required to be generated externally from the external sources.

(Refer Slide Time: 19:02)

Now, for example we talked about in another way round that think here about that the
relationship of the external financing requirement and the growth level of the sales, growth
level of the firm. Growth of the firms is always means translated in terms of the growth of
sales when the operations of the firm increase, when the sales level of the firm increased,
when the sales level of the firm go up, so it means other things automatically go up. So, if
you change this model little bit it is written here manipulation of the equation number 1 a bit.

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(Refer Slide Time: 19:30)

This equation number 1 which is given here is if you manipulate this equation then it looks
something like this that external financial requirement as a ratio of the change saves of
increased sales is equal to A/S minus L/S minus the remaining things. But one more thing we
have added here is that is g means is the growth level of the sales growth level of the firm in
terms of the growth level of the sales and the sales of the firm grow certainly your other
investment requirements also grow.

So, whatever the other functions you talk about here whether it is external financial
requirement whether it is the say increase in the total assets whether it is increase in the total
current liabilities, increase in the profitability, increase in the dividends this all is the function
of the g that is the growth of the firm or other around it is the growth of the sales. So, it
means g is very important here.

So, with the help of the illustration we can use this model this equation that for example if
you look at this that this model which is given to us you can find out with the help of this
model EFR which is given to us with the help of this model you can find out that whatever is
given to us the information given to us is that is the total change in the assets as a proportion
of the increases sales is 90 percent.

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(Refer Slide Time: 20:40)

Then is the change in the sales is 6 million rupees and your total sales are going to be in the
next one here is 46 million and yours say profit margin is going to be just 5 percent and your
dividend pay-out ratio is going to be 60 percent and your liabilities as a proportions of the say
change the sales are going to be a 40 percent.

If you put all these values in this model you will find out that external financing requirement
will be 2.08 million. This figure external financing requirement will be 2.08 million if you
calculate this figure 2.08 million figure you can easily find out that this is the external
financing requirement we have worked out, very simply you can find out.

So, if you have all these estimates with you your assets are level is calculated your liabilities
level calculated your sale level already with us your profit increases expected your dividend
ratio is known to us then finally we are going to be in a very comfortable position.

Now, the next thing is that when we are manipulating the previous equations the model with
something means when we are taking the g adding the g into this growth because ultimately
these are the functions of growth. So, if you are say manipulating that previous model this
equation you are finding it out here is that this becomes this model like this EFR divided by
the delta sales and here this works out as A divided by S Minus L divided by S becomes 0.50
minus this is the profit margin is 5 percent.

1 plus g, g is the growth we have to find out and then this is the 1 minus dividend pay-out
ratio is this 1 minus D is the dividend pay-out ratio is the 60 percent. If you want to find out

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with the help of this model you can find out the growth rate. Growth rate of the sales you can
easily find out this growth rate of the sales that at what level the firm will grow the sales of
the firm will grow.

For example, we have given here different estimates for the given level of g, given level of
the growth of the sales for example if your g is 5 this external financing requirement as a
proportion of the changed sales will be going up by 8 percent if it is g is 10 percent then 28
percent g is 15 percent then it is 35 percent. For example, here it is this all calculation is
based upon these two estimates.

What is your level for example if you talk about this level what is our total requirement? 2.08
is the EFR External Financing Requirement. So, 2.08 divided by 6 million this you can
calculate is this works out as the total amount as 15 percent.

(Refer Slide Time: 23:38)

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2.08 if you calculate this 2.08 divided by the 6 million this is a 6 million of the this is the total
amount of the 6 you will find it out if you calculate this amount this works out as the 15
percent, sorry this not 15 percent this works out as 34 point some percent. So, this works out
as 35 percent this becomes 35 percent and this we have calculated here is 35 percent and if
you see that a say 6 million.

6 million means and what was the sales in the previous year 6 million and now because of
this 6 million the current year sales have become 46 million it means in the previous years
they must be 40 million. So, if you divide the say this change 6 by 40. So if you calculate this
6 by 40 this is the change and if you divide by 40 which was a previous year sales. So, it
means the g is going to be how much 15 percent, g is going to be 15 percent.

So, if your sales are going to increase by 15 percent if the g is the percent here g is 15 percent
your sales total sales S1 is the total sales in the forecasted period. There are going to be 46
million and your sales change between previous years or between the current year and the
next year I am going to be 6 million only. It means the previous year sales are how much? 40
million. So, it means 6 million increases there. So, 6 by 40 there is a increase of g is going to
be 15 percent.

If you put the g here as a 15 percent your final external financial requirement will go up by
35 percent and this works out as 35 percent 2.08 million of this 46 million, sorry 2.08 million
of this 6 million changes says is this 6 million. So, this 6 million and this is the external
financing requirement 2.08 million. So, this becomes how much 35 percent of this 6 million

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of the sales. So, this by this is this by this and this becomes how much 35 percent and in this
case this minus 46. This is 46 is the 40.

So, 6 by 40 is going to be how much 15 percent. So, it means your growth rate is going to be
15 percent. Your sales are the coming 46 million from the 40 million of the previous year or
the current year it means the firm is going grow at the 15 percent rate of interest an if the firm
grows at the 15 percent rate interest then the external financing requirement as the proportion
of the increased sales is going to be 35 percent.

In this entire exercise we have proved it that 2.08 million is 35 percent of the 6 million and if
you calculate this as say the 40 million, 46 has become because 6 we have added it means
when you are adding 6. So, it means previously it was 40. So, 6 by 40 is going to be, you are
going to call it as 15 percent. So, when g is 15 percent the external financing requirement is
going to be the proportion of increase sales as 35 percent.

When the g is 10 percent the external financing requirement as a proportion of the increased
sales is going to be 28 percent if it is going to be 5 percent g is going to be 5 percent then
EFR as a proportion of the increased sales is going to be 0. you are going to call it as 8
percent total is 8 percent. So, similarly if it is 20 percent then the say EFR as a proportion of
the change requirement is going to be, say how much this is 38 percent.

So, easily with the help of this model depending upon the growth of the firm and growth
means in terms of the sales depending upon the growth of the sales of the firm your financing
requirement can be worked out and since we know the internal financing requirement. So,
only the external financing requirement has to be means worked out. So, the internal
financing availability is known to us.

So, how much we need to generate the funds from the external sources that we can easily
calculate from all these calculations and all from these figures. So, it is very, very important
because the problem always comes in arranging the funds from external sources arranging the
funds from the internal sources is not a problem. Now, important question here arises that if
you are not able to generate these funds 2.08 million from the external sources if you find it
difficult.

What we will do here is we know it in advance that our dividend pay-out ratio is 60 percent
we will reduce it to 20 percent when you change the dividend pay-out ratio more funds will

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be available from the internal sources and more funds are available from internal sources then
the dependence upon the external sources will come down. So, this requirement will not be
2.08 million it will subsequently come down.

When it comes down then certainly we are at a very very easy means at a very comfortable
position and the requirement the dependence upon the external sources is going to be much
less. So, this all is going to be possible with the proper financial planning process. Here we
now talk about here is that say when we are, there are some limitation or something to born in
mind before means applying this model we are saying here as the level of sales have changed
level of the assets also change, level of the current liabilities also changes and we are thinking
that there is change is constant.

The change is constant that in but proportion the sales are changing in the same proportion
your assets will also change your liabilities will also be change. Sometime it does not happen,
so we have to be very careful while applying this model that certainly it may be possible that
this sales are increasing but may be some time your current assets are not increasing rather
we are selling more form of inventory which we already have manufactured in the previous
years.

So, when we are drawing more from the inventory and manufacturing at the same level but
the sales have been increased. So, your inventory level will come down. So, we have to be
very careful in that case because here we have given the point of caution that.

(Refer Slide Time: 29:51)

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The assumptions of the constant ratios and identical growth rate may be appropriate
sometimes but not always. In particular, it is applicability is a suspect in the following
situations economies of the scales. When we start producing more your cost of production
starts coming down. So, sometimes we have use the plant up to the fullness capacity but sales
are too high in the market still we are not able to serve the total requirement of the market.

So, total production current period production plus some amount we are withdrawing for the
inventory. So, that is making the total sales for example your total requirement in the market
of selling is a 120 units. We are able to manufacture only 100 units also by running the plant
at the 100 percent capacity 24 hours. So, remaining 20 units we will be drawing down from
the inventory which we have kept from the previous year production.

So, in that case rather than the assets going up in the proportion of increased sales assets will
come down inventory will come down. So, we have to be very careful while applying this
model but yes to a larger extend this models serves many requirements and it can full fill
many say external funding requirements assessments and it helps us that if you know your
investment requirements well in advance and you have to arrange that investment from
outside the firm.

Then if you know it in advance you know that how much investment is required. How much
are my internal sources and how much is the balance in short fall and from where this balance
and the short fall will be made good. So, financial planning overall financial planning is good
and we are at a very comfortable position.

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(Refer Slide Time: 31:38)

So, some part of it will be means some other things are also there for example internal growth
rate and some sustainable growth rate and their role and this say the financial planning
process these are some another corollary available. So, which can add up for strengthening of
your financial planning process.

(Refer Slide Time: 31:53)

So, these two important components that is the internal growth rate and the sustainable
growth rate and its role the role of these two further two important models in the overall
financial planning of the firm I will discuss with you in the next class.

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So, till now we have discussed is that what is the financial planning how the financial
planning can be done and if we are knowing in advance that what is going to be our say
investment requirement in the time to come then we remain prepare for that we arrange the
source, funds from the different sources as far as the internal sources are concerned we are
more comfortable but if we know in advance we become equally comfortable for arranging
the funds from the external sources also.

So, that is all for today and remaining whatever the discussion on the financial planning but
plus one or two some practical problems I will discuss with you in the next class. Thank you
very much!

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology Roorkee
Lecture 08
Financial Planning and Forecasting Part III

Welcome all. So, we are in the process of learning about the financial planning and in the
previous class I discussed with you that if you want to find out the external financial
requirements for attaining a given rate of the growth. So, how we can work out that?

(Refer Slide Time: 00:43)

And with the help of this small given model. We can easily find out the external financial
requirement and in the say with this particular model here where we can take the say assets as
a proportion of sales liabilities as the proportion of the sales and then is the profit margin and
the dividends. If these say estimates are given to us, then easily we can find out the external
financing requirements.

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(Refer Slide Time: 01:04)

And the second important thing we discussed in the previous class was the growth means say
for the given amount of the growth for the given rate of the growth of the firm means what
would be the external financial requirement? Because when the firm grows at a particular rate
of the growth, growth of the firm means that the growth of the sales of the firm when the
sales of the firm grow at a particular rate of the growth, so it means your financial
requirements also increase.

Because your internal funds we have whatever the internal funds are available from the
retained earnings or from the other sources that are available with us, but we are more
concerned and worried about the external sources of the finance and external financial
requirement. We have to work out so that external financial requirement to a larger extent
depends upon the growth rate of the form or in a term, I would say that the growth rate of the
sales of the firm.

So, what is the given amount of the sales in the current year and in the next year what is
expected amount of the sales. So, what is the growth of the sales? Accordingly, you can work
out you can plan for the external financial requirement and see the financial planning why we
do that if you know that what are going to be our say future needs for the funds or the finance
if we have plan that in the beginning and we know that this much of the requirement of the
funds is going to be there in future.

Certainly mean if you know it in advance certainly we are going to be in a very comfortable
position that happens in the individual life also. That happens in the corporates life also, that
happens everywhere that if you are able to estimate or plan for your future whether it is

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finance or whether it is any other need we remain at a very comfortable position. And to run
the business organization or business firms comfortably or in a professional manner.

If we are able to plan for our finances well in advance that gives us a means extra importance
and the extra comfort and the firms can perform operations. Well say with the given amount
of the comfort and the given amount of laxity. So, financial planning is very, very important
component and to manage your finances very well and to arrange the funds for your future
requirements.

If you know well in advance, then certainly we are going to be is at a means at an ease and
we are going to be means say perform the business operations with the more say comfort with
more laxity and we are not going to dig the well as & when there is a need for the water. We
have already dug the well we have already estimated our requirement. And we know that our
sales are going to grow at this rate.

So, our financial requirement is also going to grow at this rate. We have already known that
requirement. We have already identified the sources. So, when there is a need we can get the
funds from the source and the business operations can be carried on very smoothly. So, there
is a relevance of the financial planning. So, for example in this entire say setup, when we saw
this model and we discussed one thing is that what is external financial requirement how to
work it out?

So, you have to relate it with g that is a growth and the growth rate is important here that with
the growth rate, you can find out at what rate we are going to grow other way around you can
look it at the problem that for example, we want to grow at a one particular rate. We know
that we have the capability to manufacture the product or the series of the product or the
product mix which we are already into and we can sell that to the market.

We have the demand for our product in the market. But the question mark is whether we have
the required amount of the funds from the external sources or not? So, you will go in search
of the external funds of the sources provided you know the amount, if you know the amount
you will go in search or you will go for the extra production and sales you will be sure about
the extra production and sales if you know the funds are going to be available with me.

So, first you have to work out the requirement, then you have to go in search of the funds.
And if the funds are available, then we can be sure about that the growth rate of the firm is
assured. So, in this case we have seen we have first of all calculated the external financial

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requirement. Second we have seen the growth rate. So, g without g because g is a function of
all other things.

External financial requirement also depends upon the growth rate. Then the growth rate of the
assets growth rate of the liabilities that is also directly linked to the external financial
requirements. And this all depends upon the growth rate of the sales because everywhere we
are seeing sales is the common denominator. So, firms grow in size and in the turnover means
when their sales go up.

So, in this case we have found out that for example these rates we have found out that g…
Percentage of the g and then the external financial requirement is a proportion of this change
in sales. So, we have seen that if we are growing at the rate of 5 percent. Then the external
financial requirement as a proportion of the sales or the increased sales will be 8 percent. If
you are growing at the rate of 10 percent your external financial requirement as a proportion
of the increased sales would be 28 percent.

Similarly, in this case we have seen that we are going to have that increased total sales, which
is S1 in this case is the 46 million rupees. And now out of this 46 million rupees 6 million, we
are going to manufacture as an increased sale. It means what was that before that 40 million
was our base sales till the current period and next year. We are going to add 6 million sales
more. So, delta S is the 6 million sales. So, in this case if you calculate the proportion of
external financial requirement, which we have worked out is 2.08 million.

So, 2.08 million as a proportion of the 6 million works out as how much 35 percent and if
you calculate this that the say change in sales increased amount of the sales as compared to
the current sales. So, the current sales are 40 million and the say increased sales. We are
going to add up the sales by 6 million more rupees so that comes up as it means we are going
to increase the sales from the 40 to 46 million rupees.

It means the growth rate the g percentage here is 15 percent. So, you will be dividing 6
million by 40. So, you will find out at the 15 percent growth rate of my sales my external
financial requirement as a proportion of the increased sales is going to increase by 35 percent.
So, it means there is a clear cut relationship between the growth and the external financing
requirement.

But as I told you in the previous class, there are some points of caution that every time
because here we are talking about that when the sales change assets also change total assets

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also change largely the current assets current liabilities and provisions also change your profit
also change and your dividend ratio also changes that happens. But it may not be that it
changes constantly or the change is constant it may there may be some ups and downs.

As I told you in the previous class that if you are going to cover up the increased amount of
the sales of from the adjusting inventory, which we have already with us. So, what will
happen your current assets rather than going up with the increased amount of the sales will
come down it will come down it will not go up.

(Refer Slide Time: 08:40)

Because you for example what we are going to do here is we are going to sell the 100 units in
the market out of that we are 80 units we were already selling and 20 units we are going to
add up here. So, this is becoming the 100 units of the sales in the market in the current period

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out of this what is happening that we have some say 50 units, in the stock which is we are
keeping for our means you can call it as bumpy days.

So, 50 units are lying with us. We are currently manufacturing the 80 units. So, units we were
selling currently and 80 units, we are manufacturing and 20 units. We are going to add up
now. So, now we have two options that if you want to increase the 20 units’ production from
80 to 100, if you want to take the total production and sales you can manufacture the 100
units.

80 we are currently manufacturing and 20, 20 units more we will manufacture if the plant
capacity permits. So, we will manufacture the 100 units currently sell them in the market and
our stock will remain intact. We will not touch the stock but there may be another decision
taken by the firm that say for example 80 units we are currently selling which we are
manufacturing 20 units, which we are going to sell additional in the next year.

We will not manufacture that but we will draw that from these 50 units. So, your inventory
will come down to how many units 30 units and these 20 units will be adding up here and
selling in the market. So, it means the total sales will become 100 units and 30 units will be
now left over there in the finished goods inventory.

So, in that case what is happening we are assuming here that your assets will increase, but in
this case assets not increasing assets are rather than increasing the current asset inventory
rather than increasing has decreased from the 50 unit to 30 units. So, there can be any kind of
the changes or for example it may be possible that the entire 100 units we are going to
manufacture.

If the plant capacity permits from the current production. So, it means in that case your
current assets as inventory will not change it will remain as a 50 units. So, all the times blind
fully we will have not to follow this model that every time when there is a change in the sales
from the present period to the next period featured period always the assets increase liabilities
increase or some changes take place.

We have to see that what practical is going to happen if certainly if there is an increase in the
sales, certainly you have to factor for it. If there is increase in the short term liabilities, you
have to factor for that. But if there is no change you have not to factor for that. So, this I
discussed with you in the previous class also this I wanted to thought of reminding you in the
current class also.

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(Refer Slide Time: 11:33)

So next thing now the two more important things which we are going to learn here are the say
important other corollaries of the financial planning and these corollaries of the financial
planning are one is the internal growth rate and second one is the sustainable growth rate.
Because why the financial planning is important? Currently if we want to keep on performing
at the present rate.

Then there is no issue at all. We have the sufficient amount of the funds may be from the
internal and external sources and if you want to generate the funds from external sources, we
know it that what is our current requirement as per the current volume of the production and
sales.

So, we are at a comfortable position financial planning is always required. When the firm
wants to grow in the market and since firm is a dynamic organization is not a static
organization growth is always expected to be there with every business organization. At
whatever the level they are performing in the current year next year. They expect to increase
their level of production their level of sales their level of operations.

So, growth is means you can call it as is directly related to the performance of firm without
growth. There is no business and a business which is a static business you cannot call it as a,
the business which is professionally managed. So, growth is directly related it is linked to the
firm performance.

So, you always have to be careful about that. So, when there is a growth in the firm, maybe
the overall growth and the overall growth takes place with the growth in the sales when the
sales of any firm grow then in that case how we have to fund that growth, how we have to

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fund that growth? So, here we are going to talk about that one important thing is internal
growth rate and second one is the sustainable growth rate.

So, what is internal growth it? Let us see it here, the internal growth rate is the maximum
growth rate that can be achieved with no external financing what so ever. No external
financing. That is why it is written here as internal growth rate. We do not want to depend
upon the external borrowings. We do not want to grow in the market by external borrowings
or external source of financing.

We do not want to risk the firm because here the point of caution is that when you raise extra
funds from the market by borrowing, especially in the firm of the debt it creates so many
problems for the firm. It is always good that the borrowing is always good if you are assured
about your production and sales in the market and the growth rate of the firm, but because of
certain ups and downs in the market as in these days, for example, the recession is going on
in the market and firms are not able to means say sell-off in the market whatever they are
producing.

Many a times their production. They have to stop for example you talk about the automobiles
companies almost every company is stopping the production from one day two day one week
or 15 days or something like that. They are retrenching their contractual employees and the
demand is not there in the market. So, because recession recessionary face is there in the
market the market is hit badly by the recessionary phase.

So, the performance is not up to the mark. So, in this situation if you have raised the funds
from the external sources, especially by way of borrowing. So, borrowing sources they do not
wait for that you are not selling in the market as per the expected amount. So, you are not
able to return their funds back you have to return their funds back.

So, if there is a sustainable growth and sustainable production and sales in the market than
fine, you can service the external debt and you can be the principal amount also as and when
it is due. But sometime if it is hit by the recessionary problems in the market, then external
financing becomes a problem.

In the capital structure also, I told you in some previous class that capital structure. Basically,
what is the capital structure? It is the mix of the equity, is a mix of the internal and external
sources. So, if you are funding the growth of any organization from internal sources though it

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is expensive it is costly that is cheaper, because it is tax detectable but that comes with so
many limitations.

That debt is always cheaper supportive and better, if the firm is maintaining the sustainable
performance and the growth rate. But if it is hit by the negative economic environment or
because of the negative say conditions in the market then it is not good for the firms to
depend more and more upon the external borrowing.

The well managed organization like Reliance industries, Grasim industries or may be well
functioning other say business houses if you look at their balance sheet she will find that they
are external borrowings are much less as compare to their internal reinvestment of the funds
whatever they are generating internally.

Now, you see in case of the Vijay mallya's companies what happened he resorted to the
external borrowing so much 9000 crores and internal say whatever the funds were being
generated. They were misappropriated not properly reinvested back into the business. So,
finally when they resorted to the external borrowing so much that one day a time came that
they were not able to justify that what is their borrowing and how properly they are means
making use of it.

Finally, the business collapsed all Kingfisher group companies they collapsed and finally the
chief promoter of the company is now in the difficult state of affairs. Similarly, you talk
about the Nirav Modi because why they, they had to meet this kind of the fate because they
are borrowing was so much from the market. Because they thought easy funds are available
from the market so borrow it and we will think at the time of return of the funds whether we
are able to return it or not.

And finally they have to means pass through this kind of the phase that they have to leave the
country. So, be careful always be always as a good financial manager you have to be very
careful that external borrowings have not to be resorted or if it is to be resorted at a minimum
possible amount. And if you are borrowing a 1 rupee from the market at least invest 1 rupee
from your own pocket also or from the internal sources also.

So, if the internal generation of the funds is there and reinvestment of the internal funds is
there then certainly you can borrow from the market also, but always keep your borrowing
power intact. So, that tomorrow if the internal say funds are not available and somehow we

133
have to borrow funds from the market then yes, you can make use of that always unused
borrowing capacity.

(Refer Slide Time: 18:03)

So, we are talking about here the one important corollary of the financial planning internal
growth rate. When you talk about the internal growth rate internal growth rate is the
maximum growth rate that can be achieved with the no external financing whatsoever. It is a
growth rate that can be sustained with the retained earnings which represents internal
financing.

Which represents internal financing, so it means you can find out the internal growth rate you
can work out is that is the return on assets multiply plough back ratio divided by the 1 minus
return on asset multiply the plough back ratio. So, internal growth rate can be worked out,
internal growth rate can be worked out that is a return on assets multiply plough back ratio
and 1 minus return on assets multiply plough back ratio with this help of this model internal
growth rate can be worked out.

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(Refer Slide Time: 18:47)

Second one more corollaries are sustainable growth rate. Sustainable growth rate is means
what is written here? Let us see it sustainable growth rate is the maximum growth rate that a
firm can achieve without resorting to the external equity finance, external equity finance. It
means in the previous case what we have seen that it is a growth rate that can be sustained
with retained earnings, which represent the internal financing.

It means internal growth rate is a maximum growth rate that can be achieved with no external
financing whatsoever. In this case we are talking about both debt and equity that no means is
sorry. We are talking about the largely the focus in this internal growth rate is upon the
external funds and that is the emphasis here is on the debt. That without borrowing anything
from the market in the form of the debt. We want to grow and what growth rate we can
achieve that can be worked out with the help of this model.

In this case what we are talking about here is that sustainable growth rate means that
whatever the amount of the funds is available with us. Whatever the amount is of the funds is
available with us. We want to grow with that at with that rate of growth how much we can
grow here. We are talking about of the 0 borrowing, 0 borrowing that no borrowing in the
form of the equity we will not have any external financing.

So, whatever the funds we have internally available from within the internal operations that
only means we want to make use of and with the help of that. It means if you are if the
situation arises tomorrow that for example, if the firm is, firm equity is not very means
preferred stock in the market. So, if they want to raise additional equity or the funds through
additional equity by coming out with an FPO Followed on Public Offer in the market.

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So, it may be possible that it will not be subscribed at all because adjusting stock of this
company is not doing well in the market in the stock market. So, people might have the say
this see apprehension in the mind that no this company is not good and we will not buy the
stock of this company. So, externally equity is not available at the same time because the
reputation is not very good or maybe because of any temporary setback the borrowing is also
not available.

So, it means in that case whatever the funds available with this company are they have to run
the show for the time being with that given amount of the funds. It means you have to sustain
in the market at the means whatever the amount of the funds is already available with them
from both debt and equity. So, it means that rate is called as a sustainable growth rate that at
what rate you can sustain in the market or what is your sustainable growth rate without
resorting to any kind of the external financing debt or equity.

How can you stay in the market how can you perform in the market? So, this all is about the
financial planning we wanted to discuss here and when you talk about the financial planning
as a whole the concept of the financial planning is a whole you can understand that it is very
important to always look forward into the future. It is always important to look forward in to
the future.

So, if you wanted to be sure about that, yes what is our financial requirement for the future
period if it is estimated beforehand and if the funds are already arranged so as and when we
need those funds they are already available with us. We can arrange the funds and carry on
the show in the market. So, financial planning has a very, very important role to play and for
every department every say unit and subunit budgeting is the one exercise which is the
planning tool.

So, we prepare the budgets for all the units and subunits and we translate that into the
financial terms and then we sum total it. So, we call it at that this is the total financial
requirement of the firm and then at the end of the say this entire process. We prepare the
projected financial statement projected your income statement projected your balance sheet
and the projected cash flow statement.

So, that we are means going to create a balance sheet. We are going to create a profit and loss
account which actually will be there in the next year. So, if that projected balance sheet is
already with us. We mean are a very comfortable position number one it acts as a roadmap

136
the guiding force and second thing it puts the pressure in the minds of the people working in
the different units and subunits that what their performance is expected up to.

So, if they know well in advance that this is the target we have to achieve. So, in the
production department is very careful how much production is expected purchase department
is very careful how much purchases are expected. Marketing department is very careful R &
D department your sales and distribution department and finance department also is very
clear that this is a requirement of the other departments.

So, this much of the funds we have to arrange we have already arranged the funds. So, the
funds can be provided so that your budgeted profit which is we have calling it as a projected
profit can become the real profit the budgeted financial position which we are calling it as a
financial position becomes a real financial position. And similarly the budgeted you call it as
the, your cash flow statement becomes the real cash flow statement.

So, this is a role of the financial planning which is very, very important in any kind of the
financial management functions. And as a student of finance, you must be very clear about
what is financial planning? What is the role of it? And how the financial planning is done in
any organization.

Now, I will discuss with you small two problems that means where we will apply the concept
of say calculating the growth rate without resorting to the external sources of the funds any
kind of the external sources of the funds means internal growth rate.

(Refer Slide Time: 25:03)

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How we can achieve the internal growth rate and for that purpose we have some say
information here and with the help of this information, we will calculate the internal growth
rate without resorting to the external financial requirement. Because here we have calculated
external financial requirement EFR. So, if there are no external funds are available then from
the given internal funds how we can grow in the market and what can be the expected growth
rate. How can you calculate that?

(Refer Slide Time: 25:10)

So, for example, there is a company call it as XYZ limited and about this complete
information available with us is assets to sales means assets to sales are expected to be in the
ratio of 0.80 and then as the liabilities to sales L/S are expected to be say 0.50 in the ratio of
0.50 profit margin, if you look at here the profit margin that is expected to be say 5 percent
and dividend pay-out ratio dividend pay-out ratio.

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If we talk about the dividend pay-out ratio that is the 0.6 and previous year’s sales. Previous
year sales though, we do not require it. But previous year sales are given to us as rupees say
1200. For example, we assume it as rupees 1200. So, question is what is the maximum sales
growth rate that can be, what is the maximum sales growth rate that can be achieved?

That can be achieved, without raising without raising external funds without raising external
funds. This is our question without raising the external funds. So, this is our question here
maximum sales growth rate that can be achieved means. We have to find out that can be
achieved without raising the external funds.

So, now if you look at this part, we have to find out this external growth rate and for this
external rate we have to now go ahead with this is the simple formula given to us is that if
you apply this formula. The formula is EFR External Financing Requirement delta sales and
is equal to what is this A/S minus L/S bracket closed minus small m multiply 1 plus g.

That is the growth rate multiply 1 minus d and divided by g here. This is our model this is the
formula. So, what we are given here is we are given the A/S. And A/S is how much 0.80 this
amount is A/S is 0.80 that is acid to sales is 0.80.

We are given the L also or say L/S what is L/S, L/S is also given to us is 0.50 and then we are
given the m small m which is given to us is how much that is 0.05 and then we are given the
d is value is that is the dividend value the dividend ratio is also given to us and that is 0.6.
And what is the question maximum sales growth rate that can be achieved without raising
external funds.

So, EFR is, is equal to 0. So, it means we are given this all information. So, this side becomes
0 if we applied this into this model. So, what is going to happen here? This side will become
0 and this is going to be how much if you take it as, so this will become something like 0
point sorry 0.8 then minus 0.5 and then it is minus if you take this here this becomes as how
much 0.05 this is the profit part.

And then what is the growth rate that is known to us that is not known to us. We want to find
out this growth rate. So, we are going to close it and here we are going to find out this ratio is
1 minus d is 0.6. So, this 1 minus d becomes is the 0.4. So, now and what is the growth rate
here that g is also not known to us we want to calculate this g. Now, if you solve this
particular equation, so I think that will value have put here 0.8 minus 0.5 multiply 0.05 and

139
that is 1 plus g which we want to find out into 0.4 and divided by Z. So, finally this is equal
to 0.

So, in this case, if you want to find out this growth rate, if you solve this particular equation,
so what you will be able to find out here is that if you solve this equation your g will come
out as finally the g will be 7.14 percent, g will be the 7.14 percent. So, what is here? We
wanted to find out that this is a company XYZ limited and there is all information is given to
us assets to sales will be 0.80, liability to sales will be 0.50.

And the profit margin will be 5 percent and dividend pay-out ratio is 0.6 and the say you can
call it as the existing sales you call it as that is a pre period sale, or the present sales you call
it as 1200. So, it means the sales will be increasing the growth rate of the sales will be 1200
multiply 7.14 percent. If you do not resort to any kind of the external financing. So, in this
case, we have not taken the external finance as a say as a proportion of the increased sales.

So, it means we wanted to find out that from this given information. If you want to find out
the growth rate so growth rate, we have worked out is that without resorting to the external
sources of financing. If you have the present rate of the sales or the level of the sales is worth
rupees 1200.

So, it means without having any extra funds invested from outside your growth rate for the
coming period will be 7.14 percent means now the next year the sales will be 1200 plus the
7.14 percent of the 1200. So, that will be the total amount of the sales. So, it will become 1
plus R is the growth rate or 1 plus g you can say.

So, g will be the growth rate and growth rate is a 7.1 percent. So, without say resorting to
external sources of financing you can calculate the growth rate. And this way the growth rate
can be worked out with the help of this model. One more problem relating to that say sort of
that for example for the given amount of the sales. If we are going to predict that we want to
achieve the certain amount of sales, they are currently we are selling for example for 400
million rupees and next period we want to sell for the 500 million rupees.

So, if you want to increase the sales from the 400 to 500. So, what will be the external
financing requirement that also can be worked out? So, that one more problem. I will do in
the next class and then we will stop the discussion on the financial planning. You can refer to
the books of for the detailed discussion. You can refer to the books on the financial

140
management and one book and again time and again referring to is the financial management
by Prasanna Chandra.

If I refer to that book so detailed discussion on the financial planning, you can have in that
book. So, one more problem, we will discuss in the next class and then we will close the
discussion on the financial planning. So, for this class, I will stop it here. So, thank you very
much!

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 Financial Management for Manager
Professor Anil K. Sharma
Department of Management Studies.
Indian Institute of Technology, Roorkee
Lecture 09
Financial Planning and Forecasting Part IV

Welcome all. So, we are in the process of learning about the financial planning and I will
now in this class conclude about the say entire discussion on the financial planning. So, we
discussed some important concepts that what is the financial planning and what we include in
it, and we discussed that with the sales forecasting and the projected financial statements and
some other important say tools we can go for the financial planning.

We discussed at length the importance of the financial planning relevance of the financial
planning, and how we can take the things forward and how we can means improve the things
the overall things as far as the financial performance of the firm is concerned. So, now before
I close a discussion on the financial planning I will also discuss one more small problem
which is with regard to say estimating the or learning about estimating the external financial
requirement for the given amount or the projected amount of the sales growth. Practically
how we can do it.

(Refer Slide Time: 01:29)

So, we have seen it with the help of this model here that with the help of this model we can
do or we have applied some values also here and we have found out that how that external
financing requirement which is 2.08 million we have calculated here can be calculated. But
for example if you are given some say hypothetical figures or the hypothetical balance sheet.

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So, from that balance sheet how can you think about that from this given information from
this say balance sheet how much is going to be our external financial requirement.

Means if we are at this level and we want to grow our sales from the current level to the next
level then how to calculate that external financing requirement. One more problem I will do it
here and then I will close a discussion on the financial planning. So, here I am taking the
figures for example there is another company ABC limited.

(Refer Slide Time: 02:16)

This is the company called ABC limited, ABC limited and the balance sheet of this company
is for example we have share capital. This is the share capital and the share capital for
example is 50 lakh crore whatever you call it as this is; the figures are in rupees. So, this is all
the figures we are taking here as in the rupees. So, this is the share capital 50 lakhs then we
have the retained earnings.

The retained earnings are like 60 lakhs then we are given the long term borrowings we are
given the long term borrowings L.T.B, Long Term Borrowings are given to us here as 80
lakhs or the 80 million then the short term borrowings, short term borrowing are already with
us which are given to us as 60 million and then we are given the trade creditors or you call it
as sundry creditors. You know sundry creditors when we buy the raw material on credit from
the suppliers.

So, we means have some, some liabilities short term liabilities which appear in the balance
sheet they are called as a trade creditors and this source of financing for example share capital
is an internal source of financing retained earnings are the internal source of financing
retained earning means retained earnings means the part of the profit which is reinvested back

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into the business that becomes the retained earnings long term borrowings means long term
borrowing mean from the financial institutions or may be from the, with the help of the bond
or debentures short term borrowings this is again from the banks or the financial institutions
for the working capital requirement or the short term financial requirement.

And then we have the, now the trade creditors largely they are called as spontaneous finance
they are called as spontaneous source of finance and for example the trade creditors given to
us here are 50 lakhs and then we have the next one is the provisions we have the provisions
here and the provisions is again 20. So, this total becomes the 320 lakh rupees or 320 million
the size of this balance sheet from the liability side if want to find out is 320 million.

So, this is the liability side of the balance sheet. Now, I will take it to the asset side of the
balance sheet again in the rupees all figures are and here first we have the fixed assets. We
have the fixed assets how much is the fixed assets 130 lakhs or we are given the second is
inventory.

Inventory is how much? That amount is given to us is 90 and then we are given here is as a
receivable. So, you call it as accounts receivable I am writing in the short form accounts
receivable given to us are 80. And then you are given the cash, cash available with us is 20.
So, if you total it up the size of this side also becomes 320 million or 320 lakhs or whatever it
is.

So, now this is the balance sheet available with us and now the present level of sales is in the
current period the present level present sales if you calculate the present level of sales is the
400 lakhs and rupees 400 lakhs and if you and next year if you want to take the proposed
sales, proposed sales we want to make it to how much 500 lakhs rupee. We want to make it
as 500, so there has to be a net increase of the 100 lakh rupees.

We want to increase it by 100 lakh rupees. So, the 100 lakh rupees means we want to grow
the sales from the 400 lakhs to the 500 lakhs or 100 lakhs we want to increase the sales worth
rupees 100 lakhs we want to increase the sales. So, if you want to increase the sales in the
next year from the 400 to 500 and the another important information given to us is the profit.

So, here if you look at this balance sheet now we are given all these assets this liabilities and
assets and now our say present sales are 400 lakh rupees and proposed sales are 500 lakh
rupees. So, we want to increase the sales by 100 lakh rupees and profit margin which is say

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we want to take is 5 percent and dividend pay-out ratio, dividend pay-out ratio if you
calculate is or which is given to us is 0.50 this is the information given to us.

So, we are given this balance sheet if this balance sheet practically because if you mean
tomorrow work in the organization in the department of finance you will find this kind of
balance sheet than you will have on the one side of the liability on the other side you will
have all the assets. So, we have the share capital explained it to you what is it retained
earnings are the profits part of the profits reinvested back.

Long term borrowing is the, borrowing which is for a period of more than one year from any
source financial institution and banks. Short term borrowing is a borrowing up to one-year
period of period of time that is called as a short term borrowing. Normally in India we borrow
from the banks.

Trade creditors, so it means what happens in finance we have the three source of finance one
is a long term finance then there is a short term finance and then we have the spontaneous
finance or the spontaneous sources of the finance. Long term finance, short term finance and
the spontaneous finance long term finance if you should talk it as in this case it is the long
term finance up to this it is a long term finance share capital retained earnings and long term
borrowing is a long term finance.

This one thing is the short term borrowing is a short term finance and then other two sources
are called as spontaneous finance. Spontaneous finance is one where you have not to say
enter into a special agreement while borrowing any money or any kind of the other inputs it
say continues regular arrangement.

And as & when there is a need for any particular input we place the order and the input
comes to us and when the payment becomes due to be made to that source after the end of the
credit period automatically the payment is send to that source and that spontaneous finance
largely works in case of you say supplies or the raw materials suppliers.

Because raw material suppliers normally supply the raw material on credit and in India the
standard credit period is 45 to 60 days. So, when the raw materials arrangements are done
with suppliers. So, once a long term arrangement is by the companies. So, when there is a
need for the raw material order is placed with that with the supplier and then raw material
comes and after that credit period which has been entered into, means entering into an
agreement at the end of that credit period the payment is send to the supplier.

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So, that source of the finance where no special arrangement has to be done. No, special
arrangement has to be done, no special agreement has to be entered into is called as a
spontaneous source of finance. So, these two are the spontaneous sources of the finance and
when we talk about in our model A/S and L/S. So, L is particularly the spontaneous
liabilities, spontaneous finance there we do not even include the short term finance.

So, this is the liabilities side of the balance sheet this is the asset side of the balance sheet in
the asset these are the fixed asset or long term asset and all other assets are the current assets.
So, inventory account receivable cash this all is, this all are the current assets. So, we have
both fixed assets plus the current assets and we have, we have three sources that is the long
term sources then we have the short term sources plus short term sources and then we have
plus the spontaneous sources of the finance we have three sources.

So, finally whatever the funds we are generating we generate 320 lakh rupees of the million
rupees and we have invested that in to the different type of the assets both fixed and the
current assets. So, both the side are equal 320 is equal to 320. So, your balance sheet is
balanced current level of the sales present level of the sales is the 400 lakhs or the 400 million
and proposed for the next one year or during next one year we want to attain or take it to from
the 400 to 500 million.

So, we want to increase the sales by 100 million or 100 lakh rupees and our profit percentage
is 5 percent and dividend pay-out ratio is 50 percent. So, if this information is available, so to
attain that growth in the sales from the 400 to 500 lakhs or million rupees, how much external
financing requirement will be there?

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(Refer Slide Time: 11:15)

So, in this case external financing requirement we all know can be EFR we have to work out
here and we have already known the formula for that. So, it means the formula is we are
applying the formula here again and if you know the formula. So, it means with the help of
simple formula here this we can use it A/S minus L/S and the bracket is closed and then we
take it here as what is the total amount is we are going to multiplied by the say delta sales that
we are going to multiply by this model simple change in the model is going to be here that is
the delta sales minus M and then it is multiplied by S1 and multiply 1 minus D.

With the help of this model we have already discuss this model means earlier. So, the
previous problem which is did that was for the growth rate and this is for working out the
external financing requirement. So, A/S minus L/S multiply delta sales means the changed

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level of the sales if you talk about the change level of the sales minus M is the profit margin
as compare to the sales.

That is given in the period that is the say S1 and then it is called as the dividend pay-out ratio
is 1 minus D is the dividend pay-out ratio. So, what means when we talked about here is what
is the A by S we talk about here is the that is the total assets, we have to take it A means the
total assets not only the short term assets. So, total assets are how much total assets are, the
total assets are going to be the balance sheet says 320 and what is the sales level, sales level
currently is 400 minus what is the spontaneous finance level.

If you talk about here is the spontaneous finance level is just only 70 this and this. We have
not to take even the short term finance in this. So, spontaneous finance is going to be this
much. So, this is how much 70 divided by sales in the period 1 this is 400 so if you close this
bracket and multiplied by the delta sales.

So, how much sales we want to increase from the 400 to 500. So, delta sales mean the
increased in the sales that is multiplied by 100 and minus here is the bracket that 0.05 is the
profit. And what is the sales level now S1. Sales are going to be how much 500 this is the
sales level and what is the D that is 0.5 because your dividend pay-out ratio is how much 50
percent let us be more clear here.

So, dividend pay-out ratio is going to be how much 0.5 percent or 0.5 or the 50 percent. So,
this finally the values we have placed in the model 320 is the total A/S. A means the total
assets divided by the sales amount which is the present level sales L is the spontaneous
finance only trade creditors and the provisions 70 divided by 400.

And then is the delta sales means the change in the sales which we want to increase from the
present level to the in the future period on the next year and multiplied by M is the profit
margin which is just 5 percent and that is the 5 percent of the increased sales and increased
sales S1 means this S is 40 so S1 is 500 multiply 0.5.

So, it means this is going to be the final we have put the things here in and if you solve this
the final result comes out as 50 rupee or 50 lakh or 50 million is going to be the total
requirement of the funds that is EFR is going to be.

The total EFR External Financing Requirement is going to be rupees 50 million if the balance
sheet level is this much which is already prepare by us 320 million or lakhs and the present
level of sales is 400 and the project level of the sales we want to take to 500 profit is 5

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percent dividend pay-ratio is 50 percent. So, by applying a simple model here you can find
out what is going to be my External Financial Requirement.

So, for example now you look at how easy it is we have already estimated before the
beginning of that future period that means our level of sales is 400 we want to increase it by
another 20 percent. Say 25 percent so we want to make it from 400 to 500 means we want to
increase it by 100 million rupees.

So, if I have to increase my sales how much funds I require? Because if the funds are
available from the market then only I will grow in the market or I will think of expanding my
market, if the funds are not there available in the market then I should be means satisfied with
or with the company should be satisfied with.

Their sales worth rupees 400 million or 400 lakhs are enough we need not to means to go
beyond. Because funds are not available from the desirable sources. So, this is the beauty of
the financial planning that what we are going to do in future and how much is the financial
requirement for that that we have the assessed well in advance and if you have the required
amount of the funds available from the different sources then you go for implementing your
plans.

If the funds are not available in the market, then you do not go for implementing the plan. So,
it means now with these two small problems one we discuss is about that how to calculate the
growth rate without resorting to any external financing. Second thing we discussed here is
that if you want to grow from the present level to the next level of the sales and companies’
performance.

How much is going to be the external financing requirement and how to calculate it and if
you know this advance then how to arrange the funds from the different external sources
which are accessible to the firm. So, I think with this entire discussion of the financial
planning it, if we little go back at the beginning and try to find out that where we started from
and what are the different techniques of the financial planning.

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(Refer Slide Time: 17:05)

So, we started with that we have to first of all take the economic assumptions or we must be
knowing that economic environment in the country. For example, these days if somebody or
these auto mobile companies or the electronics companies had they been knowing it in
advance that there is going to be a recession in the market.

So, they must not have means planned their production capacity or their say plant capacity or
their say human resources they have hired they must have been means mentally prepared that
market is going to be hit by the recessionary phase. So, we have to be very careful about that
we are not going to sell in the market in the time to come as we have been selling in the past.

So, either we have to reduce the production or we have to look for the markets somewhere
else. If we are not able to sell in India, then that leftover production which is there left with us
which we are not able to sell in the present market or in this countries market we have to
think of means exporting it to the other countries.

So, you have two options available at that time one is that either you minimize the, you
curtail the production and then adjust according to the sales or you keep on producing
whatever you are producing in the past when there is a normal economic trend in the market
and then there is a surplus production left over that can be sold in the other countries market.
So, economic environment, the assessment of the economic environment is very very
important.

So, we have to do the EIC analysis Economy Industry and Company analysis and that is
always important for the financial planning. After that then when you come to the company
level you have to start with the sales forecasting if you know that in the future period of 1, 2,

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3, 4 years what is going to be growth rate of the sales then you start back tracking and then
you think of that for selling this much of the product how much I have to produce and what is
the production cost what is the input requirements including finance and then we can arrange
for the funds.

And even we are not only going for assessing the sales we are going to create the projected
financial statement for the next 1, 2, 3 years. So, that we know that how your profit and loss
account will look like, how our balance sheet will look like, how your cash flow statement
will look like.

So, if you have already created the road map walking on that will not be a difficult thing but
we have not created the road map and if you are going to move in a phase which is totally full
of dark we do not know what is going to happen in the future period. Then I think the firm is
going to face so many ups and downs and so many problems.

There must be requirement for external funds but we have not assess our requirement
suddenly the requirement has come up. So, now we are not able to find the source from
where the funds can be arranged. So, financial planning is something which is very very
beautiful process and the basic tool of the financial planning we use is the budgeting the
process of budgeting.

We prepare the budgets for each unit and sub units in the firm we sum it up and then we
prepare the entire budget for the firm as a whole we prepare the budgeted profit and loss
account, budgeted balance sheet and budget cash flow statement and then from the different,
with the help of different concepts we can go ahead that how we can say assess the growth
rate how we can work out the growth rate of the firm.

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(Refer Slide Time: 20:15)

So, if you know the growth rate in terms of the sale, you know the requirement of the funds
also. So, whatever the internal funds are available with us that we know but what is external
requirement if we know the growth rate we can assess our external funds requirement also.

(Refer Slide Time: 20:35)

And at the same rate because you are growing so growth will depend upon the availability of
the finance and the financial requirement will be possible to be worked out upon the say
working out the growth rate. So, growth and external source of financing they are reciprocal
to each other they are compliment to each other. So, we are able to find out therefore given
rate of growth how much external financing requirement is there and if we do not want to
resort to any external financing what will be our growth rate?

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(Refer Slide Time: 21:12)

So, everything can be worked out with the help of these models and these formulas and you
can be very comfortable that when we are into the real business we can find out if we have
the sufficient external funds available at what rate we can grow? If there are no external funds
available at rate what we can grow?

And if we do not want to have even the funds are available but we do not want to borrow any
external funds may be by way of debt or equity then at what rate we want to grow or we can
grow we can sustain in the market you can calculate the sustainable growth rate also. So, with
this say some discussion, some important discussion, some relevant discussion I would like to
stop the discussion on the financial planning.

So, financial planning is a very very important component of the overall financial
management is a very very important tool of the overall financial management. So, after
discussing the fundamentals of financial management at length I could discuss with you the
concept of financial planning different tools and techniques of the financial planning and I
think by now you must be clear about that what is the financial planning what is the relevance
of the financial planning and what are the important tool and techniques of planning for the
funds requirement for a future period of time.

With this I will stop the discussion on the financial planning and in the next class or in the
next say, part of the discussion we will now start talking about the next and a very interesting
concept a new concept which is called as time value of money. So, what is time value of
money how important it is for all of us and important it is for the financial managers and the

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business organisations that all and everything about the time value of money, I will discuss
with you in the next class. Thank you very much!

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Time Value for Money Part 1
Lecture 10

Welcome all. So, now we are going to start very important concept in finance Time Value of
Money. The Time Value of Money which is a very, very important concept and without learning
about the Time Value of Money I think the discussion on any subject on the finance or the
financial management will not be complete. This is basically the you can call it as the, the back
bone of any financial learning or the learning about the finance and the financial management.

Without time value of money, you cannot complete any discussion on finance, you cannot take
any financial decision and we cannot arrive at on very reasonable say conclusion that if you want
to take any investment decision, if you want to take any yes or no decision with regard to any
investment then largely we have to take that say decision in the light of the total discussion
which is in terms of the time value of money.

Because, value of the money changes as the time changes. Value of money is not static, because
value of money is always dynamic this, this concept is always dynamic it changes always
changes it does not remain static, it does not remain stable. Money a 1 rupee in hand today is not
equal to the 1 rupee we are earning after 1 year.

Number of reasons are their, number of factors are their so when you talk about the time, value
of money you talk about 2 important things present value of the future earnings or that present
value of the future cash flows and the second important concept is the future value of the present
cash flows, future value of the present cash flows.

For example, we have 1000 rupee today, I have 1000 rupee today in my hands, I want to grow
with that amount, now I have different options if am totally risk averse then what will happen? I
will go deposit that 1000 rupee in the, in the bank and after depending upon the rate of interest
for example the, if the simple rate of interest is 10 percent then after 1-year bank will give back
me not 1000 rupees but say its 1100 rupees.

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So, 10 percent addition they will make. So, in a way we call it as an addition earning on my
investment that is at the rate of 10 percent. I have earned that interest on that 1000 rupees so my
1000 rupee which I deposited in the bank today has become 1100 rupees so that is on the one
side called as an earning on my investment but if you calculate in terms of the time value of
money then my 1000 rupees is equal to the 1000 rupee, 1000 rupee of today will be after 1 year
equal to 1100 rupees, because the value of that 1000 rupees of today is equal to the value of the
1100 rupees after 1-year period of time.

So, why we want to means calculate the future value of the present amount? And why we want
to say earn something on that? Why we want to invest in such a manner that at least there is no
appreciation in my investment but at least there should not be any kind of the depreciation also
which is called is a real depreciation because of the time factor that should also not be there.

So, after 1 year when the bank is returning you back 1100 rupees against the investment of 1000
rupees which we made today they are not making any kind of obligation. They are returning you
only 1000 rupees back if you calculate that their value of that 1100 rupees after 1 year that will
be almost equal to that 1000 rupees.

Because if they are returning you 1000 rupee they taken today and after 1 year they return you
back 1000 rupees it means we gave them 1000 rupees and after 1 year they are returning me
something lesser maybe 900 rupees, because the value of that 1000 rupees after 1 year will be
equal to 900 rupees. So, value of the money comes down with the period of time.

Second important concept is the, say present value of the future amount, present value of the
future amount. So, for example, we have the present value of the future amount means that we
use this concept in the project evaluations. When we go for any investment, business investment
proposal evaluation of business investment proposals we call it as an independent project.

Maybe it is a addition of the 1 new product into the existing line of the products or maybe say,
say conglomerate diversification or you call it as a say vertical growth or horizontal growth or
maybe any kind of diversification the firm want to do when any new investment is planned we
want to add a new product into the existing say the product mix or you want to move into a
diversified area and you want to start the production of a new product at all every time it’s a new
investment opportunity, new investment and it has to be evaluated in terms of a new project.

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Once you have to evaluate it in terms of a new project so what happens? There comes a question
of the say evaluating it and trying to find out that whatever the investment we are making today
in that project the total funds which we are putting into that project are we able to recover the
minimum decision making criteria is that minimum that whatever investment I am making in this
project today that must be returned over a period of time when the cash flows from the project
will be available.

(Refer Slide Time: 06:21)

So, for example, we have the say concept of the cash out flows and the cash inflows. So, for
example there is a project which we want to start and this project is for example X, we want to
maybe start a new product we are diversifying for example as in case of anchors I discussed with
you, anchor diversified from the conventional electrical products segment to the fruit beer.

So, when they wanted to have this project so they thought that how amount they are going to
invest in the current year in this period we call it as we divided into number of years 0, 1, 2, 3, 4,
5, 6 we want to have like this. So, it means this is the current period 0 period is the current period
and these are the future periods one year, second year, third year, fourth year, fifth year, sixth
years.

We can say that if we make an investment of this any amount in this present period, in the 0
period, in the current period and then the forcible life of that project which will come into
existence after this investment will be next 6 years and all the 6 years over it will be giving us

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some cash flows back so it means how much we are investing in the 0 period and how much it is
returning with the life can be any, any number of years.

For the forcible years are today we can see look forward into the future is only up to 6 years. So,
we have these 6 years we are seeing here that ok, it can run up to another 20 years but I can say
that yes in the next 6 years this is going to happen with this particular company of particular this
project.

Now, we have got 2 time periods 1 is a 0-time period which is a current period and these are a 6
future time period is a 6 years. I making investment of for example, 350 crores here so this is my
investment and this will be known as the, what we will call it as? Cash out flow. This will be
called as cash out flow of the 350 crores which I making in this period that is in the 0 period.

And over a period of this you are going to get back 100 here then you are going to back in the
second year also 100, then you are going to get back again the 100, then you are going to get
back here is a 150, then you are going to get back next year also 150 and now you are going to
get back is the total 200 crores are coming back to us.

So, after making this investment of how much 350 crores we are going to get back some amount
here and that amount is available to us over the period of time which we have assist basically on
some say estimates and estimation is all based means any estimation begins always with the
forecasting of the sales.

So, if you sum it up this becomes 1, 2, 3 300 then it is 450 then it becomes 600 plus 800. So, you
invested how much? 350 crores and how much is coming back to us is the 800 crores. But would
you call it as this is 350 crores rupees and this is 800 crore rupees would you call it as that these
800 crores which we are earning over a period of 6 years is equal to the 800 crores.

This 350 is equal to the 350 crores because this is currently in the 0 period we are investing so
the time value, time value of this money 350 crores is equal to 100 percent that in the current
period 350 crore I am shelling out of my pocket so this 350 rupees’ investment in the 0 period
which is called as a cash out flow will be called as 100 percent equivalent to 350 rupees.

If I go with that 350 crore rupees in the market, I can buy the goods and services worth this
amount from the market and no reduction in the value of this will be there will be done by

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anybody. But this cash flow is coming to us over a period of 6 years total in flow is coming to us
this is called as cash inflow, this is called as cash inflow.

So, this is coming to us over a period of how many? 6 years. In the first year at the end of the
first year after the operations of the first year I am getting back 100 crores cash flow I am talking
about is not the profit. Second year we are getting another 100 crores, third year we are getting
another 100 crores and then it is we are getting again the 150, then 150 and then 200 crores.

So, now what I have to do is, that 100 crores which are coming to me at the end of 1 year, next 1
year that is not equal to 100 crores it is something less than that. So, I have to calculate the time
value of money of this 100 crores so it may be possible this is not say 100 crores but this is 80
crores, this is 70 crores and this is further coming down to 60 crores this comes out as plus 90
crores this comes up as again 80 crores and this comes up as 120 crores.

So, this amount will be how much? This may amount will become is the this 70 and this 80 and
this 70, 150, 210 this is 200 and 300, 380, 380 and it is 480, 500 this becomes 500 rupees 500 is
the discounted value. So, how much I invested? I invested is 350 crores this is my total
investment. How much I got back is? My total amount coming back to me is that is rupees 500
crores.

So, we have to make a now our present value analysis, we have to calculate the present value
analysis so my cash out flow and the discounted value of the present value of this so total cash
out flow is 350 and total present discounted value of the cash inflows over the period of 6 years
is 500, so it means what is my NPV?

Which is called as net present value of this project will be rupees 150 crores. This is called as
rupees 150 crores which is called as the net present value, this is called as the net present value.
If you call as a present value if you want to ask, present value of this project is 500 crores but if
you want to calculate the net present value then from the discounted value of the cash inflows
you have to subtract the present value of the cash out flows and then that is the present value of
the cash inflows minus present value of the cash out flows will become the net present value and
in this case this NPV becomes 150 crores.

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Now, question arises that how this 100 crore came down to 80 crores? 100 crore came down to
70 crores we discount it against some discount factor and discount factor normally is basically
the cost of capital, the cost of capital because this 100 crore means simple I in the simple terms
we will be, I will take you to the intricacies of this time value of money in the literal meaning, in
the literal financial language also but in the simple terms we can say that the present value of the
future cash flows is the one important requirement working out those is the one important
requirement and the future value of the present cash flows is another important requirement.

So, in the time value of money we will learn both what do we mean by the future value of the
present cash flows? And what is do we mean by the present value of the future cash flows? This
is a present value of the future cash flows. So, we have calculated and we are trying to find out as
net present value.

So, whenever we take the decision about any kind of the projects, we have discussed in the
beginning when you few remember that discussion of the this during the fundamentals of the
financial management I have told you that ultimately the objective of the value maximization of
the form will be achieved if the total return which is means the reward of shareholders
investment which is returned back to the shareholders by the company over a period of time is
more than whatever the investment this shareholders have made in the company.

So, if for example, the shareholders have invested 100 rupees you if you are returning 150 rupees
back so it means this is the 50 rupees is the reward of their investment which they made into this
company. This much of the risk they have taken they moved into the business and everything so
it means we have achieved that our objective of the value maximization so shareholders’ wealth
maximization we have attained.

Same is a case here in every project when we take the decision of the projects we apply the
concept of the present value of the future cash flows so present investment is equal to 100
percent future cash flows have to be discounted against some discount factor and they have to be
brought equal to present say value of that future cash flows so that both become comparable.

Now how, because you cannot compare the apples with the oranges and oranges with the
bananas its not possible. So, what we have to do is one is the present cash flow another is the
future cash flow so how the present cash flow can be equal to future or vice versa it’s not

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possible so you have to convert both into the present cash flows. So, present is present that is
their 350 crores but the future is coming to us which is estimated cash flow you have to convert
that into present and then these two become comparable.

So, there we are able to take a decision that if we are investing 350 crores and we are getting
back 500 crores so yes, we are going to have the net present value of the 150 crores so project is
worthwhile. Plus, you can add up the value over the next subsequent years also which is not
forcible here that we are seeing only the 6 years the life of the project but it may be possible
project is running for the 20 years.

So, additional then when the cash flows will come to us they will keep on adding into this NPV
and this project will become more means worth taking up or its economic might must further go
up. So, here lies the importance of the concept of the future value of the present cash flows and
the present value of the future cash flows and both the concepts are the two sides of the same
coin and here these two important concepts make the time value of the money.

So, I told you that the future value of the present cash flows for example, the example of a bank
you have 1000 rupee given it to the bank, so you are giving 1000 rupee after 1 year they are
returning you back 1100 rupees so they have returned you not 1100 rupee if you discount that
against 10 percent cost of capital you will means come back to the 1000 rupees.

So, 1000 is coming back to you as a 1000 so it means you kept your 1000 rupees safe with the
bank and after 1 year, after using your money whatever the return on investment they earned part
of that they have returned it to you and your money ultimate objective is I may not get 1050
rupees for an investment of 1000 rupees.

But at least I should be able to get back if I am investing 1000 rupees today I should be able to
get back 1000 rupees after some period of time my investment should be safe. So, growth means
keeping your investment intact. So, this both the concepts I am going to discuss with you in
detail in this concept of the time value of the money.

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(Refer Slide Time: 17:46)

So, now question arises here, time value of money some important things we are going to discuss
here. What we are going to discuss here? These are the important things. Why time value of
money? I discuss with you at detail why time value of money, why we talk about the present
value of the future cash flows and why we talk about the future value of the present cash flows
and how it is important.

Future value of a single amount now when we will be calculating it you have the different
questions now arising here. If you have a single amount 1000 rupees you deposited in the bank
after 1-year period of time at a given rate of interest how much it will become. After 2 years for a

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given rate of interest how much will it become, after 3 years for a given rate of interest how
much will it become.

So, we will calculate the future value of the single amount we can calculate the future value of
the multiple amounts which are not same, which are not same which are the different amounts,
so we will have to work out that also. Sometime we have to calculate the future value of an
annuity that every year you are depositing the same amount in the first year you deposited 1000,
second year you deposited 1000, third year you are deposited 1000, fourth year you deposited
1000.

So, at the end of 5 years how much that amount will become at the given rate of interest. So,
different questions will arise and we will answer the different questions under this future value of
the single amount. Then is the present value of a single amount. So, when you are investing 350
crores in a project and the project forcible life is 6 years and over the years we are getting the
different cash inflows if you calculate their discounted value and compare with the cash out flow
of the 350 rupees, so what is going to be the net present value. That is going to be the present
value of a single amount.

Present value of an annuity, that every year you are getting the same amount so 100 crores, 100
crores, 100 crores everywhere, so is that, that return is not changing focus what we discussed
here in this? We have discussed the different amounts we have invested this and we are getting
100, 100,100, 150,150 and 200.

But for example if you get the same amount every time, every year at the end of every year you
are getting the same amount so it means how to calculate the present annuity means when at the
end of any period you get the same amount back that amount does not change and over a period
of 5 years you are getting the same amount at the end of every year how to calculate the present
value of that and what is the meaning of that?

Then the intra year compounding and discounting. So, these are some other concepts we will be
discussing. So, compounding is important when you calculate the future value of the present
amount. Because you must have heard about there the 2 rates of interest in the market one is a
simple rate of interest another is the compound rate of interest.

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(Refer Slide Time: 20:31)

And the growth of your funds is different under the 2 rates of interest. If it is a simple rate of
interest, then you the funds of somebody grow like means this they grow like this as a straight
line but if it is a compounding rate of interest it goes up like this. So, the growth rate is different
because in the compounding rate of interest you get the interest on the interest.

But in the simple rate of interest what we say we earn the interest and we consume that interest
only the principal amount is reinvested back. So, when the principal amount you are reinvested
in back for the 1, 2, 3, 4, 5 years so ultimate you are going to get back the say lesser amount of
the interest.

So, that difference of compounding and discounting, discounting comes into the picture I
discussed with you in this case that when we are talking about this particular part how I have
brought down the 100 to 80 and this 100 to 70 that is the by way of discounting and discounting
is always done at the rate of the cost of capital.

Whatever the cost of capital of the firms cost of capital is that at the weighted average cost of
capital we apply a discount rate and we say that whatever is my cost of capital minimum that has
to be my return on investment, that has to be my return on investment, so either you call it as
ROI or you call it as cost of capital so that is called as denominator we use it as 1 plus R.

So, we use it as the discount factor and when you discount it against that discount factor the
future cash flows then you get something lesser than what we are expecting to get after 1 year

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and that is called as the discounted value. So, the concept of compounding and the concept of
discounting we will discuss at length and every point of time when we will be answer different
questions under time value of money we will talk about all these things.

(Refer Slide Time: 22:20)

So, this is the total means the discussion we are going to have under the time value of money, so
if you proceed further then now the question comes up I have discussed with you already but
something is written here.

(Refer Slide Time: 22:31)

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So, let us go through it why time value of money? A rupee today is more valuable than a rupee a
year hence. Rupee in your hand today is more valuable than a rupee hence it means a world is in
hand is better than to in the bush, simple thing. A world in hand is better than to in the bush so
same is a case here a rupee today is more valuable than a rupee a year hence, why?

Number 1, preference for the current consumption over the future consumption people are more
interested to use their resources for the current consumption and not for the they want to means
go for the future consumption. So, when the preference for the future, present consumption is
more as compared to the future consumption it means the rupee which is in your hand today and
which will come after 1 year which one is more important the one which is in our hand today.

So, you can calculate how much is in my hand today when you are calculating the present value
of the future cash flows it means I am shelling out 350 crores and after 6 years over a period of 6
years the total amount coming back to me is not 800 crores that has to be something less because
that is now subject to the future earnings and that will come back to me not as 800 but actual
value of that will be 500 crores.

So, preference for the current consumption over a future consumption so the time value of
money is important. Productivity of the capital. You invest 1 rupee or 100 rupees in any
investment or you invest a 100 rupee today or 100 rupees after 1 year because 100 rupee of today
is equal to 100 rupees and 100 rupees after 1 year is not equal to 100 rupees because productivity
of the capital changes.

When you are investing 100 rupees the return will be same means accordingly. When you are
investing 100 rupees after 1 year but that is not 100 rupees that is less than rupee so your will
also be accordingly less than 100 rupees. So, because productivity of the capital keeps on
changing because of the say the interest rates or because of the other important factors in the
market.

So, you prefer to go for say having the resources and invested them today and whatever the
return is available maybe coming in the future period of time but that has to compare with the
today's investment that how much is my out flow, how much is I am getting the inflow
discounted value of that I have to calculate.

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So, that my objective is if I am investing 350 crores at least I should be able to get back 350
crores. If I get minimum because what is the decision criteria? NPV should be minimum 0, if the
out flow is more 350 but the discounted value of total inflows is 300, so NPV is negative you
will reject the project.

If it is 0, yes we can think about it. But if it is more than that if it is a plus positive, NPV is
positive always you will go ahead with this because my objective is growing my investment or at
least I should get back that if I am investing 350 crores my discounted value of all the inflows
has to be that much.

And another important factor is inflation. Because of inflation the value of money keeps on
reducing. Inflation means the amount of goods and services which you can buy for a given
amount of money today as compared to how much the amount of bundle of goods and services
you can buy, the basket of goods and services you can buy for the same amount of the money
after 1 year.

If you go with 100 rupees in the market and buy apples for example today you get say 1 kg of
apple for 100 rupees because the price of the apple is 100 rupees today but if you save that 100
rupees and say that ok, I will save these 100 rupees and I will consume the apple after 1 year,
after 12 months with the same 100 rupees if you go to market and want to buy the apple you may
not end up buying 1 kg of the apple but sometimes 800 grams or 700 grams of the apple.

Because of the inflation the price of the apple is gone up. So, when the price of the apple has
gone up, the value of your money has come down. That 100 rupees is 100 rupees but the amount
of the apple we are able to buy today with that 100 rupee and the amount of the apple we are able
to buy after 1 year there is a difference in the quantity of the goods and services.

So, because of the inflation, because of the rising prices when the say price is keep on rising then
the say demand for the more money is there and the value of the money say continuous going
down when the value of money reduces you have to adjust the future cash flows with the present
cash flows.

So, that we can say that at least I should be able to buy same amount of the apple means for 100
rupee I am able to buy 1 kg of apple after 1 year it may be possible that for buying 1 kg of the

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apple, same amount of the apple you have to sell out the 150 rupee. So, it means, because of
inflation your 150 rupees of the next year are just equal to 100 rupees of this year.

So, because of three important reasons the time value of money becomes important. Finally, I
would say here many financial problems involves cash flows occurring at the different points of
times. Because cash flows in the business occur at the different points of time. For evaluating
such cash flows an explicit consideration of time value of money is required.

Explicit consideration of the time value of money is required if you make investment anywhere
always think of your objective should be that if you are investing 1000 rupee at after 1 year or
after 2 years whatever the return means comes back to you that is 1000 plus interest if you
discount that, that should be equal to the 1000 rupee of today.

Because you have given the 1000 after 2 years if you get back 1000 it means you have not
getting back 1000 you are getting something less than that maybe 700 or 800 that because of
inflation the value of that 1000 has reduced to 700 rupees.

So, tools of compounding and discounting are important which are very useful in finance from
valuing securities, shares what is a price of 1 share today that given 1000 rupees how much
shares you can buy today you cannot buy maybe in the next year the same amount of the shares
by that investment.

So, valuation of securities, to analyzing projects I just I made the analysis of the say cash out
flow and in flow from a project determining lease rentals. When we give anything on the least
how much rent I have to take monthly for means allowing somebody to use my asset that also
keep on changing.

Choosing the right financing instrument means if I want to borrow money then maybe different
sources their rate of interest may change so I have to means choose the right amount of the
financing and there also the time value of money will be more important because I have to see
the rate of interest being charged by the different sources.

Setting up loan amortization schedule and valuing the companies. So, for valuing of 1 stock to
valuing their company as a whole time value of money is important. Everywhere when you will
take any financial investment decision or financial management decision every time we will be

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talking in terms of the present value of the future cash flows or the future value of the present
cash flows.

So, this is just beginning about the time value of money we will grow with this total discussion
over a period of time and by the end when we will complete this discussion on the time value of
money you would be very clear about all the concepts that why this concept of the time value of
money is important.

How useful it is and how with the help of this concept of time value of money we can take the
very important business and the financial decisions. For the moment I stop here and remaining
discussion on this concept will be in the next class. Thank you very much!

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 11
Time Value of Money Part II

Welcome all. So, with the process of a time value of money learning. This concept I started in
the previous classes and we are still continuing with the same process of the time value of
money, because it is very very important concept. And I discuss in the previous class also that if
you are a student of finance or the financial management you must be well versed with the
concept of the time value of money.

Because at every work of life or at every decision which is a financial decision. We will have to
use this concept of the time value of money. So, we are discussing this we are learning it, and I
want to spend quite some sufficient amount of time on the different concepts, and different
aspects of this concept of the value of money.

So, that we are clear that in later on, when we discuss the other concepts and techniques of the
financial management, or different another says sub-components of this course or this particular
area of learning. Then we are very clear about that what we are talking. When we are talking
about the cash flows maybe the future cash flows or the say the present value of the future cash
flows or anything.

So, means every time we will have to talk in terms of the, say discounted value of the future cash
flows or the in terms of time value of money. So, I think we should be very clear about the
different concepts of this sub-component that is a time value of money. I talk to you that when
you evaluate the new investment proposals of the new projects.

There is very important because cash flows will come sometimes in the future, and the
investment we are going to make it today. So, something coming in the future and something
going out of our hands today. Both cannot be compared, so they have to make both the figures
comparable and for making both the figures comparable.

We will have to have means bring them to the present value. So, every time this concept of the
time value of money is important and I am discussing it at, detail I want to spend sufficient time
on it. So, in the previous class we discuss just the started talking about it. That how the time

170
value of money is important? Why it is important? And that we discuss here something that in
terms of the present consumption.

As compare to the future consumption or the productivity of the capital or the inflation factor.
Because inflation is a one important factor that reduces the say value of the money over a period
of time. Because in a growing economy, in a developing economy inflation is a one important
factor which means keeps on going up.

So, means when there is more say availability of the money in the market. People start
demanding for more goods and services and sometimes when the stock of the goods and services
is not growing because we are a developing Economy. So, that leads to the inflation. So,
because of the inflation or the inflationary trends in the market.

The value of the money goes down it changes also and you otherwise also in a common men
language we can also understand that what we can buy for a say some of hundred rupees today.
Probably we cannot buy the same amount of the goods and services 1 year hence, from now. So,
it means it is important that because of inflation because of some other factors the value of the
money goes down.

And we will have to means evaluate that that how much reduction is there in the value of the
money? So, that when the future cash flows you are comparing with the present investment. We
have to convert that into the present value.

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(Refer Slide Time: 04:02)

So, just beginning discussion we had about all this and we have seen that we are this time value
of money is important. We have seen that right on the valuing single stock, single share or the
return available from the investment in first stock of a company. Valuing the whole company or
the company as a whole there means lies in between the whole spectrum of the time value of the
money lies. So, you can understand the importance of the time value of money.

(Refer Slide Time: 04:23)

Here is the timeline. When you talk about the something here it is the timeline and
understanding this timeline is very important. If you look at this timeline we are given into 2

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parts. Part A and part B. In the part A if you look at it the value is same and the percentage.
The rate of interest or the discount factor is also same. But there are some points were this
values are put at different points in the 2 structures.

In the structure A now, we are talking about that we? The how many periods? We have the 6
periods 0 means present year present period, current period, 1 is the next 1 year, second 1 year,
third 1 year, and then the fourth next year and the fifth next year. So, it means we have the, this
is a 0 period is a current period. Maybe 2019 and then 2020, 21, 22, 23, 24 like this is the future
number of years are given here in timeline.

In rate of interest, cost of capital or discount factor whatever you call it as it is the 12 percent and
this cash flow is 10000 rupees. Now, this cash flow shown at 10,000 is at the say end of the or
you can call it as here we have shown it as the beginning of the say or at the end of the say year
1. So, when you talk about here the end of the year 1, it means this cash flows are occurring to
the firm.

That this investment has gone into current period whatever the investment we are making we
have made that investment in the current period and then against that investment now from that
project from that total investment. Cash-inflows are available, so first inflow is available of
10000 rupees that is at the end of first year that is at the end of the first year.

Second cash flow is available at the end of the second year. Then it is the end of third year that
at the end of the fourth year and then at the end of the fifth year, the cash flow is available. Now,
here this timeline shows that some cash flows cash-inflow are available at the end of the year.
So, we have the 2 important points to be born in mind here that the point of cash flow and the
period of the cash flow.

So, if you are talking about the point of the cash flow though these are the 2 points. Point 0 and
this point and this point this is the beginning point; this is the end point. For example, and this is
the 1 period. This period is from 0 to 1 year; this period is 0 to 1 year. So, this at the end of the
first year how much cash-inflow is coming? Back to the firm which he has made the investment
in the 0 period?

Then the second cash flow is coming at the end of the second year. Third cash flow is coming
same 10000 at the end of the third year at the end of the fourth year and fifth year. So, and so

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forth, so this are the cash flows are coming when it is given at a point that is from 0 to 1, the 2
point this period is connecting period from 0 to 1 from current to the next 1 year a period of 12
months, and that period of 12 months ends at the end of the first year.

So, currently in the 0 period at the current time you made investment use that investment for the
1 full year in that project, and at the end of the year at the end of the first year we got the inflow
of the 10000 rupees. Then second, third, fourth and fifth. So, these inflows are coming at the end
of the year and if you look at the second structure here you talk it about here we also have the
again the points. And this points are 0 to 1, 0 is the 1 point, 1 is the point.

But the cash flow is shifting from the right hand side to the left hand side. So, here when we are
showing that the cash flow is coming to us, so it is not coming at the say end of the first year but
at the beginning of the first year. It is coming at the beginning of the first year so when any cash
flow is coming at the beginning of the first year, it means that has to be discounted in that way
and when it is coming at the end of the first year it has to be discounted that way.

Now, for example, when you talk about when we are making this investment in this 0 period in
the current period. Whatever that investment for example it is not given here, but whatever the
investment we have made here is for example, that investment is 40000 rupees, against that
investment of 40000 rupees in the 0 period. We have got the first inflow at the end of the first
year, 10000 rupees. So, what you have to do is now these 10000 rupees are not equal to what is
the 10000 rupees at the 0 period.

So, now to make these 10000 rupees equal to these 10000 rupees in the current period, you have
to discount it against the factor of 12 percent. Then the second 1 has to be discounted for 2 years
at the rate of 12 percent, this for the 3 years at the rate of 12 percent, this for the 4 years at the
rate of 10 percent, and this is for the 5 year at the rate of 10 percent. So, when you discount this
cash-inflows by applying the say power Sn that number of years.

Then you will find it out the discounted value of this 50000 rupees 5 cash streams of the 10000
rupees each will become something that will be discounted value and that has to be compared
with the initial investment of say 40000, or 35000 or 30000 rupees and then final decision has to
be taken whether this investment should be made or not. In the second case when you talk about
the inflows are occurring at the beginning of the year.

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So, again its connecting 2 points and the 1 period is here that is 0 to 1 this is a second, point 1 to
2, this is the third and fourth period and fifth period. Periods are same periods are nor changing.
Discount factor is also same that it is also not changing, but what is the difference here? That the
when we are making the inflow sorry outflow, when you are making the investment in the 0
period. The inflow first inflow is also coming at the beginning of the first year it means at the
beginning of the first year, means 0 period itself that inflow is coming.

So, it means when that inflow is coming at the beginning of the year means beginning of the first
year is the 0 period in that case this 10000 is equal to 10000, the value of the 10000 is equal to
10000. This will be discounted for 1 year this will be discounted for 2 years, this will be
discounted for 3 years, this will be discounted for the 4 years. Because this cash flow is coming
at the beginning of the year so this is coming 1 year in advance. This is coming 1 year later, so
here when you will have applied the first cash flow as we discounted for 1 year.

Whereas, in this case the first cash flow has not to be discounted at all because it is coming in the
beginning year. Which is equivalent to the value of the value of any investment we are making or
inflow we are getting in the current period. So, here discounting will differ the points we have to
think about at what point the investment the inflows coming back to us and for what period. This
is what the period but this inflow is coming in an advance to us.

In the second period from 1 to 2 for the second year, the inflow is coming at the beginning of the
year it may be possible that for example, we have made some investment in some assets. Both
the options are both the situations are possible that for example, we have made some investment
for some asset and that asset is rented out?

Here in this case that asset is rented out and the rent agreement that asset is leased out. So, the
rent agreement is that at the beginning of every year the rent will be paid by the borrower or the
person who is using that asset, or to whom it has been rent out. It maybe machine, plant building
machinery anything that he has to pay the rent in the beginning of the period not at the end of the
period.

So, what is happening? B purchase a machine for 100000 rupees and or for the 50000 rupees and
we rented it out. And so it means in the 0 period our outflow is how much? 50000 rupees? So,
that 50000 rupees is equal to 50000 rupees or that 40000 rupees equal to 40000 rupees whatever

175
the price of the machine, and then it is rent out to somebody for the use then it was the agreement
condition in the agreement that while you will receive the machine for using before means you
start using you will pay back the first year rental value back to the supplier.

So, it means in the 0 period the investment is 40 or 50000 rupees and the 0 period itself maybe in
the beginning of the first year the first cash-inflow is coming and that is 10000 rupees. So, it
means the first 10000 is equal to 10000, remaining that again the 4 streams of 1000, 10000
rupees each. They have to be discounted for different periods.

So, the second one has to be discounted for 1 year this has to be discounted for 2 years, this has
to be discounted for 3 years, and this has to be discounted for the 4 years. Whereas in this case it
is again connecting 2 points, point 0 to point 1 and the period becomes the first year, 0 to 1 is the
first year the total 1-year period is first year.

But the cash flow is occurring at the end of the year. So, when it is occurring at the end of the
year it means all these 5 cash flow have to be discounted against this discount factor of the 12
percent. Whereas in this case we have to discount only 4 cash flows for a period of 4 years’
maximum and the first one has not to be discounted because it is occurring in the current period.

So, timeline is very important you have to be very careful when the cash-inflow is occurring
from any investment from any project when the cash-inflow is occurring if it is occurring in the
beginning of the period, then the discount the period of the discounting will be different. And if
it is occurring at the end of the say year then the period of discounting total period of discounting
will be different

So, we have to be very careful number 1 is the point of cash flow and the period of the cash flow.
If you talk about the point then here it is occurring at the 0 point, here it is occurring at the point
number 1. So, at this point this is occurring at this point, this is occurring at this point. This need
to be discounted because period of the 1 year is already over.

So, whatever the cash flow is coming to us after 1 year, that cannot be equal to the cash flow
coming in the current period that to in the 0 period? So, this timeline is very important while
understanding the concept of the time value of money.

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(Refer Slide Time: 14:54)

Now, we will discuss some important things I told you in the previous class also that in the time
value of money, we will talk about we will try to learn about the concepts of future value of the
present say cash flows future value of the present investments and the present value of the future
cash flows.

These are the 2 important things we have to means make use of and we have to learn about it.
Normally we confront with the 2 kind of decisions that we have certain amount, the sum in our
hands we want to invest that in the market. And we want to find out that after certain period of
time if I invest this 10000 rupees, after 5 years’ periods of time what will these 10000 rupees will
become? For a given rate of interest.

For example, another way around if we make an investment of some amount in the beginning
say 50000 rupees we invest in the market. And somebody says that after 5 years I will returning
back 80000 rupees. So, you are now means this major question which comes in our mind is that
if I am giving 50000 rupees in the beginning of a period and then after 5 years that user of those
funds is returning back me 80000 rupees, then how much interest I have earn that is the annual
rate of interest is going to be how much?

So, this is regarding the say the future value of the present investment or the cash flows. And
second question comes up is the present value of the future cash flow. Whatever the investment
we make in the market in terms of the projects or may be any kind of investments were the cash-

177
outflow occurs in the current period in the 0 period. But the cash-inflow comes over a say period
of subsequent number of years.

So, then we have to compare the 2, I have in time and again I have been say emphasizing upon
that the time value of money is important for the investment proposal also. So, here for example
we learn about first we will learn about the future value of the single amount. Then we will learn
about future value of an NOT, similarly we will learn about the present value of the future cash
flows.

Maybe if they are even same cash flows are occurring. For example, in this case when you talk
about we are getting the same cash-inflow of 10000 rupees at the beginning or at the end of
every year. So, you have 2 situations either the cash flows in remaining the same or that cash
flow is uneven. Normally the cash flow becomes uneven because when we receive that back over
the number of years, that remains uneven and uneven cash flow has also to be discounted, so we
have to solve this problem also.

So, future value and the present value these are the 2 important things we have to learn in this
entire process of the time value of money. So, now I am just going to talk to you about is the
future value of a single amount. If you talk about the future value of single amount. So, it means
for example, we are saying here that there the 3 years given to us the period of 3 years given to
us and what is happening here?

That we have a principal amount of the 1000 rupees which is invested in the beginning of the
year. The rate of interest is 10 percent. Interest for the year is 10 percent. So, what will be the
amount of principal amount? That the principal amount will become 1100 at the end of the first
year. Second year now, we are reinvesting back this 1100 rupees, and again the rate of interest is
10 percent.

So, this amount will become 1210, third year now this amount is reinvested back and we have
the again same rate of interest and that rate of interest is say again 10 percent. This is added into
it so at the end of this year, so total amount comes up is 1331. This amount is 1331 is the total
amount, so you can call it as 1000 rupees invested in the beginning of the first year at the rate of
10 percent has become 1331 rupees at the end of the third year.

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But here you have to be very careful that we have to be very careful that which rate of interest
was it. It is only the 10 percent is given to us here, 10 percent rate of interest is given to us, Rate
of interest are of the 2 types, 1 is simple interest second is the compound interest. 1 is the simple
interest second is the compound interest, and we will learn about the magic of compounding
which is a very very interesting magic and it means grows increases normally money in the
geometrical progression.

And means under the compounding say process. What we do is? We make investment or some
basic amount and we earn interest on that after certain period of time. But we do not take the
interest back from that investment. And that investor or the fund manager reinvest the interest
earned on the first period, again back for the second period.

So, second period the base of the investment increases. As in this case we have seen 1000
invested in the 1st year we earned interest of 100 rupees so second year this amounts become
1100. There could have been the another option available with you that the investor could have
opted for that interest part I will be withdrawing every year and only principal amount has to be
invested for the second year and the third year or maybe for the any number of subsequent years.

So, in that case that will become simple interest that interest whatever the interest you are getting
it is that will become simple interest because you are getting that interest stream of say for
example, in this case you got the interest of 100 rupees that you withdraw, or the fund manager
has paid you the interest. So, again how much is left with us 1000 rupees.

And 1000 rupees we are investing back for 1 more year again 100 rupees is available. So, that is
a simple rate of interest. So, here when you are calculating in this way when the interest earning
is also reinvested back along with the principal amount. This process is called as the process of
compounding and by say using the compound rate of interest, you can calculate the future value
of any present amount and when you apply this concept this is the way how this process works
and the future value of a single amount applying the compound rate of interest of say here in this
case 10 percent become this 1000 rupees becomes 1331.

If you want to see how does happen because it is only very simple figure of the 1000 rupees and
the rate of interest is 10 percent and only for a period of 3 years. But you talk about the
investment of the millions and billions of rupees. Which has to made for the next 20 years. And

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they there we have to means say calculate the interest rate or we have to find out the compound
amount or the final amount it is becoming after 10 years or 15 years or 20 years.

There this simple calculation will not work, you cannot do it manually, you cannot do it with
calculator. You have to use the say well measure say efficient. IT systems softwares were this all
your formulas and everything is fed and automatically when we give the values, you put the
values of any investment amount you want to make invest, rate of interest is this and period is
this.

Immediately the result comes out from your computer that this amount is going to be this after
the end of this desired amount of the period. That maybe a period of 10 years, 12 years or 15 or
20 years. So, what we have to is there is a formula clear cut model given to us is. Future value
model is given to us and what is the future value of model? Present value present value in this
case is 1000.

Present value into 1 plus r power n. 1 plus r is r is basically what is this? Rate of interest. And
what is n? Number of years. So, if you multiply the present value with the 1 plus r maybe the
interest factor and for the number of years with the power of say number of years. Then you can
easily find out any amount will become how much for a given rate of interest.

But here the important point here is you should be knowing all these 3 things. First should be
knowing the present value or the investment you want to make. Then you should be knowing the
say the rate of interest, which somebodies offering where the investment is going to be made.
And third important thing is the number of years for the, for which the period for which the
investment is going to be make.

If these 3 things are known to us. By applying this model, we can calculate the fourth thing and
the fourth thing is that how much that present value investment that we are going to make in
particular revenue will become how much? Will become how much so this is the sub the process
of compounding. And this is used for calculating the future value of any amount provided that is
the single amount.

Now as I told you that for the small this calculation you can directly do it with the help of
calculator or manually or maybe in any way you can do it. But for the bigger investments you

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have to use a say very very sophisticated IT softwares. So, for the facilitation of calculating this
future values of any amount we are already given this say multiplication factors?

This factors are already calculated in any book, good book on the financial management. The
one which I am following that is a financial management by Prasanna Chandra at the end of the
book the table is given and from that table all this values can be found out.

(Refer Slide Time: 24:37)

So, for example, we are given here the different rates of interest horizontally 6 percent, 8 percent,
10 percent, 12 percent, 14 percent. And on this vertical side we are given the number of years, 2
years if the period of investment is 2 years and the rate of interest is 6 percent. Whatever your
basic amount is you want to invest you multiply this by this factor 1.124. You can easily find out
the value coming out will be the value which will becoming after the period of 1 year, after
period of 2 years.

So, with the help of this table this is called as a future value interest factors table. So, with the
help of this you can easily, find out and this future value interest factors are worked out. For the
different say durations by assuming the certain rates of the interest which are prevailing in the
market. So, this tables which are pre calculated available almost at the end of every book of the
good book of the financial management, you can make use of it.

So, simply you multiply any investment 1000, 2000, 20000, 100000, 200000. By say this future
value interest factor and you will find out the amount which is becoming something like this.

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Now, for example, if you look at this factors you there is 1 important point to be born in mind.
This factors are 1 point something they are more than 1. This factors are more than 1.

So, it means you can easily find out that if you multiply any amount by this factor or this factor
or this factor or this factor or this factor that amount will become more than what it is currently
with us. And what is that more than? That is just 1 plus r power n 1 plus r power n. So, your
amount will become there is a present value and plus interest on that and interest for that number
of years, so that amount will become.

So, this table is automatically showing always 1 point something, which is more than 1. So, your
investment will always grow from the present value always it will be more than that. So, this
table is you are finding it out here is that all the factors are 1 point something which is more than
1. Whereas if you look at the table of the present value interest factor PVIF table.

There the factor will be less than 1. It will be 0 point something. Because we know that the
present value of the future cash flows will be lesser when you convert that into the present value,
future cash flow value. When it is converted into the present value it will be lesser than what we
are going to receive in the future.

Practically it is going to be lesser in the today’s term. So, that factor will automatically be less
than 1. But this factor is more than 1 because you are calculating the future value of the present
investment. So, that will grow because of the interest plus the number of years for which we are
making the investment in the market. Then now we talk about the certain say related concepts
with the future value of a single amount and other things.

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(Refer Slide Time: 27:37)

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Now, for example we are given a small problem here suppose you want suppose you deposit
rupees 1000 today in a bank which pays 10 percent interest compounded annually. Suppose you
deposit rupees 1000 today in a bank which pays 10 percent interest compounded annually. How
much will the deposit grow to after 8 years and 12 years?

Now, you see very simple thing that because the 10 percent interest which is compounded
annually. Annual compounding this is the process of the annual compounding. So if you want to
calculate it here, you can easily find out that how you can calculate this the amount given to us is
how much is the amount given to us that is amount is 1000 rupees? Which you want to deposit in
the bank rate of the interest bank is given us 10 percent compounding is annually.

And the period is we are given the 2 periods 1 period is 8 years and the second period is 12
years. So, now how you have to put it? How you make it? So, this is the investment of how much
is the investment? This investment of 1000 rupees we are going to make and what is the, this
increase? The rate of interest and power is 8 years we are going to make the power is 8 years.

So, if you do like this you can find out some value, and in the second case when you are going to
talk about is it maybe period of 12 years, so it is going to be how much? 1.10 and only the period
is going to change. In the first case the period is 8 years’ power n. So, in the first case the period
is 8 years. In the second case the period is 12 years.

So, if you give the power n, so what will be give this it is 1000 for example, can be go for this we
can find out the factor if it is further 8 of 10 percent than for the period of 8 years. Now, let see if

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it is given this values given to us or not. So, this rate of interest is 10 percent. And period is 8
years. So, this is given to us. So this is a period of 8 years, this is a rate of interest is 10 percent.

This is also given to us 10 and period of 12 years also given to us this is this. So, what will do
our job is very simple now you will have to multiply this investment with this factor. So, what
we are going to do here is we are going to do multiply by that factor and what are the factors we
have seen from the table the factor is 2.144 this is the factor if you multiply this, this investment
becomes how much rupees? 2144 this investment becomes 2144.

In the second case what is the factor? If you look at the factor here and if you go back and if you
try to find out the factor. Factor is 3.138. This is the 3.138 and if you say multiply this 1000 with
this factor 3.138. So, what will be this this investment will become 3138. This investment will
become 3138. So, job is very easy because this factors are easily available with us.

Otherwise what was the case? You had to apply that model. 1 that present value 1000 multiply 1
plus r power n. So, you had to write there 1 plus the r is the rate of interest is 10 percent and
power is 8. Same is the case with the second so we not need to do any all this calculation no or
fresh this information is available from the future value interest factor table from there you pick
up only you should have to know is the rate of interest and the number of years.

If these 2 things are given to us, you can simply apply the present investment or the present value
of the investment, with that factor future value interest factor and you will find out the amount.
In this case if 1000 rupees invested today for a period of 8 years and the rate of interest rate is 10
percent, and compounding is done annually. Then this amount will become 2144.

In the second case if 1000 rupees is invested at the rate of 10 percent for the period of 12 years
and the compounding of the interest is done annually. Once in a year compounding takes places
then this amount of 1000 rupees at the end of the 12 years will become 3138, very simple. So,
now you can understand here the compound interest.

The magic of compounding for example, if you calculated as a simple interest for a period of 8
years and simple interest for period of 12 years this will not become this much. This will not
become 2000, 1000 will not become 2144 at the end of the 8 years. Similarly, the 1000 will not
become 3138 at the end of the 12 years. It will not become like this.

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So, just because of the magic of compounding power of compounding this figure has grown up
to this. So, this figure of 1000 has become 2144. Now, these days must be hearing about the
period of compounding has come down. If you go to banks or financial institutions, then the
compounding is now the period of compounding is being reduced.

It maybe half yearly compounding it maybe quarterly compounding, and it maybe monthly
compounding. And these days if you talk about in the banks there is a daily compounding. There
is the daily compounding that on both the borrowing also on the lending by the banks also there
is a daily compounding. If you borrow any money from the bank whatever the loan you are
borrowing from the bank.

The interest bank is charging that is being compound on the daily basis. They are calculating the
interest on the daily basis and on the today interest means tomorrow what will be the amount
outstanding in your loan account? The borrowing the total for example, you borrowed 10000
rupees for a period of 1 year and you have not paid anything.

So, the day you have the amount has been transfer to your account or you have withdrawn that
amount from that day onwards. You have not return any amount any installment back to the
bank. So, bank will start calculating the interest, and the interest is for at the rate of 10 percent
for a period of 1 year we have borrowed 10000 rupees.

So, at the end of the first day evening. This amount will become 10000 plus the interest at 10000
at the rate of 10 percent for that particular day 1 day. So, next day that second day in the
beginning of the second day morning that loan amount will not be only 10000. It will be little
more than 10000 because interest for 1 day at the rate of 10 percent has been added. So, this is
called as a concept of the daily compounding.

Same is the case it is being done on the deposits also. When we give the deposits in the bank so
there they are also doing calculating now the interest on the daily balances. So, daily
compounding is being done. So, now you can understand how complex it is even if doing the
annual compounding once in a year when we have to do the compounding, we have to apply that
model of present value into 1 plus r power n.

So, if you are doing if you are means lowering down the periods. It means in 1 year the 365 days
and 365 times you have to compound the amount. So, this is not manually possible we have to do

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it with the very efficient IT systems. When there was no IT system available in the banking
system or in our financial institutions.

Then compounding was being done very see simply once in a year annual compounding was
there. When then we started introducing the IT systems compounding came down to say 6
monthly compounding. Then it came down to quarterly, then it came down to monthly, then it
came down to means these days now it is a daily compounding.

Both on the borrowing, both on the deposits. The in the banking system the compounding is done
on the on the daily basis. So, your amount is also growing at a very faster rate means the loan
amount is also growing at a very faster rate. So, whatever you are borrowing today and whatever
you return totally at the end of the period back to the bank, there is a big difference.

Banking charging a high amount and same as the case with the deposit. What you are depositing
today and what you are withdrawing. For example, if it is a fixed deposit what you are
withdrawing at the end of that say fix term that is a difference in the 2 amounts. But there is
another important point of caution here or maybe not caution, I would say but of interest that
though the compounding has become daily.

But the rate of interest has come down. The rate of interest has come down. If you talk about the
deposit. There was a time means in the 10, 15 years back the banks were paying us 10 to 12 to
sometime 15 times percent rate of interest. These days now the rate of interest has come down to
6 percent on the fixed deposit of 3 years and more.

And on the saving deposit it is some were 3.5 percent same is a case on the loan also the interest
rate has come down. So, in both the cases means if the compounding has become very robust.
So, the interest rate has come down. So, we are being compensated because of the 1 negative
factor we are being compensated by the 1 positive factor as per as the loans is concerned but in
case of the deposit.

Yes, we have been benefited by the daily compounding but the rate of an interest has come so
down and it is for the tax also. The interest pays earning, so that say investment in the banks has
not become has not remained as very lucrative, or very rewarding. But this is the concepts of
compounding which I thought of discussing with you.

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(Refer Slide Time: 37: 24)

Now, we talk about the say simple rate of interest. If you talk about the simple rate of interest.
So, in the simple rate of interest what we are doing? We are calculating here again the future
value we are calculating, but the model is different. The model is different there the model was 1
plus r power n. Here the model is present value multiply 1 plus number of years into interest rate.

That is 1 plus number of years multiply interest rate. For example, this is the model is different
there was 1 plus r the simple rate of interest. But here we are talking about 1 plus number of
years multiply interest rate. So, and no there is no power n because no compounding at all. So,
this is only for the means given number of years, simple rate of interest.

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So, this difference in the model will tell you that there is a difference in the two kinds of the rate
of interest. Now, here for example we given this information an investment of rupees 1000 if
invested an investment of rupees 1000, if invested at 12 percent simple rate will in 5 years’ time
will become how much? For example, an investment who is 1000 if invested at 12 percent
simple interest rate will in 5 years’ time become how much?

1000 rupees invested at a simple rate of interest of 12 percent in 5 years of period time, how
much it will become? So, what is the formula here, PV Present Value here Present Value plus
number of years multiply interest rate. So, how we can calculate this that is the present value. We
have to calculate now the future value.

So here it is the present value multiply what we have to do here is? That is 1 plus number of
years the model says 1 plus number of years multiply interest rate into interest rate into interest
rate. So, I think this is the model we have taken 1 plus number of years multiply interest rate 1
plus number of years multiply interest rate and what is the amount given? 1000, 12 percent and 5
years.

So, here we have to take is present value how much? 1000 and 1 plus number of years is how
much? 5 multiply what is the interest rate? Rate of interest is 12 percent. So, you can call it as
0.12 if you multiply if you solve this how much it become? 1000 multiply 1.6. This becomes 0.6
so if you multiply 0.12 multiply by 5 this becomes 0.6 so this becomes 1.6 and if you multiply
1000 by 1.6 this amount become as 1600 rupees.

So, this amount will be become 1600 rupees here now you can find out the difference when you
are investing 1000 rupees at the rate of 10 percent, here it is 12 percent. When you are investing
1000 rupees at the rate of 12 percent, at a simple rate of interest, at the end of the 5 years. This
amount is simply becoming 1600 rupees.

But when you are investing 1000 rupees just for 3 more years but at a lesser rate of interest of the
10 percent. Not of the 12 percent at the rate of 10 percent this amount is becoming more than
double though the number of years is 3 more but the rate of the interest is less by 2 percent.

So, you can understand here the amount is just 1600 here the amount is becoming more than
double that is 2144 and if you are increasing the number of years. At the same rate of interest of

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10 percent that is amount becoming more than 3 times. So, this is called as the this is on the 1
figure on the 1 side this is another figure this say another figure.

So, you can understand the difference in this 3 figures. This is the simple rate of interest, these 2
are at the compound rate of interest, so this all is explaining very nicely very clearly the magic of
compounding. The power of compounding so you can understand what is a difference between
the simple rate of interest and the compound rate of interest.

So, this is something I wanted to talk to you about the future value of a single amount and how
we can calculate the future value of a single amount and how we can work out the that final
value, future value whether the rate of interest means were we apply the compounding or we are
applying the say simple rate of interest.

What will be the say the future value of the present amount? Furthermore, discussion with regard
to this time value of money and the future and the present value of money. I will have in the say
in the coming classes. So, for this class I will stop here. And remaining concepts we will discuss
in the next class. Thank you very much!

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 Financial Management for Mangers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 12
Time Value of Money Part III

Welcome all. So, in the previous class we were learning about the power of
compounding and we learned about that how we can calculate the future value of a
single amount. And what is a basic difference between say, compound rate of interest
and the simple rate of interest?

At what rate the money grows, the future value of the money grows when you are say
investing at the compound rate of interest and at what say, pace the investment grows
when we are investing at the simple rate of interest. So, this is some basic difference
we could discuss and we could learn the compounding and the simple rate of interest.

(Refer Slide Time: 01:11)

So, here I would like to say explain it to you now that how you can graphically show
or what is the difference between these two rates of interest. You can show it
something like this. Here it is we are taking as a period and here, we are taking as the
future value of any amount, of any investment this is a future value.

So, if you talking about the simple rate of interest, it goes like this. It increases but it
goes like this. It increases like this but when you talk about the say, compound rate of
interest, it goes like this. So, this is the difference in this case.

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This is a difference, you can understand that initially it grows at a lesser pace but then
later on because in this interest on the interest, interest on the interest, you can
understand. So, that this growth pace is increasing and this is going at a simple pace at
this period of time.

I am showing this that your money is growing at the simple rate of interest is that, this
rate of interest is going up like this. But in this case, it is growing at a very spectacular
rate, at a very faster rate because after some period of time, base becomes flatter, base
becomes bigger. Base becomes flatter and when the base becomes bigger or flatter
then automatically the growth rate becomes very fast.

We invested 1000 rupees for a period of 12 years, but after some period of time
because we are not withdrawing the interest so at the say, you call it as, at the say
your what do we say here is, that at the end of the 10 years or at the end of the 5 years,
at the end of the 8 years, your total amount will become very high because the base of
that investment is also becoming bigger and we are adding further interest on that.

So, this is how you can show the difference between the simple rate of interest. This is
basically the simple rate of interest, this is a simple interest and this is the compound
interest. So, the difference can be seen with the help of this structure and we have
practically also seen this difference.

Now, I would like to discuss with you one shortcut here that if you do not want to put
into the this all intricacies of the future value interest factor table or applying the
future value say, interest factor model and that all calculations of future the present
value multiply 1 plus R power n.

All these things if you do not want to do then we have got the very simple rule here
also and these called, these are called as the say, doubling period rules. We call it as
the doubling period rules or the rules of the thumb of the doubling period, right.

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(Refer Slide Time: 03:58)

If you want to calculate the doubling period of something then the rules of thumb can
be applied here and how you can apply the rule of thumb here, that for example the
question here is, how long would it take to double the amount at a given rate of
interest?

Any amount 1000, 2000, 10,000, 20,000, 100,000 or 1 million rupees. How long
would it take to double the amount at a given rate of interest? If you want to find out
that period, number of years, that in how many years your amount will be doubling or
amount will become double?

If you know the say the present value of the investment or the investment which we
are going to make and if you know the rate of interest then simply by applying this
rule of thumb of the doubling period we can have, we cannot get the exact value,
means the exact number of years but we can we have the approximate number of
years that we can reach nearer to the exact value if you calculate the value by
applying the future value interest factor table or you follow the proper say you can
call it as mathematical process.

So, simple rule of thumb given here is, that is the doubling period rule of thumb is the
rule of 72, rule of 72. So, whatever the investment we are making and if the rate of
interest is given to us. Any investment which is invested or any amount with the
present value, if it is invested in any avenue of investment and that avenue of
investment is giving us 15 percent rate of interest.

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So, what you have to do here is, you simply divide this is a standard rule of thumb and
this rule is called as the rule of 72. This rule is called as the rule of 72 so it is a
doubling period and you simply divide this 72 by that given rate of interest and you
can find out that period by which your amount your investment will become double.

For example, doubling period here when we are calculating we are taking the rate of
interest, assuming the rate of interest as 15 percent. So, you are dividing 72 by 15
percent, number of years are coming up as 4.8 years, about 5 years. About 5 years,
within a period of 5 years, your investment will become double.

Whatever the amount of investment you take, if you know the rate of interest which is
going to be paid by that avenue of investment then we can find out the doubling
period. 4.8 will be the number of years, and we have seen means long back, 20 years
back or say, 25 years back the rate of interest was something like this, 15 percent, 12
percent or 13 percent.

Even the banks in India were also paying this kind of the rate of interest and at that
time, any investment we were giving to the banks, that was doubling in 5 years’
period of time. These days it has become more than 10 years, sometimes say 12 years
also, because rate of interest has fallen.

But if the rate of interest is very high, 12 percent, 13 percent or sometime 15 percent
then any amount given to any investment avenue can become double in this period of
time. So, rule 72 says you divide the 72 the, this say 72 figure of 72 by the given rate
of interest.

That figure which comes out is the period by which the given amount of investment
will become double. And if you want to become more precise, if you become more
nearer to the truth then you can call use the another rule and that rule is called as the
rule of 69. That rule is called as the rule of 69.

This is a more accurate rule of thumb. More accurate as compared to the rule of 72
but here, you have to add something more in this, say, formula that is 0.35 plus 69
divided by the rate of interest. Earlier it was 72 now it is 69 divided by the rate of
interest.

So, the interest rate is again 15 percent and doubling period we are calculating is, so
we are, we are more precise. Earlier were saying approximately 4.8 years. But now,

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by applying the rule of 69, we have been able to find out that the rule of doubling,
sorry, the amount of period of doubling your investment, whatever the amount of
investment is. If the rate of interest is 15 percent then by applying the rule of 69, our
doubling period is again about 5 years and exactly it is 4.95 years, 4.95 years.

So, and if you lower down the rate of interest for example, it is not 15 percent, for
example it comes down to 10 percent then what is happening here? Then the doubling
period is increasing. That now, in the 7.25 years, the total amount of the present
investment will become double. If it 10,000 rupees after 7.25 years, it will become
20,000 rupees from 10,000 to 20,000 rupees.

We are we are see, having or getting the interest at the rate of 10 percent. So, two
rules are, very simple rules are available here in the literature, that rule of 72 and rule
69 so if we do not want to go into any kind of the intricacies of say, applying the
future value interest factor and then say applying the future value interest factor
model 1 plus R, present value 1 plus R power n.

If we do not want to say indulge into all this kind of the calculations then simply by
these two direct rules, or the direct rules of thumb, you can calculate the or we can
calculate the say amount by which our investment will become double. This is another
important corollary of the time value of money.

(Refer Slide Time: 09:34)

Now, we will go the next part and that next part is present value of a single amount.
What we discussed earlier? We discussed earlier was the future value of a single
amount. Now, we will discuss the present value of a single amount reverse. Earlier we

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were calculating present investment is going to become how much after 5 years, after
10 years or after 8 years?

Now, we are going to learn reverse that the present value of the future cash flow, a
single amount which we are going to get 5 years from now then what will be the value
of that amount currently, if you want to compare it in today’s terms then what is the
value currently of that amount which you are going to receive after 5 years or 5 years
down the line.

So, present value of a single amount and now if you look at this model, just carefully
look at this model. If you look at this model, this has become reciprocal of what the
model of the future value interest factor. There, in the future value interest factor it
was, that is the 1 plus R power n.

1 plus R power n, and in this case it has become now 1 divided by 1 plus R power n.
So, now this has become the discount factor. That was the interest factor, future value
interest factor. This is the present value discount factor you call it as. This is a present
value interest factor of, we call it as the present value discount factor.

So, for any rate of interest at which we want to discount and for the number of years
for which the, after which the cash is cash flow is going to come to us. If you want to
convert, say any amount coming to us after 5 years and we know our cost of capital.

Now, how you have to find out this discount rate? This should be minimum our cost
of capital. This should be our minimum our cost of capital or opportunity cost of
capital so if I know the discount rate, if I know the amount which I am going to get
after that given period of time and if I know their period also exactly then I can
calculate the present value of that amount and if somebody says that after 5 years I
will pay you 10,000 rupees for any means, the work I am doing or any investment I
am making so I should be means thinking in today’s terms.

That after 5 years if I am getting some amount back to me, what is the value today to
be. Because my efforts are going today, my services I am rendering today, my
investment I am making today. So, how much I am getting back after 5 years? Let me
discount it and try to find out the present value.

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So, present value of a single amount, here also if you want to calculate with the help
of the model, you can calculate with the help of a model. But simply means as we
discussed the table in case of the future value interest factors of a calculating the
future value of a single amount.

Similarly, we have calculated a say table of the values and here, these are the discount
factors which are available here with this, again the number of years and again the
interest rates. Interest rates are normally costs of capital. So, they are available with
this and we have already calculated. Therefore, example any say, cost of capital is 6
percent and number of years are 2. What is the discount factor? That is 0.89.

(Refer Slide Time: 12:54)

So, I was discussing with you that, for example if you go back then we have seen, I
was talking to you that when you talk about the future value interest factor, these
values become more than 1 because you are say, converting the present value into the
future value. And the future value will become present value plus interest. So, it
should be more than 1.

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(Refer Slide Time: 13:11)

Whereas, in this case if you talk about that you are converting the future value into
present value. So, future value though it will be very high in future but in present
value terms, the value of that will be less than 1. What you are going to receive after 5
years 10,000 rupees.

Today that is not, say is going to be the value of that received 5 years 10,000 rupees
from now, is not equal to 5 years. You have to convert that and it is something less
than that. Because inflation will reduce the value of money or some other factors will
play a role.

So, this in that value of that 10,000 rupees which you are going to receive after 5
years, it is going to be lesser than that. So, this discount factor is becoming always
less than 1. So, it means this gives an indication that whatever the investment you are
talking about, that will be certainly less than what we are expecting after 5 years.

So, this is a very clear and simpler way for the method of calculating the say, the
present value of a single amount or any amount which we are going to receive in
future, that present value of that can easily be calculated.

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(Refer Slide Time: 14:20)

Similarly, now we talk about the next part of the present value and if you talk about
the present value of an uneven series, present value of an uneven series. So, if you
talk about the present value of an uneven series. Because in that basic any investment
projects, the cash inflow which occurs over a future period of time, that normally
remains as the uneven. That cash flow, cash inflow remains, largely it remains uneven
because if any investment we are making.

For example, we invested 50 lakh rupees, 5 million rupees in any project today, any
say business project today. After say, building of the project and starting the

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production, at the end of the first year we got some cash flow back. I am not talking
about the profits. I am talking about the cash flows back.

So, what is that cash flow? Second year, the cash flow’s value may be different as
compared to the cash flow we are getting at the end of the first year. Third year, the
cash flow’s value will be different, what we are getting at the end of the first and the
second year.

So, all the 5 years or all the ten years, the cash flow’s values may be different. They
are not even in series, they are uneven. They are in coming in series. Every year we
are getting something but they are coming as uneven cash flows. So, if we get the
uneven cash flows and if we want to compare it against some, say, investment.

Then we can find out how much is the investment we are making in the current period
which is called as 0 period, and how much cash flows are going to occur to us after
the period of 1 years, 2 years, 3 years, 4 years any foreseeable period. So, you can
easily calculate the sum total of that and then you can find out that whatever the total
cash flows we are getting over the next number of the 5, 8 or 10 years, the total
discounted value is going to be this much.

For example, now we have this model here. Now, the how this model applies? This
model is basically if you talk about present value interest factor model is this, if you
want to use it. And this is a sigma of the number of years and time periods t1. If you
take this A t, A t is basically the cash flows occurring over the different periods of
time and again discounted by 1 plus r power t the number of years.

If you are discounting it for 1 year then it will be 1 plus r. If it is for the 2 year then 1
plus r power 1or 3 years is so 1 plus r power 2. Like that, so power will keep on
increasing as the number of years means in future the cash flow is going to, we
calculated.

So, finally this way you can extend this formula and if you have seen this, finally the
summarized form model of this is the present value of the uneven series can be
calculated this. So, again by using this model, we already have converted that into
some factors and these factors are already available with us.

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Those factors from this table, we will not go into long calculations. We will use these
factors from the table and if you use these factors from the table, so you can easily
understand that how we can calculate the present value of the uneven series.

For example, in this case we have taken how, we have taken the 8 years. 1, 2, 3, 4, 5,
6, 7, 8 years’ period of time. Cash flows we have taken here is, that is 1000, 2000,
2000, 3000, 3000, 4000, 4,000 and 5000. Now, if you total it up, if you total it up how
much it becomes? It becomes 3 plus 2, 5, plus 6, 11, then 15, 4 is 15.

Then it is 19 that is 24. It is becoming 24 thousand rupees. If you calculated this total
amount, this becomes is the 24. Again we can check it up. This is 5 plus 4, 9 plus 4,
13, plus it is 16, 19, 19 and 5, 24. This total amount if you sum up it becomes 24000
rupees.

So, somebody may tell that if you make any investment of say 20,000 rupees or not
20,000 rupees for example, any investment of say 10,000 rupees. If you make an
investment of 10,000 rupees today. After 8 years, after 8 years, I will give you return
you the total amount of 24,000 rupees. So, we will be very happy that we are
investing 10,000 rupees today and after 8 years we are going to get back say 24,000
rupees but we have not to feel happy.

As a student of finance you must be knowing about, we have to convert that future
value of the different cash flows amounting to 24,000 rupees into the present value
and that annually we have to discount the annual cash flows.

So, if you discount it, we know the, this interest factors present values interest factors
are known to us and here we are discounting it at the rate of 12 percent. My cost of
capital is 12 percent and n is the number of years. So, here when we calculate these
factors given to us 1000 multiplied by this, this value becomes this. 2000 it is and it is
this this is a factor; the value becomes this. So, finally, I am not going to get back
24,000 rupees. I am going to get back equal and to 13,376 of today.

I am giving 10,000 today so I want that, for example, after 8 years I am to get, going
to get 24,000 rupees. As per today’s investment, my outflow cash outflow how much
I am going to get back? For example, if I give today and I have to return back today
only, then how much I am going to get back.

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So, I am going to get back for an investment of 10,000 rupees, I am going to get back
13,376. So, the present value of those cash flows which is going to occur to me over a
period of 8 years, is going to be this much. So, this is called as the present value of the
future cash flows.

(Refer Slide Time: 20:15)

And if I calculated the net present value, so I have to calculate is the net present value
will be 13,376 minus initial investment is 10,000. So, this amount will become how
much? 3,376 which is in the literary terms called as the net present value. This is
called as a NPV or the net present value.

So, we will calculate this net present value and this analysis we will do while we will
talk about the capital budgeting. So, at that time we will discuss all those things but
currently say this is the process, how we can calculate the present value of the cash
flows which is coming to us in a series but the inflows are uneven. That is a series is
uneven series.

Now, here we talk about something is the future value of an annuity. Now, we talk
about the future value of an annuity and if you talk about the future value of an
annuity say, future value of an annuity is means we confront this kind of problem in
our daily lives, in day-to-day lives also as a common investor, as a very small level
investor.

We also confront with this kind of the problems and future value of an annuity that for
example, I buy any investment say product and every year I keep on investing 1000

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rupee in that product, in that investment fund. So, at the end of 5 years, how much
amount for a given rate of interest, how much amount I am going to get back.

So, it may be possible that I know the interest rate so I want to know the total amount.
I know the investment also. I am making investment, annuity means same investment
you are making every year, you are not changing. That investment is not uneven but
that investment is even when you are making the even amount of investment, same
amount of investment every year. Then for a given rate of interest, after a certain
number of years, how much that amount will become? So, future value of an annuity.

Other way round the question can be means asked is that for example, I am depositing
or anybody is depositing 1000 rupee in any investment fund for a period of 10,000
rupees. 1000 is annuity means same amount every year. 10,000, 1000 rupees for a
period of 10 years and somebody is promising that after a period of 10 years.

After a period of 10 years, I will be returning you back 15000 rupees. It means, in
total period of 10 years how much I deposited? 1000 into 10 is the 10,000 rupees and
after 10000 somebody is promising to return me 15000 rupees. So, in the question, the
question will become as that what is the rate of return.

What is the interest rate I am going to get that against 10000 rupees of annual
investment, if I am going to get back 15000 rupees, how much rate of interest I am
going to earn on my annuity, my investment which is in the annuity.

(Refer Slide Time: 23:28)

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So, future value of an annuity can be calculated. So, how we can calculate the future
value of annuity. For example, we have kept here is the one problem that is a, say
suppose X deposits rupees 1000 annually in a bank for a period of 5 years and his
deposit earns a compound interest at the rate of 10 percent.

What will be the value of this series of deposits, an annuity at the end of the 5 years?
Assuming that each deposit occurs at the end of the year, assuming that each deposit
occurs at the end of the year. So, it means suppose X deposits rupees 1000 annually in
a bank for a period of 5 years and his deposits earn a compound interest, the interest is
compound at the rate of 10 percent. What will be the value of this series of deposits,
which is an annuity, at the end of the 5 years assuming that each deposit occurs at the
end of the year.

(Refer Slide Time: 24:18)

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Now, how we have to explain it? The amount will become how much? 6,100 and,
6,105, this amount will become at the end of the 5 years. When compounded
annually, compounding is annually, it is already given to us that when you are talking
about the compounding amount, this amount is given to us.

This is the compounded annually. What will be the value of this series of deposits at
the end of 5 years and the compounding we are doing here in this case is the interest
rate at the rate of 10 percent and it is a compound rate of interest.

So, when you talk about this compound rate of interest, how it has been calculated?
Future value of an annuity. An annuity is a series of periodic cash flows. An annuity
is a series of the periodic cash flows, payments or receipts. It can be payment also, it
can be receipt also, of equal amounts which we will discuss later on, ordinary or
deferred annuity and the annuity due.

So, these three kind of the annuities we will discuss later on, but simply you
understand at this moment that an annuity is a series of the periodic cash flows,
payments and receipts, of the equal amounts.

So, how we will that amount will become? How much we are investing? We are
investing 1000 rupees for a period of how many years? 5 years, and the rate of interest
is 10 percent. So, if you look at this model, this model is given to you, that is the, the
amount that is the cash flow here, 1 plus r power n minus 1 divided by r.

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This is the model; little different model is here for calculating the future value of an
annuity. Earlier what was the model for calculating the future value of a single
amount? It was the present value multiply 1 plus r power n.

So, we are doing the same thing. Present value is A, multiply 1 plus r power n but
now we are doing it minus 1 and whole is divided by r, that is an interest rate for
calculating the annuity, that is the future value of an annuity. So, what is the number
of years? We are getting 1, 2, 3, 4, 5 number of years. How much investment we are
making here? 1000 every 5 years. We are making the investment of the 5000 rupees.

Now, when we have invested first 1000 rupees, after 5 years, it is becoming, it is the
say invested at the end of the year. It is clearly given in the question, assume that each
deposit occurs at the end of the year. It means, first 1000 rupees has to be
compounded for how many years? 4 years.

Second amount has to be compounded for how many years? 3 years. Third amount
has to be compounded for how many years? 2 years. This has to be compounded for 1
year because we invested at the end of the fourth year, and fourth to fifth year, only
one year is there. So, it means only one year’s compounding. So when you are doing
one year’s compounding, what is happening? This 1000 is becoming 1100 rupees.
And final amount, which you gave at the end of the fifth year, so this amount is 1000
is equal to1000 because no period has elapsed so no interest is due on this.

So, finally if you sum it up, you can calculate the future value of an annuity that 5000
rupees which we gave, we did not give the total amount in the beginning as 5000
rupees. We gave 1000 rupees every year in the say, same amount that is called as
annuity, and at the rate of 10 percent compound rate of interest, this amount has
become 6105 at the end of the 5 years.

So, this is the magic of compounding here and with the help of the say this future
value of annuity process with the help of this model, which is a very important and
interesting model, you can find out that if you, means keep on depositing in any fund,
a certain amount every year, at the end of every year then at the certain number of
years, at the given rate of interest and normally, the rate of interest is compound these
days, compounded these days.

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Only difference comes up is whether the compounding is annually or the
compounding is at the say, bi-annually or quarterly or a monthly or daily. That
difference comes up but normally, whatever the return we get these days, they are the
compound interest, provided you have not opted for that you will take the interest
back every year.

So, it means if you take the interest back every year then it will maybe a say, it will be
a simple rate of interest but if you are not taking the interest back at the end of every
year then certainly the total interest will be added back into the principle amount. So,
next year the base will be going up.

Now, for example, if you look at this base of 1000 rupees at the end of the fifth year,
it is becoming 1464. This base of 1000 rupees is becoming 1331, 1210 then it is 1100
and this is same 1000 because it is the end of the fifth year. So, total amount will
become 6105. So, this is how we can calculate the future value of annuity.

Please remember all these concepts because they will be very useful when we will
discuss the other advance concepts in this course, means some other parts of the
syllabus when we will be, or the other parts of the course plan. When we will be
discussing the other topics everywhere we will be using these terms, future value or
present value, future value of a single amount, present value of a single amount,
future value of an annuity, present value of uneven series.

All these things are useful, so I am say very means carefully discussing all these
concepts with you so that you remain very clear when we start applying these
concepts for the, say different kind of the business decision making.

Now, here are some of the say, application of the say, future value of an annuity.
Some of the applications of the future value of an annuity which I would like to
discuss with you, and we will discuss 4-5 applications which are very interesting
applications and would answer the questions pertaining to your day-to-day life, means
we all make investment and normally we select some investment products where the
investment has to be made, say in the even series and at the end of certain number of
years.

For example, you talk about that when we take the say, insurance policy and that is
not a term policy but the endowment policy which is basically for the both, your say,

207
the lifesaving also plus the money back also, part of the money also comes back. So,
every year the amount of premium remains the same.

When the amount of premium remains same, you pay at the end of every year or
maybe twice a year, whatever it is. And for a certain number of years we take that
policy for 20 years 30 years, and the end of 30 years, they return us some amount.
They the life of a person also remains insured but if the person remains safe and
nothing wrong happens, then at the end of that period of the insurance that amount
comes back

So, there we apply the concept of the future value of an annuity and there, means the
part of the amount which is invested in the market for the saving purpose by the
insurance company, that amount has to be returned back after means say subtracting
their own expenses, administrative expenses and their commission, it has to be
returned back. Or anywhere when you say buy, maybe for example, you open up a say
recurring deposit.

So, if you take the open up an RD account in the bank, it may be possible that every
year we decide that I will deposit 10,000 rupees in that say, recurring deposit account,
and for a period of next 10 years I will keep on depositing 10,000 rupees. So, after the
period of 10 years, it will become 1 lakh rupees 100,000 rupees plus the interest on
that.

So all this, these are the kind of the questions we are going to discuss here and we are
going to means learn about the applications of the future value an annuity. So, these
are very interesting applications, very interesting say day to day means, answer to the
day to day problems.

So, when I will discuss all these applications, you will find them quite interesting and
you can use them also for answering so many questions which pertain to your daily
life. So, all these applications, 4-5 applications plus some other related concepts of the
time value of money, I will discuss with you in the next class. Thank you very much!

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 Financial Management for Managers
Professor. Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 13
Time Value of Money Part IV

Welcome all, so in the previous class we were talking about the future value of an annuity and
we learned about that how to calculate the future value of an annuity and there also we talked
about that we have, we have to use the concept of compounding. So, we saw it that when we go
for a compounding and especially when the cash flow is say is occurring at the end of the year.

So, how to calculate it then you have to be very careful that only compounding has to be done for
one year lesser. Total time period is five years in this case, but since we are giving our money,
we are making the investment at the end of the year. So, it means what is the total time available
for the first investment four years. So, second, third, fourth and fifth year.

So, we have we will not be compounding it for five years, we will be compounding it for the four
years. But yes, if you are giving the investment in the beginning of the year, then for calculating
the future value of an annuity, you have to compound it for the means compounding will done
for the five years.

So that differences that in the beginning we discussed that the timeline of the, this time value of
money. So, when we were talking about that timeline there, it's very important that at what point
the point and the period two important things at what point we are making the investment and for
what period we are making the investment if we are making in the beginning of the year, then
total point is the beginning of the year.

So it means every year we have got the full five years. So it means the compounding of that will
be done for a period of first amount which we are giving that will be compound for five years.
Second for the four years, third for the three years second for the two years and the last one
means that the fourth one for the two years and the last one for the one year.

209
(Refer Slide Time: 02:23)

But if it is being given as in this case, we have shown that we are giving this investment at the
end of the year it is clearly written that the investment is assuming that each deposit occurs at the
end of the year, then what we are doing here is this value we have calculated here is that is 1464
is that is by compounding at the rate of given rate of interest and that rate of interest is 10
percent.

So, we have compound this for a period of four years, this for three years, two years, one year
and zero years. So, this we have to be very, very careful about the timeline of the say, interest
factors or for the compounding.

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(Refer Slide Time: 02:50)

Now, I was talking to you in the previous class that we will discuss some applications of the say
future value of an annuity. So here are means these are the very day to day decisions which we
take in our life also, and we want to answer these questions or we want the answer of these
questions to ourselves also, not necessarily that we are a finance manager, we in the normal
terms also we want the answers to these questions and when we want the answers to these
questions. So, means it is very helpful in our day to day life also, in the corporate life also or in
any investment decision, we get the answers to very relevant questions.

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For example, what lies in the store for you this is the first application how you can answer this
question. Suppose, you have decided to deposit 30000 per year in your public provident fund or
anybody xyz, any person has decided to deposit 30000 rupees per year in his public provident
fund account, PPF fund account which is very common, we all make investment in the PP fund
accounts or PPF accounts.

For a period of 30years of means we can decide this period depending upon our life and then the
service and the income level, what will be the accumulated amount in your public provident fund
account at the end of 30years, if the interest rate is 8 percent if the interest rate is 8 percent right.
Now, how it has to be answered? How it has to be means solved in and how answer we have to
get for this, because we have already got that future value interest factor annuity model.

This model we have discussed here this model is here, this model is already given by applying
this model here simply we can get the answer to these question and here it is, the accumulated
sum will be how much rupees 30000 and future value interest factor for annuity means at one
important point of caution here I would like to share with you, when you look for the future
value interest factor tables, there will be two tables in every book if you open Prasanna Chandra
financial management who Prasanna Chandra the book which I am following here for all this
discussion.

If you open that book at the end, the book two tables are given one table is with done which is
giving you the FVIF future value interest factor, future value interest factor if you take if you see
that interest factor that is only for a single amount, but if you want to find out the future value
interest factor for an annuity, then there is annuity table which is called as future value FVIFA
So, you have to refer to that table because models are different. So, values are going to be
different.

So, say interest factors are also going to be different. So, be careful there is one table which is
called as the FVIF table and annuity is called as the FVIFA table. So, for the different purposes if
it is a single amount, then you see refer to FVIF table but it is annuity amount you refer to
FVIFA table in every book of financial management two tables are given. So, for the no annuity
is different, and for the single amount it is different. So, look for the right interest factor or if you
want to apply the model here, we have seen the model.

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So, here what is this 1 plus R power 30, number of years is 30 minus 1 and divided by the
interest rate, what we are expecting the interest rate these days roughly the interest rate on the
PPF account is 7.8 or we are assuming it as 8 percent. So, if you with the help of this model, if
you want to calculate this rate of interest, this works out as something that 30000 multiplied by
this interest factor PBIFA factor and this amount becomes as 33,98,490 rupees.

This is the total amount which will be becoming, so it means whatever the total return I am going
to get back is this total return is going to be there with the help of this when we are investing a
certain sum of money rate of interest has come down to 8 percent period is 30 years. So, what we
are giving is this amount we are amount we are not giving, say for example, a period of 30 years
and this amount is 30000, this amount works out has to be how much nine lakh rupees.

So, this nine lakh rupees, we are not giving in one go. This amount we are giving in how many
this amount we are giving in 30 installments, this amount we are giving to the fund in 30
installments for a period of 30 years 30000 rupees invested and the rate of interest we are
expecting is if it is 8 percent then how much this amount will become.

So, this is basically you have to calculate with the help of the present, future value interest factor
for annuity process. And there you can apply the model also you can put the values in the model,
but for the simplified purpose you put this amount and apply it by the interest factor and the
interest factor if you look at it in the table, that interest factor becomes as 113.283 and total
amount becomes as 33,98,490 rupees.

So, this is one very important question which we can answer with the help of the future value
interest factor for annuity process. Then second important question second important application
of the say future value of annuity. And here is again a very interesting question, how much
should you save annually for a particular purpose, you want to achieve one particular purpose
and to achieve that particular purpose, how much should you save annually? This is our question.

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(Refer Slide Time: 8:39)

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Now, what is the question? You want to buy a house after five years or I want to buy a house
after five years, when it is expected to cost me twenty lakh rupees or two million rupees. After
five years I want to buy a house I know that what are the prices of the houses in the market
today, I want to I am planning to buy a house after five years because today it does not have the
money to invest in that say investment that purpose.

So, I will have the sufficient amount of the money or some time it may be possible, I do not
require a house today, I will be requiring the house five years from now. So, after five years,
when I want to buy a house, that house will cost me expected to cost me for 2 million rupees or
20 lakh rupees. How much should you save? How much should I save annually, if my savings or
your savings earn a compound return of 12 percent?

Interesting question. How much should you save? Or how much should I save annually? If my
savings or your savings earn a compound interest of compound return of 12 percent? How much
should I save? Now the future value interest factor for a period of five years’ annuity we have to
apply here because we want to find out that amount, one single amount, which I want to save
annually every year I want constantly I want to save the same amount. So, amount will remain
consistent amount will remain the same.

So, if I want to save that amount, the future value interest factor for a five years and annuity and
at the given rate of interest of 12 percent, we have to calculate at the given rate of interest of 12
percent we have to calculate. So, we are applying the concept of future value interest factor for

215
annuity, number of years’ n is 5 and then R is 12 percent number of years is 5, R is 12 percent
and then if you apply this again the same thing is coming again the same model we are applying,
this model we are applying here. So, when you apply this model, so you are getting this and this
is the 1 plus 0.12 power 5 minus 1 divided by 12 percent rate of interest.

And this factor comes up with this. This factory comes up with this that is 6.353, if you go to the
table, future value interest factor for annuity table in any book, then you will find this factor is
there, this factor is already calculated there provided your number of years means for different
number of years you will find it out 1 2, may be next 20, 30 years the factors are given and the
for the different rates of interest 2, 4, 5, 2, 4, 6, 8, 10, 12. So, 12 is covered and normally, which
are the prevalent rates of interest in the market for that the interest factors are there given in the
in these tables.

So, if you find this factor, we have calculated this factor our self here, we have calculated this
factor our self here, but you can find it directly from the interest factor table also and the you can
find out the total amount but that is twenty lakhs, two million we want to save, I want to have
means in my hands after 5 years. So, dividing it by this factor, it means this amount comes up as
how much? This works out as 3,14,812 rupees, 3,14,821 rupees, I have to save annually.

I have to save annually to have a house after 5 years, which will cost me a sum for a sum of
rupees two million or twenty lakhs, interesting. So, it's a very important question, which we can
answer in the previous case, but we wanted to find out that what lies in store for me, if I save a
certain same amount 30000 rupees every year for a period of 30 years and the rate of interest is 8
percent.

This is a question in this case we answered how much should you save annually to achieve a one
particular objective. Provided, you know that means, the cost of that objective and the rate of
interest available on our investment, you can easily answer this question and this question is
going to help us to find out that if you want to find a house of twenty lakh rupees, you can save
annually 314812 rupees and after 5 years if you earn the interest of 12 percent on your, that a
precondition, be careful.

216
That whatever the amount you are saving here, 314821 rupees that should earn a minimum rate
of interest or 12 percent if it earns at 12 percent, then certainly this amount will become twenty
lakhs or two million at the end of the 5 years.

(Refer Slide Time: 13:35)

Next question is annual deposit in a sinking fund, annual deposit in a sinking fund. Now, what
happens many times, this problem comes to the companies which in the corporate life, this
question is more relevant. Because corporate companies confront the problems like that when
they borrow money from the market. And say for example, in the form of the bonds or
debentures, when the bonds are issued in the mark market or the debentures are issued in the
market, then these bonds or debentures are issued by the companies for a certain stipulated
period of time.

For example, 5 years, 7 years 10 years. After ten years, those bonds have to be redeemed by the
companies, those bonds have to be redeemed by the companies. Means, bonds have to be bought
back and the investment made by the say buyers of the bonds has to be returned back with the
interest. Normally, if it is a, different options are given by the companies, but if people choose to
the cumulative interest option, then people do not means proffer to get to the interest annually
back on that investment, but they choose to the option that at the end of the say at the time when
these bonds will be redeemed,

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I would like to get the in that principle amount along with the interest. So for that, what has to be
there because company knows that we have to return back after five years or after 10 years a sum
of rupees five million, fifty lakh rupees which we are borrowed from the market. So, it means, if
you immediately at the end of the fifth year or the end of the tenth year, you have to arrange a
sum of rupees fifty lakhs, it may not be possible for the companies that that amount is not
available.

So, they plan it that every year they keep on depositing something in some fund which is called
as a sinking fund, they keep on depositing either they buy some say investment product. So, they
keep on depositing that money equal amount of sum in that, say investment account or in that
investment product or within the firm if they use the funds then they keep a proper account of
that and they provide every year the interest on that.

So, money keeps on accumulating in that account. They use that money internally but they create
a proper account and they know it that after 5 years or after 10 years when we have to return fifty
lakh rupees back with interest. So, it means, we need the money, so they have already created a
sinking fund where they are annually saving certain amount. So, that amount becomes that
amount in that fund at the end of that period becomes fifty lakhs plus interest on that, equivalent
to the same amount so that you liquidated the fund at that time and then easily that liability can
be paid off.

Second situation can be that in case of the say replacement of the fixed assets. For example, there
is a plant which is purchased by the company, they are using it and the life of the plant is for
example, ten years and say, the cost of the plant is say one crore say ten billion rupees. So, the
total life of this plant is one crore rupees, you know, that the life of the plant is 10 years only and
after 10 years, we have to replace this existing plant with the new plant or the existing machinery
with the new machinery.

So, we have to be very careful that we have to means we know the process of depreciation, every
year we charge the depreciation on the existing plant of that investment of one crore rupees at
certain say given method of depreciation, we debit with that amount of depreciation every year
the profit and loss account and then from the profit and loss account. Because since it's a non-

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cash expense, so that money does not go anywhere that is taken out from the profit and loss
account and is kept safe.

So, that kept safe is that can be invested in some fund and that fund is also called as a sinking
fund at the end of the ten year, when this asset will come the value useful life of that plant will
become zero or that plant will become unusable. So, we will have to replace it at that time. So,
we have collected the sufficient amount through the process of depreciation.

So, and we are depositing that depreciation amount in some sinking fund account. So we will sell
off that sinking fund at that time, we will liquidate the sinking fund at that time. So entire one
crore plus interest on that will come back to us and probably that will be the price of the new
plant along with the, see the basic amount of the one crore plus increase in the price because of
the inflation. So, means the company is at a very comfortable position.

So, maybe in case of the redemption of the bonds or debentures or for the replacement of the
existing plant and machinery, the firms require funds in the lump sum after a certain at the end of
certain period of time and at that time the funds may not be available. So, they planned the things
in such a way in advance that when that replacement or requirement of the fund arises, then they
have already collected the fund by setting aside a certain amount every year plus interest on that,
that at the end of that period that fund is liquidated and we get the funds readily available in our
hands.

So, here is the question and will deposit in a sinking fund for example, you want to say a say
replace a plant of one crore rupees for creating a sinking fund how much amount you have
annually to deposit in that. So, that at the end of ten years, it becomes say the same amount One
crore plus interest and that may be the same amount, which is the price of the plant at that time in
the market.

Here it is, Futura Limited has an obligation to redeem 500 million bonds and a 500 million, 6
years, 500 million bonds 6 years hence. Futura Limited has an obligation to redeem 500 million
bonds 6 years hence. How much should the company deposit annually in a sinking fund account,
where in it earns 14 percent interest to accumulate rupees 5 million in 6 years of time.

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They have to return the five million rupees these are the bonds issued that amount may become
the total amount that is the say principal plus interest or it may be possible. The company is
paying their interest annually from the revenue incomes and the principal amount of 500 million
will be paid back after these 6 years. How much should the company deposit annually in a
sinking fund, now they know it that this liability will arise at the end of the sixth year.

So, we should be planned enough in advance we should be knowing that we have to create a
fund. So, that every year from the profits we are earning, when we are apportioning that profits
distributing their profits, we will have to set aside a certain amount, we will have to set aside a
certain amount. So, that we are safe that are the time when the requirement of the funds that
arises, we are very safe at that time because we have made the proper arrangement for the funds
in the beginning you can call it as the financial planning also it is a part of the financial planning.

So we are financially very planned. We have done this financial planning beforehand and now
we are very safe and secured. So after the six years at the end of the six years, when 500 million
rupees will be required to be paid back to the bond subscribers. So, in 6 years’ period of time,
that how much the company has to save? It means the question is how much should the company
deposit annually or save annually in a sinking fund account wherein it was 14 percent interest to
accumulate rupees 500 million in 6 years’ period of time.

So, it means, one condition here is interest is 14 percent interest is 14 percent. So, we have to be
very careful, what is the rate of interest because the moment the rate of interest changes this your
installment to be deposited in the sinking fund will change. So, we apply the same concept of the
future value of annuity, because we want to find out the same amount to be deposited every year
in the sinking fund account.

So, if you apply here it the future value interest factor four or five years’ annuity given and
interest given at the end interest rate of the 14 percent is you can calculate here is that is. So, it
means when we are making the investment here, what is the total period? 6 years. But we are
assuming here, because we are writing here five years’ annuity, five years’ annuity means every
year when we will transfer the investment to sinking fund that will be invested at the end of the
year.

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So, at the end of the first year, you will transfer for some amount at the end of the second year
you will transfer some amount. So, at the end of the sixth year, you will transfer some amount.
So, we are going to create the interest factor for a period of 5 years’ annuity for a period of 6
years.

So, it means when you are going to create this annuity for 5 years, we are going to find out here
that is the future value interest factor and n is 6 years, R is the 14 percent and when you are
means applying this model here you are getting effective here. When you are getting the factor
here 8.536, this factor is coming up simply as we did it in the previous problem that you got this
factor for a period of six years, we have charged the interest because the amount of the funds will
be available, we are liquidating this say annuity at the end of the six year will be liquidating it,
So, we will be calculating this for the period of 6 years.

So, it means if you try to find out this factor has come with us, and if you divide the 500 million
with this factor. So, it means this amount comes up as how much 58.575 million rupees you have
to save to collect a total amount of the 500 million rupees. Annually, this amount has to go to the
sinking fund 58.575 million rupees has to go to a sinking fund. So, that at the end of the period
of six years, this amount becomes and the rate of interest they have already factored, we have
already factored this.

So, they have calculated this factor, future value interest factor we have already calculated. So,
rate of interest is already taken care of. So, now you have to save rupees fifty-eight lakhs or
58.575 million every year and transfer it to the sinking fund. So, that at the end of the 6 years
when there will be the need for the 500 million rupees for the redemption of these bonds or
whatever the obligations of the different bond subscribers are this money is readily available
with us.

So, very interesting question that whether it is the redemption of the bonds, whether it is the
replacement of the plant or machinery, or whether it is any kind of other kind of the fund you
require, we should be planned enough in the beginning. So, that we know that some financial
requirement is going to arise, say 5 years from now, or maybe a 10 years down the line. So, we
should be very clear about that we should be well planned in the beginning.

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And if we know that this much is going to be a requirement, if we keep on setting aside certain
amount every year, and plus, you know the interest we are going to earn on that fund every year
than I think we are at a very safer position. So it does not put any pressure in the mind of the
CFO or maybe in case of the individual investors in the mind of the individual investors that he
has already planned for his future. And what is now is going to his financial requirement every
he is setting aside a certain amount.

So, he will have the sufficient amount at the end of the given amount of the period or the number
of years. So, now, there are some other kind of the say applications also. So, for example, finding
the interest rate or maybe some other say how long should I wait? Or maybe there are some other
important questions are there also which we can answer with the help of this future value interest
factor for annuity.

So, means we have discussed to some two, three applications till. Now, say three applications we
have discussed today in this class and remaining applications plus some other related concepts of
the time value of money I would discuss with you in the next class. For this class, I will stop it
here and thank you very much!

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 Financial Management for Managers
Professor. Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 14
Time Value of Money Part 5

Welcome all. So, we are in the process of learning about the different aspects of the time value of
money and in the previous class we were talking about some of the applications of the future
value of annuity. So, we saw we discussed the some two, three, say applications of the future
value of the annuity. Where we tried to find out that say for example, we want to find out that
what is there in the store for you that, for example we deposit a certain sum every year and then
for a given rate of interest how much that amount becomes at the end of his certain period of
time.

Similarly, that for fulfilling one particular requirement of a house, how much should you save
annually. So, that we can buy the house 5 years from now, which will be for the 2 million rupees
20 lakh rupees. Third say application we discuss was the sinking fund application, annual deposit
into a sinking fund. So, that say, if any company has to redeem the bonds, worth rupees 500
million. So, how much they should say deposit every year to a sinking fund or into a sinking
fund.

So, that at the end of the 6 years they have the sufficient amount means equivalent to 500 million
rupees for returning back the say investment they have sought in the bonds from the different
investors 1 or 2 more applications, we will discuss which are quite interesting in the series and
then we will move to the say next part and the next part we will be talking about is the present
value of the annuity.

So, we have talked about the future value of annuity and after discussing the future value of
annuity, we will move to the next part that is a present value of annuity. But before that, let us
discuss one or two more applications of the future value of annuity and when we talk about the
one or two more applications of the future value of annuity.

For example, here in this case is finding the interest rate, sometimes what happens that some
company advertises that if you say, keep on giving us a certain sum means annuity sum, means
the same sum every year, for a certain period of time, then we will return you this much amount.

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So, they know we are in this discussion, they are talking about the rate of interest, what rate of
interest they will be means returning the money back at what rate of interest, they will be
returning the money back to the firm they are not talking about anything.

They are simply talking in the lump sum value, that every year you give us this much of the
amount in the annuity form in the same amount every year and at the end of say this much
number of years we will return with this much amount. Now, for example, if this situation arises,
they are not telling you the interest rate.

Because normally what happens, the comparison of any investment is, means normally takes
place with the help of the interest rates, that if I make investment in one important avenue, how
much interest I am going to get back, or what rate of interest I am getting, if I invest my funds in
the fixed deposits of the banks, how much interest I am getting back how much tax I am paying
on that, if I am say investing into the bonds of certain companies, how much interest I am getting
back how much interest tax, I will be paying back to the government.

So, it means every time we need to find out the, say, the percentage of interest that which we will
be earning, our investment will be earning, but sometimes what happens that the company just to
say you can call it as not to communicate the, say, the real picture, they simply say, give us this
much every year for a period of this much a number of years, we will return you back this much
amount.

So in this case, that important question is, million-dollar question is to find out the interest rate
which will be means earned by that investment, when we will give that investment in the form of
annuity, annuity to accompany for a certain number of years and they will return again back us
asset and lump sum amount, then what is the rate of return is at which our investment is growing
while investing into that fund of that particular company.

(Refer Slide Time: 04:29)

For example, in this case, what is given a finance company advertises that it will pay a lump sum
of rupees 8000 at the end of 6 years, a lump sum of 8000 rupees at the end of 6 years to investors
who deposit annually rupees 1000 for 6 years, 1000 for 6 years are the 2 important things and
one is 8000 rupees, and that number of years are 6 here. So, here they are only talking about the

224
amount to be paid back at the end of how many 6 years and how much they are asking as annuity
deposit, they are asking for 1000 rupees to be paid annually.

So, it means in the total number of 6 years, we will be ending up paying how much 6000 rupees
to the company and at the end of the 6 years for a deposit of 6000 rupees given by the person or
the investor, the company will return back to the investor 8000 rupees. Now, in this case,
nowhere the company is talking about the rate of interest. At what rate that investment will be
growing and that 6000 rupees will be becoming 8000 rupees.

So, what rate of interest the company's paying back to the investor nowhere the company is
talking here about the interest rates. So, what we have to do is our job is to find out the interest
rates and if you have to find out the interest rate here. So, there are the one step process, one is
there is twostep process. So, the interest rate may be calculated in this two steps.

One is find the future value interest factor for annuity, find the future value interest factor for the
annuity for this contract and you have to find it out how you can find it out for finding it out the
processes explained here. How much they are returning back to us 8000 rupees, and how much is
we are paying to them, they are paying 1000 rupees every year, annuity, and future value of the
annuity means we have to find out for example, if r and say this number of years’ n is given to
us, then there is no problem we can easily find out the interest rate, but in this case, r is missing, r
is not given to us and the number of years the n is given to us.

So, what is our job we have to find out the r. So, then you mean solve this you find this situation
that future value interest factor is unknown and number of years’ n is 6. So, that is equal to 8000
divided by 1000 and that value comes out as 8. Now, what is this meaning of this 8 it means it is
the future value interest factor for that annuity, 8 is the future value interest factor for that
annuity and now, what you have to do is how to find out the interest rate, you have to search for
this particular value in the future value interest factor for the annuity table future value for the
interest factor for an annuity table.

That table I told you which is given in the end of every book or with every good book of the
financial management. For example, Prasanna Chandra, I am referring to you time and again if
you buy that book and if you see at the end of the book, all the tables are given their present

225
value interest factor, future value interest factor, present value interest factor for the annuity and
the future value interest factor for the annuity all these tables are given.

So, you have found out this factor, feature value interest factor for annuity have found out and
which has come up as 8. So, now you have to refer to that table and there in that table future
value interest factor for annuity table you have to look at that in the same table, you have to go to
the row number of years that is on the vertical side and on the horizontal side the rate of interest.
So, against that 6 number of years because they are giving 1, 2, 3, 4, 5, 6, 7 like this.

(Refer Slide Time: 08:19)

So, against the say the table is given like this. So, here you are given the say your number of
years 1, 2, 3, 4, 5, 6, and here you are given the rate of interest 2 percent, 4 percent, 6 percent, 8
percent then it is say you call it as maybe a 10 percent you take it as say it is 10 percent and then
you can say for the extended 12 percent. So, what you have to do is against a 6 you have to find
out some value here wherever it is in the table and that value against 6 number of years, the
value, you have to find out which is nearer to this value of 8, which is the nearest to this interest
factor of the, this future value, interest factor of the 8.

You have to find out that value and if you move to the table in the table against that future value
interest factor at the rate of 12 percent for a period of 6 years, if you find a value, this value
comes up it is a table value, this value comes up as 8.115 this value comes up as 8.115 which is
the nearest value to this factor 8.

So, you can conclude here that by giving 1000 rupees annually to a company for a period of 6
years, and if the company agrees to return 8000 rupees at the end of the period of 6 years, then
this interest rate is slightly below the 12 percent because, this value is more than this factor this
value is 8.115.

So, this and this is the rate of 12 percent. So, it means this is the rate of interest is near about the
12 percent not 12 percent but slightly less than 12 percent. Because exactly 12 percent will be
this value since this factor is this value is less than this value. So, this interest rate has to be not
12 percent but little lesser than that. So, you can call it as 11.95 or 98 percent something 11.9598
percent something like that will be there.

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So, near about 12 percent rate of interest we are going to get by making say, investment in this
particular annuity and you can calculate that this annuity fund, where are we are depositing 1000
rupees for a period of 6 years at the end of say 6 years you are going to get back 8000 rupees. So,
you are going to get back this return of 8000 rupees at the rate of near about 12 percent near
about 12 percent.

So, this is one important, another important application of the future value of annuity. Where
with the help of this you can find out that if the interest rate on any investment decision is
missing only the lump sum values are given only absolute values are given, then how to find out
the interest rate interesting. Then you go to the another, this is the last application of the future
value of annuity, then I will take you to the next important component that is the present value of
the annuity.

(Refer Slide Time: 11:21)

So, in this case now, for example, you said the last one is how long should you wait? How long
should you wait? Now for example, what is the objective here that you want to incur some
expense. Any investment or any expense you want to make and the total amount required is say
for that is any given say 1 million rupees you want to have acquire something any investment
you want to acquire or maybe any say, where you want to go the cost of going there is a 1
million rupees.

Now in this case, you have to collect 1 million rupees. So, it means you can find out that what is
my annual savings that is very easy to find out that depending upon my total annual income,
depending upon my say consumption. So, total income minus my total consumption or me and
my family my consumption this much annually I can save or I normally save. I want to achieve
some certain objective buying that investment or going somewhere.

So, that cost is approximately say this much say 1 million rupees my savings say for example is
50,000 rupees per month. So, how long should I wait to take my savings of 50,000 rupees per
month up to that amount of 1 million rupees. So, the question here is the application of the future
value of annuity is how long should you wait?

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So, for example, we have taken the say another situation here we have created another example
we have found out it is not I have found out but it is given in the book of Prasanna Chandra if
you see the all these applications I have taken from the book that is a percentage and that is
financial management by Prasanna Chandra which is a McGraw Hill publication.

So, this problem says that this example says that you want to take a trip to USA which costs 1
million rupees, which costs 10 lakh rupees and the cost is expected to remain unchanged in the
nominal terms, you want to go to US over a period of time and expected a cost is going to be 1
million rupees or 10 lakh rupees, and this cost is going to remain constant, this is not going to
change.

It is not that because of the time value of money, by the time we collect 1 million rupees. So, the
cost will become, 1.2 million rupees, that is not going to happen. By the time you collect 1, 1
million rupees, the cost will be 1.2 million or something like that that is not going to happen. So,
you can save annually 50,000 to fulfill that desire, requirement is 1 million rupees 10 lakh
rupees, and our annual saving rate is 50,000 rupees to fulfill that desire.

How long will you wait? You have to wait if your savings earn and interest of the 12 percent
How long do you have to wait? If you are saving earn an interest of the 12 percent and in this
case, you have to find out the say, means the future value of an annuity, which is of the 50,000
rupees that earns a 12 percent interest and we have to make it equal to the 1 million rupees. So,
how long will it take that that 50,000 rupees saved annually invested at the rate of 12 percent per
annum, making it 1 million rupees or 10 lakh rupees, how much time will it take?

So, how long should you wait this is another application of the future value of an annuity. So, it
means different diverse questions we are going to answer or different applications we are going
to means make us have to clarify the process of the future value of an annuity. So, in this case,
this entire process has been explained how that value will be worked out and that how long the
question of this how long will be answered and here the answer is that almost 11 years.

How it has been worked out? For example, what do you want to collect is 1 million rupees or the
10 lakh rupees and what is your annual saving 50,000 rupees and future value annuity say factor
if you calculate in this case what is missing now, n is missing in the previous case if you go back,

228
in the previous case r was missing and was given r was missing. In this case r is given, but n is
missing.

So, if anything is missing out of this in this model. That to out of the total requirement if any
item is missing provided all other items are given to us. So, the missing item can be found out.
So, 50,000 multiply future value of interest factor for annuity n is missing we have to find out the
n. So, and that has to be made equal to the 1 million rupees. So, if you mean convert that into
that say future value or interest factor of our annuity this kind of the factors and you want to
equate it to 1 million rupees.

So, finally, this amount becomes like this if you solve this, this equation becomes this and this
very comes up as 2.4 and finally, this amount comes down to 3.4 and the help of log converting
these simple estimates to the log estimates finally we can solve it with the help of the logarithm
and if you mean convert into the log values, So, finally, we find out that this value is coming up
as 10.8 years.

That within a period of 10.8 years, we will be able to collect a sum of rupees or x would be able
to collect a sum of rupees 10 lakhs or 1 million, if he saving 50,000 rupees annually, that
investment is made into a fund and that fund gives that 12 percent rate of interest per annum. So,
at the end of 11 years or within a period of 11 years or by a period of 11 years, that sum savings
of 50,000 rupees annually saved for a period of 11 years at the rate of 12 percent will become 1
million rupees.

So, this is another application, so you can means see all these applications can help us that if has
anything is missing, we can find out and all kinds of questions have been tried to be answered
here that for any particular type of investment or good investment, how to make estimates, how
to go ahead about it and how to find out the relevant values the future value of an annuity,

Because normally when we think of making investment in any say fund or in any investment
avenue, we think of that say if we buy any investment fund or maybe insurance policy, which is
basically the investment for the investment purposes not for the lifesaving purpose or maybe we
buy any mutual fund or when we buy maybe any provident fund account, when we get opened in
the banks, we try to find out that if we give this much of amount in this particular fund, annually
means that fund that amount of saving remains the same.

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So, how much will it become if the rate of interest is also known to us and if the number of years
are also known to us, if one thing is not known to us, then it can be founded provided the other
things are given to us and if all the things are given to us easily the all the questions can be
answered whatever it is, we want to get answered or we want to means find the solution for.

So, future value of annuity is very, very important and everywhere in the say further discussions
relating to the any aspect of the financial management of maybe in case of individuals or in case
of the firms or the organization's this same concept that the future value of annuity is very, very
important and will be making use of it.

So, that is why I am spending quite a good amount of time on the time value of money. So, that
whenever we discuss it at the later stage for the evaluation of the different investment options or
for evaluating the different financial decisions, then they are we have to make use of it and we do
not find any kind of difficulty or I have not to explain it again to you that how the particular
value has been worked out, how this investment has become this at the end of this much number
of years.

So, for that, you should have the complete background knowledge and there, the time value of
money and the different concepts of time value of money are in important. Now I will take you
to the next part and that next part is quite interesting like, means we simply call it as the reverse
of. We were talking about earlier the future value of an annuity and now we are going to talk
reverse present value of an annuity, present value of an annuity.

For example, we make any investment today in the zero period in the current period, we make
any investment in the lump sum amount in any investment fund and that investment fund says
that for the next 3 years or next 5 years or next 10 years, we will give you annually this much
amount back. So, it means we will have to find out that at the end of the first year I am getting
something at the end of second year I am getting something at the end of say, third year I am
getting something we are going to talk about here is that, that return is annuity it is not uneven
sum.

When we are going to get the same amount. Then we have to calculate now because we are
making any investment in the current period in the zero period and that cash flow is going to

230
occur that return is going to occur to us over the subsequent number of years maybe 3 years, 5
years, 7 years, 10 years, right.

So, we want to find it out that if I give this say 50,000 rupees or 1 lakh rupees or 10 lakh rupees
for any investment fund, and they pay me annually a certain sum of annuity, then what is the
present value of that total annuity which I am getting over the number of subsequent year or the
future years.

So, this is totally the reverse completely the reverse of the future value of annuity, the present
value of annuity from the previous concept you were trying to find out that any investment I start
making today and for the next number of 5, 7 or 10 years, I keep on making the same investment
I say amount I keep on investing somewhere at the end of that period of time, 5 years, 6 years, 7,
8, 9, 10 years, how much that amount will become. So, that is called as a future value of annuity.

Here we are going to talk about if I invest a certain sum in lump sum and over the next 3 years,
next 5 years, I am going to get some amount back, but that too in the equal amount annuity form,
then what is going to be the present value of that total cash flow. I am going to get over the given
number of years.

(Refer Slide Time: 21:18)

So, for example, here you are given small, say example here, that suppose that Ram expects to
receive 1000 rupees annually for 3 years. Ram expects to receive 1000 annually for 3 years, each
occurring at the end of the year, what is the present value of this stream of benefits, if the
discount rate is 10 percent, if the discount rate is 10 percent. So, how much is going to be the
present value?

Now, for example, in this case, maybe you can add one more thing here, that Ram wants to make
investment of 2000 rupees today in lump sum the 2000 rupees’ investment today and that
investment is going to fetch him and an annuity of 1000 rupees, annual sum of 1000 rupees for
the period of next 3 years and that rate of interest is 10 percent.

So, that 3000 rupees, which will be received by Ram in the next 3 subsequent years, comparing
that total inflow, some of that 3000s, 1 plus, 1 plus, 1000s becoming 3000 rupees, comparing

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that 3000 rupees coming over the 3 subsequent years with the present investment of 2000 rupees,
whether it is a worthwhile investment or not. So, you have to you should not feel happy that I am
giving 2000 rupees today, and next 3 years, I am going to get back 3000 rupees, 1000 rupees per
year.

So, it means certainly, I am going to get 3000 rupees against the investment of 2000 rupees, it is
not like that, you have to calculate the present value of that annuity, which you are going to get
over the subsequent 3 years. So, in this case for evaluating this proposal, what you have to do is,
you have to calculate the present value of annuity and how can you calculate the present value of
annuity, that inflow.

(Refer Slide Time: 22:59)

So, for calculating the present value of annuity, we have to calculate for this particular part, the
present value of annuity and in this case, we have to use the discount factor process, we have to
discount those future cash flows and try to find out whether there are 3000 rupees we are getting
in the 3 next years is equal to 3000 rupees or something more or less and certainly it will be less
because of the time value of money 1000 rupees coming back to us 1 year from now, is not equal
to 1000 another 1000 coming 2 years from now is not equal to 1000 and another 1000 coming
back to us, but 3 years from now is not equal to 1000.

So, let us discount it and try to find out here that how to find out the present value of that annuity
So, how you have to do is what is the inflow coming up? It is 1000 rupee. If it is 1000 rupees so,
you have to discount it; what is the discount rate? It is given to us and the discount rate here it is
10 percent and annually we are getting back is 1000 rupees’ period is 3 years, and here the
investment part is missing.

So, for example, we assume that 2000 rupees we are investing and we are going to get back 3000
rupees. So, whether it is a worthwhile investment or not. So, in this case, you have to discount it.
So, this is first year's discount that at the end of the 1 year when you are going to get back
something. So, it is equal to 1000 multiply say, 1 divided by 1 plus, 1 divided at 1.10, because
this is 1 plus r, this formula is basically 1 plus r. So, it is going to be 1.10, then second is rupees
second 1000 is also going to come to us.

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So, in this case, this is going to be again 1 divided by 1.10 this again we have to find out. So, this
is we have to take this 1.10. So, here it is, but we have to we are getting it after, we are
discounting it for 2 years. So, it means we are discounting it for 1 year, we are discounting it for
2 years and here we are again getting some amount back and that amount is how much again
1000 and again 1 divided by 1.10 that is a discount factor and how many years we are getting
after 3 years.

So, we are discounting it for 3 years. So, we have found it out that if you want to find out this
value. So, how much it is going to be this amount will become in the first case 1000 multiplied
by this factor will become how much 0.9091. This is a factor value you can find out these values
directly from the table also. Here this amount will become that is 1000 but it will be no less than
something that is 0.8. This value is 8264.

This value becomes 1000 and multiplied by that this factor value. If you find out from the table,
this becomes 0.7513. Now, if a total of these values and means if you multiply and total up these
values, you will find out the sum of these values will be how much? The sum of these values will
be somewhere 2486.8, 2486.8. So, this is going to be the present value of the annuity.

This is the annuity you are going to get. This is the number of cash flows you are going to get
and if you look at this cash flow, you are going to find out that 1000 rupees, which you are going
to get at the end of every year for the period of next 3 years, then total value of that means the
total inflow coming to us in the absolute value is 3000 rupees, but if you are discounting it
against a discount rate or the cost of capital of how much 10 percent

So, finally you are going to get back something and that amount is 2486. So, as I told you that
we can assume that we are making investment of how much rupees 2000. So, investment of 2000
rupees is made today and we are getting 3000 rupees over a period of next 3 years 1000 rupees
each. So, the total sum value of that becomes 2486.8. So, it means you can say if you want to
find out the NPV, this is the present value, we will call it as the present value and if you want to
find out the net present value.

So, this will become how much total present value of the inflows minus the present value of
outflows and this is 2000 rupees. So, this amount becomes how much 486.8. So, it means, this is
a surplus you are going to get against 2000 rupees of investment you are going to get back

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2486.8. So, this is a net present value of this investment we are going to get and this investment
you can say is worth making and we should go ahead with this investment. So, we all means note
that how the present value can be calculated.

(Refer Slide Time: 27:58)

So, in this case, I would like to explain it to you, what is a formula for the present value interest
factor for calculating the present value of annuity, you have to run this model like this, this
model is say 1 plus r and plus A. So, it means 1 plus r and A number of years are 2. So, this is a 2
plus, you can take it to further that is to the A divided by 1 plus r, n minus 1 and finally, taking it
further A divided by 1 plus r 1 plus r power n.

So, this is the model which you can make use of if you make use of this model. So, with the help
of this model, you will be able to find out the total present value of the annuity factor and for this
factor, if you want to apply, this will find out the value of the say present, any present value of
any annuity, you can easily find out. So, it means this very easy model and very you can call it as
useful model for calculating this. So, in this case for the further estimates or evaluation of
anything, if you want to go ahead about it finally, this model, what it becomes this model
becomes something like this.

(Refer Slide Time: 29:14)

This is the model, because if you solve this particular case, if you carry it on taking A as the
common outside. So, this will become something been divided by 1 plus r, 1 divided by 1 plus r
square plus 1 divided by. So, taking the A common, so if you take this out A, so what it becomes
this model becomes something like this A we have taken as a common outside so, this is
multiply 1 plus 1 minus 1 by 1 plus r power n divided by r that is again the discount rate.

So, this is the way the process how the discount factors can be calculated how the present value,
how the present value interest factors can be calculated, not discount factors but the how the
present value and trust factors can be calculated, and for making the things easy for making the
life easy now, these are all interest factors are available to us in the readymade tables. Again with
every book of financial management I am, I repeat that this table is available.

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So, you can find our present value interest factor table is available at the end of every book and
you can say readily you can pick the values here on this side you are given the number of years
this side you are given the interest rate for any interest rate or any discount rate, discount rate is
basically the cost of capital. So, for any discount rate, you want to discount the future value of
the future cash flows all that which are normally coming in the annuity.

So, if you want to say discount it this table is only for the annuity not for that and the uneven
sums for the any uneven sums of the different table is there. So, this is basically for this annuity
part. So, you can make use of this to simply what is the value given here as the cash inflow for
example, it is 1000 we have seen in our example, simply you take how many number of years 4
is a percentage, we are going to get 10 percent.

So, you find out this is the 4 and 10, 3.170. So, 1000 if you multiplied by the 3.170 this amount
will become 3170. So, it means very easily it can be done this table is available with us and right,
straight way, by picking up the value from the table the interest factor from the table, multiplying
that sum we are going to receive as annuity cash flow, we can find out the discounted value. So,
this model we have means to make use of and this model is used for calculating the present value
interest factors, all these factors are calculated with the help of this model. Thank you very
much!

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 Financial Management for Managers
Professor. Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 15
Time Value of Money Part 6

Welcome all. So, we discussed the concept of the present value of annuity in the previous class.
And now, we will learn about 2, 3 or 4 important applications of the present value of annuity.
And the first application given here is that for example, somebody want to buy a car. So,
everybody has a budget, the different cars, cars for the different prices are available in the market
and everybody has his own budget because everybody cannot buy the car of any budget or any
price in the market that is all related to the income of the person, the rate of savings of the
person, number of years he can earn and he can save.

So, he has to find out or somebody has to find out that if he has the certain given amount of the
income and out of that income, he can save a certain sum of the money for a given period of
years or number of years or months, then, means, what will be the present value of that total
amount.

So, that he can come to know that equivalent to that present value of that savings for the next
number of years, 3 years, 5 years, he can buy the car, so that he is comfortable in returning that
money back to the finance company and means his all overall budget is also not disturbed. So, in
this case, for example, we are say a say, trying to find out the answer to this question.

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(Refer Slide Time: 01:49)

And here, the question is if, for example, that after reviewing his budget Ram has decided to buy
a car. He knows that he can pay rupees 12000 per month for 3 years towards a new car. His
surplus of 12000 will be available with him for a period of next 3 years for 36 months to buy a
new car.

Ram finds out that rate of interest on the car finances, 1.5 percent per month for 36 months for
the next 36 months or 3 years, the rate of interest we charge by the car finance companies will be
1.5 percent. So, try to find out how much Ram may borrow to buy a new car. So, you have to
simply, what you have to do is it is a very simple question, you have to find out the present value
of a certain sum which is 12000 rupees is going to come back to Ram over a period of next 36
months’ rupees. So, the total amount if you multiply 36 into 12.

So you can find out that this amount is going to be certain sum; 12,000 multiply 36. That sum
easily can be calculated. But that amount which is going to come back, is going to come back
over the next 36 months.

So the value of that is not going, going equal to the say 12,000 multiply 36 months it is going to
be something less than that, because it has to be discounted against a discount factor and the
discount factor here is the interest rate and that discount factor is that 1.5 percent per month or
you can call it as 18 percent per year. So, we have to find out the say present value of this

237
annuity, which is 12,000 rupees going to be saved for the period of next 36 months. So, what is
going to be the say discounted value of this annuity.

(Refer Slide Time: 03:31)

So, here in this case, what you have to find it out you have to find out the PVIFA present value
interest factor for the annuity you have to find out, simply have to find out. Generally, as I told it
is given in the tables you can make use of the tables in any examination you are allowed to make
use of the tables.

So, it is given there, but I want to explain to you that in the tables also how it is calculated. So, it
is calculated with the help of the model and for calculating here in this PVIFA for a given

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number of rate of interest and number of years’ r and n here we have to find out if you try to find
out if you mean the expand this the model becomes something like this 1 minus 1 by 1 plus r this
is 1 plus r power n, and 1 minus 1 divided by 1 plus r power n and whole divided by r, whole
divided by r.

So, in this case, you have to place the values. So, the values are 1 minus 1 divided by 1 plus R is
how much in this case? 1.5 percent per month. So, this becomes in the percentage terms point
this in the percentage terms becomes we have to convert that into the say percentage terms and
this becomes 0.15. Because it is 1.5 percent, so this becomes 1.015 and how it is our power,
because it is a monthly the interest rate is given to us is monthly.

So, you have to take the power also in the months, that is 36 months you cannot make the power
3 say 3 years because interest rate is given to us in months is not in the years and so, this
becomes 1 minus 1 by 1 plus 0.015 power 36 months and whole is the rate of interest is 0.015.
So, you can calculate if you solve this you will get the present value interest factor for annuity
this factor will come up as 27.66 this is a factor.

Now, this factor will be equally available in the table also you can easily find out from the table
that for a certain sum of money, if you want to find out the present value of that annuity, you go
to the present value interest factor for annuity there the table is given on the vertical axis number
of years and on the say this horizontal axis you are given the rate of interest. So, you can find out
against 36 if you want to calculate the 36 months.

So, it means 3 years will be given to you, but since it is in the month, so, you can convert
yourself there it is given the years, but with the help of this model we can convert it into months.
So, you can easily find out that if you want to find out for 36 months, it comes up as 27.66 say,
not percent, but this is a value is called as absolute value 27.66 is the present value interest factor
for the annuity and with this what you have to do is you have to multiply your sum that the
amount which is available with the person who want to buy the car multiply by this and if you
multiply this, this some becomes how much rupees 331920 rupees, 331920 rupees.

So, it means, in this case, this sum is going to be available with the person, this person Ram who
want to buy a car. He can buy a car he can borrow the money from the finance company

239
depending upon, upon his income and his savings rates, the amount which is going to be
available with him is 331920 rupees.

For this sum of money for 331920 rupees, Ram can think of buying a car if he buys a car for this
much amount around 330,000 rupees or maximum he can go up to 335 or 40,000 rupees, then he
will be comfortable in returning the money back to the finance companies because his rate of
saving is 12,000 rupees per month and since the rate of interest is 1.5 percent per month or 18
percent per year to be charged by finance company. So, his budget allows him to buy a car worth
rupees around 330000 rupees, 330000 rupees’ car he can buy from the market.

So, with the help of the present value of annuity, you can answer this question; easily you can
answer this question, it is a very important application which is very, very helpful for taking a
very important decision which affects the individual’s life.

(Refer Slide Time: 08:08)

Then the, another important application is period of the loan amortization, period of the loan
amortization. Now, what is the period of loan amortization? First I would like to explain it to
you. Loan amortization means when any loan is taken by any person, maybe housing loan, a car
loan or any loan, when it is taken, it has to be returned back to the to the source from where it has
been taken the finance company or any bank or any source where it has been taken from it has to
be returned back and when it has to be returned back it has to be returned with the interest.

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So, amortizes means any amount of the loan taken by any person and to be returned back any
amount which is taken and that has to be returned back. So, returning back of any loan, along
with the principal and interest is called as the process of amortization. Along with the principal
and the interest that process returning of any loan taken by any person or any organization along
principal means the both including both, including both principal and interest is known as the
process of amortization.

So, amortization of a loan here, we may be given a certain sum of information, that for example,
we want to borrow a certain sum of money and the rate of interest will be charged by the source
from where the funds will be borrowed is this much and every year, the person can, can pay a
certain sum of money back in the form of annuity to the source. So, in how many years that loan
will be fully paid back to the source. So, that is known as the period of amortization, we can find
out the period of amortization.

So here for example, the application given is Mr. Shyam wants to borrow rupees 1080000
rupees, 1080000 rupees he wants to borrow to buy a flat he wants to buy a house, the price of
that houses 1080000 rupees, 1080000 rupees. He approaches a housing finance company, which
charges 12 percent interest, he approaches a housing finance company which charges 12.5
percent interest and he can pay 180000 rupees per year towards the loan amortization, he can pay
rupees, 180000 rupees per year towards the loan amortization, what should be the maturity
period of the loan of Mr. Shyam?

What should be the maturity period of the loan of Mr. Shyam. Maturity period means that period
of amortization and that amortization is means in say, sum total of the principal plus interest on
that in how many years he can return the load back. Because, everybody has a plan that I am
going to have a certain sum of money available for say 1080,000 rupees per year for the next 10
years.

But, after that my children will grow and I need the funds for their education. So, this amount
will be used for that purpose, and this will not remain as a free amount. So, it means people have
their own plans own budgets and their own time periods. So, the time of the amortization of 1
particular liability has to be known in advance.

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And if that period for that period, if the that period is permissible to the person, he can take that
desired sum of money, otherwise, he has to redo the whole thing, he has either to reduce the say
the total sum of the money he wants to borrow or he has to look for the alternative, where the
rate of interest is comparatively lesser.

So, he has to take all the decisions. So, here the information given to us is there borrowing
amount is 1080,000 rupees, interest will be charged by the company will be that is 12.5 percent
per annum, and the amount which he can pay in the form of the annuity to the company is that is
180,000 rupees. So, it means, he, in this case he has he want to find out the period. In the
previous case what he wanted to find out was how much the total amount, that he wanted to find
out the total amount.

Here the other information which was given was the time period was given the rate of interest
was given and the say the amount the annuity amount, which he can return back or make use of
returning back the loan was given to us, but only thing missing was the sum he can borrow with
this given information, but in this case, he is given all other information, but the period is
missing that in how many years, he can return the loan back. So, that period is missing here.

(Refer Slide Time: 12:42)

So, for calculating that means, that period of the amortization, we can means understand it in
detail, how to find the period of her motivation and for this what is the total sum of the money he
wants to borrow 1080000 rupees. So, he is going to borrow this much of the amount 1080000

242
rupees and now it has to be made equal to something like this left hand side how much he can
pay annually.

That is 180,000 rupees and multiplied by the present value interest factor for annuity and in this
case, we are known as r plus n or n plus r. This information we have to put here this is an n and r
is given to us. Let me write it more clearly, that is n and r we have to put here. So, if you take
this amount here is that is the number of years and combine it is we have to it is very small.

So, means, sometime it is connecting with each other. So, we are talking about n and it is r.
Number of years, present value interest factor for annuity for the given number of years and at
the given rate of interest. So, means both the sides are going to be equal if you say this, this is
equal to this and this is equal to this. Now, in this case, there is something which is missing. In
this case the missing part is R is given to us that is 12.5 percent but the n is missing here n is not
given to us which is missing here.

So, you are given here 180, he can pay it is given and for calculating the present value of this
annuity for a period of a certain number of years, which is not known to us at the rate of interest
of 12.5 percent. So, we want to find out that period and that means, sum he wants to borrow his
1080000 rupees. So, in this case what the missing is the value of n is missing we want to find out
the value of the n which is missing here.

So, for calculating the value of the n you can make use of this entire process this model
evaluation model and in this case, what you have to do is you have to expand now this model
here. So, it will become something like this 1080000 and multiplied by this model here and this
is multiplied by something. So, what is this we have already written that model, 1 minus 1
divided by something and this something is becoming how much 1.125 because the rate of
interest is 12.5 percent and what is this n it is missing we do not know this n and finally, you
have to divide it by again 0.125 this is 12.5 percent.

So, this model becomes this, this equation becomes this if you put the values in this, this
becomes 1 minus 1 divided by 1.125 power n and divided by 0.125 and the bracket is closed and
finally, this sum has to become the equal to 1080000 rupees. This sum has been to become equal
to the 1080000 rupees. So, here for going for this further calculation and for the further solution.

243
So, if you want to find out the n here, you have to now do this that it will be something like this 1
minus 1 divided by 1.125 power means n which is not known to us and divided by 0.125 is going
to be how much this is going to be, how much, is going to be 1080,000 and divided by something
this something is going to be how much 180,000 rupees. So, this value will come up as 6 this
values will come up as 6 and if you solve this entire thing.

So, it will become something like this 1.125 then this will become if you solve this I am taking
the shortcut, omitting 1 step. So, this value becomes finally 1.125 power n is equal to 4. If you
solve this, this value will become 1.125 power n is equal to 4 and now from this onwards you
can take the help of the log. If you take the help of the logs it will become something like this n
log, what is this value? 1.125.

Log 1.125 is equal to log 4 with the help of log you can easily find the solution to this. So, this
will become n into log values of this particular thing is, the log value is going to be 0.0512. And
this is going to be finally, if you solve this the log value for the 4 is going to be how much that is
0.6021. This value is going to be 0.6021. So, finally, if you want to kind, find the value of n and
will become 0.6021 divided by 0.0512 and this amount if you try to find out comes up as 11.76
this value if you want to find out and this is called as years 11.76 years.

If you want to find out easily you can find out with the help of this, that is the 11.76 years is
going to be the yours say period, the value of the n that if you want to borrow this certain sum of
money, money that is that 1080,000 rupees and the rate of interest will be charged by the housing
finance companies 12.5 percent and annually the person can pay 180,000 rupees for a certain
number of years.

So, he wants to find out that how many years would it take to amortize the total loan of the
180,000 rupees, which will earn which will fetch an interest rate of for which will cause an
interest rate of 12.5 percent. So, in this whole calculation, we have been able to find out with the
process of calculating the present value interest factor for annuity, we have been able to find out
here that if you say make use of this present value and trust factor for annuity model, then you
can easily find out the answer to this question that in how many years the loan can be returned
back or how many years a time would it require to return the loan of 1080,000 rupees 1080000
rupees say given the number of other particulars.

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So, very important and very interesting question it is and we can easily answer with the help of
this process you can answer this question. So, because here you can find out that every time
every question is not to be answered with the help of the table as the value is given in the table,
many times you have to means do the manual calculations also and in this process, sometimes
when the calculation becomes tedious, we make the use of the log and we use the logarithm and
by making the log values or by making use of the log values, you can easily find out the desired
results.

So, we have found out that desired, desired results here is that the period is 12 years that is 11.76
years or roughly you can call it as that to return this amount with interest rate of 12.5 percent you
need roughly a period of 12 years. So, if you have 1080000 rupees available for the next 12
years’ surplus amount every year, you can spare this amount for the next year, 12 years borrow
this amount. Otherwise, look for the alternative. So, very important means application of the
present value of annuity and we could answer a very interesting question.

(Refer Slide Time: 20:05)

So, in this case, the loan amortization schedule if you look at you can easily be able to
understand that how, means, useful this table is, which is given in the book and in the book of the
financial management by Prasanna Chandra, this table I have taken from the book and if you
look at this entire this calculation, which is nicely done beautifully done and first is given to you

245
there for example, again and other information is given to us that somebody want to borrow a
loan of 1 million rupees.

Which is given to us here and the rate of interest to be charged by the say the company or the
source from where the loan has to be taken is 15 percent and the number of years is 5 years, then
say, in this case, say how much is going to be the say in this if you want to find out the loan
amortization schedule, then annual installment is going to be how much you can easily find out
the end installment also 10 lakh rupees, 1 million rupees somebody want to borrow rate of
interest to be charged by the finance company 15 percent, number of years is known to us that is
5 years.

So, what is going to be EMI that is that you equated monthly installment is going to be how
much? So, far this calculating this total amount of the equated say installment the value of that
annuity, which is because now in this case what is missing and what is missing annuity is
missing. So, it means anything if the other things are given to us and any 1 thing is missing, we
can easily find out. So, in this case that annuity value that installment which we want to pay,
annual installment not monthly installment the annual installment which somebody want to pay
is or somebody can pay is on this borrowing 1 million rupees at the rate of 15 percent for a
period of 5 years.

So, annually he ends up paying this much of the installment. So this has been worked out with
the help of the same model and the factor which is calculated here is that is 3.3522. So, that A if
it is multiplied by this factor. So, it means we have already got about 1 million rupees and this
side is A multiplied by this factor. So, finally, the value of the A comes up as 298312. So, now
the all the calculations are shown here very clearly if you look at this, you are given the number
of years 5.

Which is given to us the period is 5 years and the beginning amount is also given to us how
much is loan in the beginning 1 million rupees and the first installment at the end of the 1 year
which we are paying is 298312 rupees which has been worked out here. So, this installment is
going, so and. Then the balance is remaining with us is this minus, this is now this amount
851688 rupees.

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Now the very interesting part here is you can find out here is which we want to remain which
always remain curious to know that out of this 298312 rupees, how much is the interest we are
paying against this loan of the 1 million rupees and how much is a principal payment has been
made and very interesting fact has emerged here that out of this total payment of 298312 the total
payment which you are making, you are paying principal as lesser amount as compared to the
interest we are paying.

So, interest payments are more than the principal payments. So, interest is 150000 rupees and the
principal going down is by 48, 148312 rupees. So, this way now, the closing balance which is
diminished balance reduced balances 851688 rupees is left here, which becomes the opening
balance for the beginning of the second year again we pay this amount again the balance comes
down to this and out of this amount when we are paying.

Now what is happening it has become reverse; that interest component has come down and the
principal of common component has gone up and for the other years if you talk about again it
keeps on changing. So, means you go to the third year in the third year also we are paying this
much amount. So, interest component is this much and this is a principal and now this is a
closing balance.

And when you are talking about this part here now, the closing balances this much and this part
is the installment we are paying. So, finally, the this is the amount of the interest we are paying
here and then the balance principal amount of this amount we are paying here. So, now, the
closing balance we are left the us is 259422 rupees and finally, we are means reaching up to the
final year this is a closing balance, this closing balances coming up here and see again we are
paying the installment, this is bifurcated into the principal and interest and finally, this amount of
23 is left.

So, this amount is just you can call it as because of the say approximations. So, finally this figure
should be 0 should not be 23000 or any amount, this should be 0 but just because the
approximations 23 is the end amount is left with us. Now, here important question is how we
calculate the principal and interest how we bifurcate the principal and interest we are able to find
out the value of an annuity that is an installment annual installment with the help of this present
value interest factor for annuity model, but for bifurcation of the interest in principal, how does it
happen or how does it take place?

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You have to find it out with the help of this that interest is calculated by multiplying the
beginning loan balance by the interest rate. So, it means is how you found it out. The rate of
interest is 15 percent beginning loan amount was 1 million multiplied by the 15 percent means 1
million multiply 0.15. So, that becomes 150000 rupees in this case also this is 851688 rupees
multiplied by 15 percent. So, this is interesting amount.

Similarly, now, this is the amount here is 484986 rupees multiplied by rate of interest. So, this is
amount, so it means with the same beginning amount, what is principal amount in the beginning
of the year leftover as a reduced balance or the beginning balance multiplying that balanced by
the rate of interest, you can find out the interest component and principal repayment is equal to
the annual installment minus interest.

So, annual installment is 298312 rupees. So, interest we have subtracted from this value. So,
finally, you are left with this part which is called as the principal repayment. So, very easily you
can bifurcate and you come to know that I say how the say the total installment can be worked
out and the total amortization schedule can be prepared and how the total this installment can be
worked out and in that installment, what is the proportion of the interest, what is a proportion of
the principal and in how many years or in 5 years or in this any number of years how that loan
amount is going to become 0 or fully amortized or fully paid.

So, in this entire calculation, one important thing which is for practical use for all of us is that
you see when you take any loan, especially the housing loan or any loan, when you take then in
the initial number of years, in the initial number of years, the interest component in the EMI,
EMI is higher than the principal component. So, it is always advisable that if we want to return
the money, we should pay the higher amount of installments in the beginning. So, that the
principal amount comes down seriously quickly.

So, that at the later stage, the whatever that know the balance left with us is there the paid more
as the principal and less as the interest. So ultimate any investment decision and repaying of that
borrowing, we have to means be careful that interest component which remains very high in the
initial installments, we should try to bring it down as early as possible and that can be done by
paying the larger amount of the say sum in the beginning, if for example the EMI annual
installment works out here is as 298312 rupees. But if somebody has got surplus funds more than
this, then it should be deposited in the loan account.

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So that this loan account balance goes down very effectively, very seriously very quickly and at
the later stage, you end up paying more as a principal component less for the interest part and
with by paying the minimum amount of the interest on any borrowing the loan can be amortized,
or that total say the borrowing can be amortized and the person can become free of any kind of
the borrowings.

So, it is a very, very interesting application of your present value of annuity, that if we want to
borrow anything, then in how many years we can pay, if this question is we want to answer you
can find out the number of years if you want to find out the even interest rate you can find out, if
when you when you find out the installment annual installment you can find out. So all these
applications are very useful for our day to day life also for the corporates life also and we will be
making use of these applications over a period of time.

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(Refer Slide Time: 29:06)

So, this is a process how you can calculate one more application here is how you can calculate
the EMI equated monthly installment. Earlier this installment which we worked out was annual
installment it is very simple to calculate, but for calculating the equated monthly installment the
process is a little different here. So, the model is given you have to look at, at this model, which
is very, very important model always be careful about this model.

So, for example, again we are given here is as the loan amount is 1 million interest is 1 percent
per month, 12 percent per year means and repayment period is 180 months, because normally the
repayment period, for example if it is given a month’s interest also we have to convert it to 2

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months if it is given in years the interest also we have to convert it into years. So, in a repayment
period is period is given in the month.

So, we are converting the interest also we are considering interests also in the month. So in this
case, EMI equated monthly installment can be worked with the help of this model, and in this
case, for example, the total amount was 180 months and this information is given to us. So, you
can calculate EMI for this borrowing at this rate of interest for this much period of time will be
rupees 12002, rupees 12002.

So, these all are the applications of the present value of the money, present, value of the annuity
not means any amount and even sum, uneven we have discussed earlier also. But in case of the
annuity this is the way how we can calculate the present value of an annuity and if we know that
we are going to acquire something on the borrowing basis and we are going to pay it over a
number of years, then this much of the amount I can or anybody can pay annually for acquiring
that particular asset.

Then easily with the help of these applications of the present value of annuity. The answer to all
the questions or concerns or related questions can be found out. So, means with regard to this
present value of annuity and the say this particular concept of say time value of money, I will
stop here and some other related aspects some other important concepts of the time value of
money, I will discuss in that next class, I would prefer to finish the discussion on the time value
of money in the next class.

So, that after that we can move to the next part of discussion. So, for this class and the time value
of money, I will stop here and remaining discussion we will have in the next class. Thank you
very much!

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 Financial Management for Managers
Professor. Anil K. Sharma
Department of Management Studies
Indian Institute of Technology Roorkee.
Lecture 16
Time Value of Money Part 7

Welcome all, so we are in the process of learning about the different concepts of the time value
of money and this is our last leg of discussion on this particular concept, time value of money. In
this class I will close the discussion on this very interesting, important concept of the overall
financial management because without time value of money I told you many times in the
previous classes also we cannot take any kind of investment decisions or any kind of the
borrowing decisions.

So, in the previous class we were talking about that equated monthly installment or EMI; how to
calculate the EMI? This is one of the application of the, your present value of the annuity. So,
here all other information is given to us.

(Refer Slide Time: 01:10)

You are given the borrowing amount you are given the interest, but interest is per month here
and the repayment period is also given to us in the months. So, finally, you can means make use
of this particular model and with the help of this model, you can find out that how to calculate
the EMI.

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(Refer Slide Time: 01:33)

Now, we will move to the next part and the next part here is that is the present value of a
growing annuity. It is means the annuity which is we are going to have or we are going to say
earn over a period of time, that amount which is going to come back to us over a period of time
is not going to be the same amount, but it will be growing over a period of time that will be
affected by the growth rate also over a period of time. So, maybe it is the annual growth rate or
maybe semi-annual growth rate or bi annual growth rate, but the growth rate has to be there.

Whatever is the cash flow is going to be there with us? That is not going to be the same cash
flow, it is going to be the say cash flow with the grown up rate. Now, what is the say the growing
annuity? First of all, because we are going to learn about the present value of our growing
annuity. So, let us understand what is the growing annuity. A cash flow that grows at a constant
rate for a specified period of time for a specified period of time is a growing annuity,

A cash flow that grows at a constant rate for a specified period of time is the growing annuity, it
does not remain same, it does not remain constant, it grows over a period of time. The timeline
of a growing annuity is shown below. If you look at the timeline, they are more important to
know for the timeline, the timeline of a growing annuity is given below to us. And if you look it
at, the same normal annuity, timeline of the normal annuity, this is basically called as the
ordinary annuity.

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So, it means because the cash flow is coming at the end of the year. So, it is called as the
ordinary annuity and any annuity on which the cash flow comes back to the investor in the
beginning of the year that is called as the annuity due. So, ordinary annuity, annuity due I will
discuss with you in the next slides, but here it is ordinary annuity and if for example, if you are
not multiplying A with the 1 plus g, 1 plus g is basically the, g is basically the growth rate.

So, if you are multiplying A with the g so, it means itself it becomes a growing annuity. So, in
the first year it is 1 plus g, in the second year, it is 1 plus g power 2 then over the number of
years it becomes 1 plus g power n, So, means we are getting this annuity certain sum is assured
but that is also growing at a given rate of say growth and that rate of growth is the constant rate
of growth,

The present value of a growing annuity can be determined using the following formula. Means
finally, with the help of this formula, we can calculate the present value of growing annuity and
with the help of this model here, what you are doing is only change, we have done here is that
earlier it was only A multiplied by the rest of the things.

But now, we are multiplying that annuity value also, that A value also, that cash flow also, which
is occurring at the end of the year is multiplied by the growth rate and then in the inside this, this
model, you are say writing it here as a 1 plus g divided by 1 plus r power n and here we are
talking about is divided by the, earlier it was only r, earlier it was only r, but now, it is r minus g.

So, it means discount rate will also be adjusted against that the growth rate. So, it means a
growing annuity when the, there is a growth in the annuity and the discount rate remains the
same. So, it means your overall value finally the discounted value of that annuity increases, that
goes up, that increases. But here a point of caution is given to us, let us read it what is given here
the other formula can be used when the growth rate is less than that discount rate, there are the
two important things, r is the discount rate, g is the growth rate,

So, this model is usable only in case r is say, the growth rate is less than the discount rate if the g
is lesser than the r or if the g is more than the r. When there is a difference in the g and r, g is
something and the r is different, then this model is workable this model is usable, but if the g and
r are equal if there is no difference in this in case g is equal to r, if both are equal to for example,

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in that case the model will not be applicable and in this case what will be the say present value of
that annuity, it will be n A.

So, n means the total annuity which is coming to us. Because the amount it is means the amount
of the annuity which is reducing because of the discount factor that is also being appreciated
because of the growth factor, So, it means in that case r is equal to g it means how much
reduction is coming because of the time value of money, because that cash flow is occurring us 1
year from now.

So, it means the value of that cash flow will not be equal to the same amount I will say coming to
us or is available with us in the 0 period. So, that will be what we normally we adjust, when you
discount it, it comes down future inflow future annuity when compared as per the today's valued
comes down, but when it is supplemented by the growth rate.

So, what is going to happen in future for example, at the end of the 1 year, we are going to get
say your 1 lakh rupees and we are going to get 1 lakh rupees, which is growing at a constant rate
of 10 percent over the years, but at the same time if the discount rate is also 10 percent then what
will happen?

The value of 1 lakh will be 1 lakh even after 1 year, which is we are going to earn after 1 year, it
is going to be 1 lakh is equal to 1 lakh even after 2 years that 1 lakh rupees is going to be there
with us if the value of that to 1 lakh rupees coming to us after 2 years will be equal to 1 lakh
rupees of the today, because that discounted value the reduction in the value is being made good
by the growth rate.

So, if the say r is equal to g or g is equal to r then what will be there the discount they say the
present value of the growing annuity will be simply the annuities number of annuities means sum
of the annuities, but if there is a difference if the say g is lesser than r or g is more than r in that
case, this model is applicable and this model adjust for that if there is any growth rate in the
annuities and even that you discount it against certain discount rate.

Then finally the, whatever the discounted value comes or is worked out more than the value of
an annuity when it is not growing. Then the value of annuity is constant and you discount it and
then sum it up something else will come up some total value different value will come up, but
when in this case, if you say get the value, which is growing at a certain rate and then you

255
discounted. So, increased value will be able to find out, so we will have to adjust here for the
growth factor.

So, there is some difference in that simple annuity and the growing annuity and the growing
annuity has to be say adjusted for the growth rate and after that it has to be discounted. So, it
means if you want to find out the discounted value of the growing annuity that will be certainly
more than the discounted value of the simple annuity or the constant annuity. Now, how you can
calculate the say for example, this application of the say a present value of a growing annuity.
This is one important example or the application of the present value of the annuity.

(Refer Slide Time: 09:02)

For example, suppose, you have the right to harvest a teak Plantation for the next 20 years in 1
field of the teak. We have purchased that field and trees are planted there which we can, which
we can have a harvest plantation for the next 20 years means for the next 20 years every year for
example, we are harvesting that or every 2 years we are harvesting that for next 20 years that
right have been purchase to harvest at the teak plantation and over the next 20 years over which
you expect to get 100000 cubic feet of the teak per year. 100000 cubic feet of the teak per year
the current price per cubic feet, say current price per cubic foot of the teak is rupees 500.

The current price per cubic foot of the teak is 500. What it is expected to increase at the rate of 8
percent. What it is at expected to increase as the rate of 5 percent per current prices, how much
current price per cubic feet of the teak is 500 rupees, but it is expected to grow at the rate of 5

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percent the discount rate is 15 percent and the say, say the present value if you want to calculate
of this annuity which is a growing annuity means here what is happening number of years for
which we can harvest the, this plantation of that teak for 20 years,

And we are going to get we ever going to get that say total per year output in that field is going
to be 100000 cubic feet. But the per price, per you say cubic feet is going to be, we are going to
sell that say to put in the market for 500 rupees per say cubic feet. But that price of 500 rupees is
not static, it is not constant, it is going to increase over a period of time and increase in the price
for the same per cubic feet of the teak is the growth rate is 8 percent and discount rate for
calculating the present value of this say annuity growing annuity is 15 percent.

So, with the help of this model you are means what you are doing here is you are giving the
power of 20 years and then you are finally adjusting it against the growth rate and growth is
going to be, so yeah this is 1 minus 1 plus g power 20 and in the denominator also, we are
adjusting the discount rate with the growth rate. So, finally, you can call it as a discount factor
has come down to 7 percent rather than 15 percent.

And when this because of the growth of the price selling price of the per cubic feet of the teak,
final value, which we are calculating here which we will be getting here for this total investment
proposal, which the rights we have got for harvesting the teak plantation for the next 20 years is
going to be 551736683 rupees.

So, roughly you can call it as 500 and 51 million and 7 lakhs almost you can call it a 700
thousand, you call it as 551 million and 700 thousand worth of the teak is going to be harvested
over a period of next 20 years’ period of time, because the selling price is not going to remain the
same per cubic feet of the teak plantation The price is not going to remain the same, it is going to
increase.

So, what we have done is we have multiplied the price per cubic feet and multiply by the number
of cubic feet is going to grow and going to be available with us and then it is multiplied 500 by
100,000 and the growth rate is 8 percent. So, this value of that growing annuity we have
calculated first, then factor with the certain other values and the growth rate. Finally, we are
going to find out that the total crop is going to be worth 551 more than 551 million rupees, which

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is the result of the growing annuity because slowly prices not constant selling prices going up at
the rate of 8 percent per annum,

So, this is a growing annuity. So, there is a difference between the say static annuity and the say
growing annuity. So, if any annuity is going to grow this inflow, cash inflow which is coming
over the period of say subsequent future years is not going to remain the constant but is going to
increase and is going to get affected by the growth rate, then you can understand that how to
calculate the value of that growing annuity with the help of this model we can easily find out and
we can easily calculate.

(Refer Slide Time: 13:41)

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Now, I was talking to you about something that is an annuity due, ordinary annuity and annuity
due. We should be very clear about it because in the beginning if you remember, I started the
process of means when I started the process of time value of money. I say discussed with you are
timeline, if you go back, it was a timeline which we discussed. And in this timeline we can go
back in that timeline in the beginning, we started that up something about the cash flows, cash
flows coming in the beginning of the period or cash flows coming at the end of the period.

This is the timeline I talked to you about in this case, the basic difference here is that in the 1 say
structure the part if you talk about cash flow is occurring at the end of the period at the end of the
year means at the point 1 not at the point 0 and in this case the cash inflow cash outflow is also
occurring at the point 0 cash inflow is also occurring at the point 0. So, this these are the 2
different kinds of the annuities.

So, this is I am going to talk about the timelines here. In terms of the annuity due, so if you talk
about what is the difference between the ordinary annuity and the annuity due so we can
understand with the help of this timeline again. Ordinary annuity is the one where cash flows
occur at the end of the period at the end of the annuity period or normally one year, we also
mean normally assume it that whenever any investment is made, that investment is made in the 0
period, this is a 0 period during this period we make the investment and this is a period of cash
outflows, not of the inflows.

So, when any investment is made in the market, it is made in the 0 period, it works in the market
or it operates in the market for a period of next 1 year, 12 months, and then at the end of the 1
year, we get something back in the form of the cash inflows. So, normally ordinary annuity, we
assume that the cash inflow will come at the end of the year, but in this case in the annuity due
this annuity due is that both the cash inflow and outflow are occurring at the beginning of the
year.

Both these cash inflows and outflows are occurring at the beginning of the year, which is called
as the annuity due. Here 0 period cash outflow is going and in the same period the cash inflow is
coming for example, I told you this in some previous class also, there is somebody say, say
purchase the building for 10 lakh rupees, and immediately after purchasing that building for say
one million rupees, he rented out that building or he leased out that building to some company or
some organization,

259
Company or any, any maybe financial institution, companies or financial institutions do not
prefer to construct their own building or other they say believe in doing the business in the rented
buildings. So, somebody purchased that building for 1 million rupees in the year, maybe 2019
and in the beginning of the 2019.

In the same year, he rented out that building and the lease agreement says that first year the rent
will be paid at the time in the beginning of the year, when the building will be leased out that the
rent lease, rental for that building by the user of that building will be paid to the owner in the
beginning of every year and first years rent will be paid, right at that time when the building is
leased out.

So, it is coming in the beginning of the say beginning of any arrangement, So, this is coming in
the beginning of the year, when it is annuity is the cash flow is occurring at the beginning of the
year, it is called as the annuity due otherwise, the normal annuity which we expect is the cash
flows occurring. Which we assume that in the zero period in the current period, the cash outflow
will occur and over the subsequent years the cash inflow will occur and when the cash inflow
will occur that will normally occur at the end of the year, not in the beginning of the year.

So, the basic difference in the 2 is that annuity due value if you want to calculate the sum total
value of the annuity due. It will be something more than the ordinary annuity, because you are
going to pay this amount is going to come to us here not at this level. So, the interest for this
period you have to calculate, interest for this period here you have to calculate.

So, annuity due is ordinary annuity multiplied by 1 plus r, So, 1 plus r is a period for this interest
under ordinary annuity your inflow coming at this point, but under the annuity due your inflow
coming in the beginning. So, rather than coming at this it is coming at this point. So, the interest
for this period has to be calculated, which has to be multiplied used for multiplying the ordinary
annuity.

So, that amount will become the annuity due, so be careful always about the point of cash flow
and the period of cash flow these are 2 important things. Time and again I am discussing this
point, time of cash flow and the period of cash flow if in the beginning, then it is the annuity due
but if it is at the end, then it is ordinary and annuity.

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Now, there is another thing which we call it as perpetuity. It is not annuity now; it is called us
perpetuity. Perpetuity means something related to the perpetual like something of the nature of
the perpetual existence, uninterrupted existence. Perpetual means uninterrupted existence. So, if
It may be possible that sometime when we purchase any investment and the benefit of that is
going to be there for say unlimited period of time, infinite period of time, unending period of
time, that investment is called as the say perpetuity or the perpetual, perpetual investment.

(Refer Slide Time: 19:25)

Now, what is the meaning of it, a perpetuity is an annuity of an infinite duration. A perpetuity is
an annuity of an infinite duration. So, infinity is involved here means when any duration which is
not countable means on fingers or otherwise are which is not foreseeable, which is an infinite
duration.

Once you have got the right over any particular asset, that is going to remain there forever
unlimited number of years for the infinity number of years, then that investment is called as the
perpetuity and the present value of that perpetuity can be worked out the present value of that
perpetuity can be bugged out as it with the help of this formula that A/r, A is the cash inflow is
the cash inflow which we are going to find out and the r is the discount rate and otherwise also
you can easily find out.

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(Refer Slide Time: 20:19)

That for example, A is that 10,000 rupees and r is the say 10 percent that discount rate is 10
percent if you try to find out this amount becomes how much this amount becomes 100000
rupees 1 lakh rupees.

It means the any perpetuity which is giving us the constant cash flow or the return of 10,000
rupees at the end of every year and the discount rate for that is 10 percent it means the value of
that perpetuity is 1 lakh rupees. Otherwise also for example, if the, the value of 1 lakh rupees
remains 1 lakh it does not go down over a period of time, it is it is not impaired because of the
period of time or because of inflation factor or because of any other factor which causes a
reduction in the value of the money.

So, you invest that 1 lakh rupees anywhere in any investment and annual rate of interest on that
is going to be 10 percent certainly, how much is we are going to get the annual cash flow 10,000
rupees. So, this is called as the perpetuity present value of perpetuity or the perpetual investment
where the return comes back or the cash flow occurs for the infinite number of years, unlimited
number of years.

It can happen and we can use this also in many business decisions. Now, we will talk about some
other interesting concepts shorter compounding period, shorter compounding period and this is a
very practical concept these days till now we were talking about the compounding concept, we

262
have talked about the discounting and compounding concept. So, till now we were talking about
that is that is the, say we discuss the concept of the future value of the annuity.

So, when we are talking about the future value of annuity, it means we were talking about the
compound interest there also, but their till now, the compounding the period of compounding
was considered as 1-year period of compounding was considered as 1 year that annually the
interest has to be compounded.

So, for example, we are investing 1000 rupees at the rate of 10 percent rupees. So, at the end of
the year, it will be compounded once in a year. So, that at the end of the year the amount will
become how much 1000 plus 100 is 1100, 1100 rupees in between we are not compounding it,
but if you are compounding it for a period of more than a year or rather than going for annual
compounding, if you are compounding it for the multiple periods within a year, sub periods
within a year then how to go for it?

This is a concept of the shorter compounding periods. So, in the shorter compounding periods,
what you can do is? You can take here means you have to make some minor change in the say a
future value formula for calculating the compounded value.

(Refer Slide Time: 23:12)

In this future value formula, what we are doing it present value and that is 1 plus r divided by m
and m is what m is basically the number of times compounding is done in the year, So, what is
given in this model if you look at this model. So, in this model you are given certain things and

263
what these things are, r is the nominal annual interest rate and if for example, if compounding is
annually, then we will not divide by m, it will remain r only.

But m is a number of times compounding is done in a year, these days. I told you the
compounding is done say, say you can call it as twice a year, 6 monthly compounding, quarterly
compounding monthly compounding and these days nowadays if you talk about the banking
system in India, then there is a daily compounding on the borrowing also, if you are borrowing
or borrowing anything from the bank, they are compounding it on the daily basis.

If we are investing or depositing anything in the bank, we are also getting the interest on the
daily basis for daily compound interest. It is not a simple interest; it is a compound interest. So,
here r is the nominal annual interest rate, m is the number of times compounding is done in a
year and is a number of years or which compounding is done n is the number of year for which
the compounding is done.

So, if the compounding has not to be done once in a year, but it has to be done for more than a
times more than 1 time in a year, then whatever that interest rate we are going to get back
annually that has to be divided by the number of the compounding number of the times of
compounding, number of the times of compounding. So for example, we have this information
here say 5000 rupees we want to invest.

Rate of interest annual rate of interest is 12 percent and the compounding rate is times of the
compounding is 4 times a year and total number of years for which this amount will be invested
is 6 years, So, you can with the help of this particular model, you can find out that what is going
to be the compound value or the compounded value of the 5000 rupees invested for a period of 6
years at the rate of 12 percent of the interest, where the compounding is done 4 times a year, this
amount becomes more than double of the 5000s and this amount works out as 10164 rupees.

So, this is the magic of compounding. This is the say you can call it as the power of
compounding I would say and the number of times when the compounding increases, when there
is the annual compounding the return will not be very high but if it is a quarterly compounding, it
will be more and nowadays this is a daily compounding, you can understand how much
difference it makes, whether it is the borrowing from the banks or it is the depositing in the

264
banks, but the sorry part of it is that whatever the interest we earn from the investment in the
bank deposits that is subject to the tax.

So, in this entire case means we can answer a question that if the compounding periods are more
than 1 in a year, then how to means try to find out the value of that investment, given the rate of
interest annual rate of interest, number of compounding times and the number of years for which
the investment can be made. One more important corollary of the time value of money is that
effective versus nominal rate of interest, effective versus nominal rate of interest.

So, what happens that when we go to the bank or any financial institution, we asked them that I
want to deposit my say, sum maybe 1 lakh rupees, 2 lakh rupees for a period of 3 years, or for a
period of 6 years for a period of 5 years or for a period of 1 year. How much interest will I get,
then bank talks in terms of the simple rate of interest or the nominal rate of interest that they say
that, yes for the fixed deposit of 3 years we pay 16.25 percent rate of interest per annum.

So, that is called as a nominal rate of interest, but, you see, as I told you that interest will not be a
simple interest when it will be calculated, it will be the compound interest, it will be the
compound interest. So, on the simple interest daily compounding will be done and on that
deposit and when you do that daily compounding. So, what happens the effective rate of interest
becomes a certainly more than the nominal rate of interest, effective rate of interest certainly
becomes more than the nominal rate of interest.

So, many times you must have heard about that many private companies even banks when they
advertise for seeking the deposits from the public, they say that rate of interest is this but the
effective yield is this. So, yield on the investment is this. So yield I am talking about is the
compound rate of interest. What is the interest rate of interest they are, say they advertise they
are advertising for is simple rate of interest, nominal rate of interest?

But practically when it comes back to us provided we do not take the interest back every period
every year or every month or every 6 months, we do not take the interest back, if we allow the
company to reinvest the back also. So, that interest is known as the effective rate of interest and
that is different from that or more than the nominal rate of interest.

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(Refer Slide Time: 28:23)

So, in this case, you can calculate with the help of this model, the effective rate of interest can be
calculated with the help of this model. And here you can see that effective rate of interest is r is
equal to 1 plus k divided by m. The m is number of compounding periods and power m minus 1,
r is effective rate of interest, k is the nominal rate of interest, right and m is a frequency of
compounding per year and in these days’ banks there is a daily compounding.

So, this is a compounding and means on the daily basis that say deposits are compound loans are
also compounded on the daily basis. So, finally, in this case, for example, a simple rate of
interest for example, in this case is 8 percent and m is 4 times a year compounding you will be
done 4 times a year.

So, r in this case becomes how much this becomes as 8.24 percent. This is called as EFR
effective rate, effective rate of interest ERI, this is the effective rate of interest ERI, if as
compared to nominal rate of interest the nominal rate of interest is 8 percent, but the effective
rate of interest is more than that, that is by 0.24 percent, it is more.

So, it becomes 8.24 percent. So, always be careful when you make the investment in the any
financial institution or in any bank always asked for that he has this is a nominal rate of interest,
but what is the see effective yield available from this investment and that will be known as the
compound say output available. So, here is a chart which has been calculated again in the same
book by the Prasanna Chandra, I have taken this directly from that book.

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So, nominal and effective rate of interest are given here is some chart is given for example,
nominal rate of interest is 8 percent or to 12 percent annual compounding is done once. So, it
will become 8 and 12 means, no compounding almost you can see annual compounding. So, at
the end of the year you will find it out 8 percent 12 percent.

But if it is semi-annual compounding means every 6 months if it is compound, then it is 8.16 or

12.36, quarterly compounding 8.24 percent 12.55 percent and monthly compounding if it is
done. So, actually it works out as 8.30 and 12.68 percent. So, you can understand the magic of
compounding, you can understand the power of compounding here, the movement the number of
compounding periods increase or times of compounding increase, the effective rate of interest is
going to increase at the same speed or the same pace.

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(Refer Slide Time: 30:54)

So it means in this case when we talk about here is effective earnings, that effective annual yields
and the you call it as the simple say applied rate of interest this EAR and the, APRs. So, in this
case you can find out is that see effective annual rate and the annual percentage rate, APR and
EAR if you want to find out there is a basic difference and we should be very, as a student of
finance, we should be very clear about this difference, that effective annual rate is the one that
reflects the total amount of interest that will be earned at the end of the year, total interest which
will be earned at the end of the year.

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In this case, we have found out is that we will not be earning 8.28 percent but on this investment,
if the compounding is done 4 times a year, we will be earning 8.24 percent. So, in this case, the
amount of interest that will be earned at the end of the year. It is also referred to as the effective
annual yield. I told you that effective annual yield or that annual percentage yield which is called
as APY annual percentage yield.

So, there is a difference in the interest and the yield, there is a difference in the interest and the
yield when you talk about interest you talk about the nominal interest, but when you talk about
the yield you talk about the compound interest. So, if we are not taking the interest back over the
periodical intervals, we are allowing this investment to be given once we will be taking it back at
the end of that investment period along with the principal and interest. In that case, the, the
interest which we will be earning will be the different one and that will be called as the effective
annual rate and not that is simply the annual percentage rate.

So, annual percentage rate is the amount of simple interest earned without considering the effect
of intra year compounding. This is the simple rate of interest earned without considering the
effect of intra year compounding. So, this is a basic difference in the 2. One is the compound
interest and second one is the simple interest.

So, when we go for any investment revenue and try to find out what is the interest their offering,
whether it is a bank deposits, whether it is any bonds of the companies or any other investment
revenue, always be means clear about that if they are talking about rate of interest or they are
talking about the yield either rate of interest they are talking about.

So, whatever the rate of interest they're offering, always be sure that the total effective rate of
interest annual yield will be certainly more than that, and not the one which is means they are
talking about they are simply at the moment they are talking about the simple interest and the
actual output or the actual yield which will be called as the effective annual rate EAR that will be
certainly more than that.

So, you can compare your investment means in the one revenue with the other revenue in terms
of the yield available and not in terms of the nominal or the simple interest available. So, with
this, these are some of the, you can call it as that important applications of the time value of
money, where we could discuss the different concepts and my objective here was to make you

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clear about with the basic techniques of the compounding and discounting, compounding and
discounting.

Because time value of money is very simple to understand that our rupee in hand today is not
equal to a rupee which will be earned or will be coming back to us after a period of 1 year, rupee
earned after 1 year is not equal to the rupee in hand today.

So, there is a difference in the two values of the money because money is going to come back to
you after 1 year and currently 1 rupee is available. So, you can compare it say or people say that
“A bird in the hand is worth two in the Bush”. Same is the principle applied here. So, if you say
that you want to take say somebody offers you that you want to take say 200 rupees today, or
300 rupees after 1 year.

So, you can easily understand that 300 rupees coming to me after 1 year or 200 rupees I am
getting at the present moment, I think it is better option to get the money what is available that is
200 rupees say presently is equal to 200 rupees, but 300 rupees coming back to me after 1 year is
not certainly 300 rupees but less than that. So, there plays the role means there comes the role of
the compounding and discounting.

So, when you talk about that, you want to calculate the future value of the present amount, you
apply the concept of compounding and if you want to find out the present value of the future
amount, you apply the say the concept of, or you make use of the concept of the discounting. So,
after compounding and discounting the final value of the cash flows which occur to us and occur
out of us is different and we should be clear about that.

What is that amount, how to calculate that amount and how to make use of this concept of the
time value of money in the real business decisions? So, with this concept of time value of
money, I will stop here, I think I could discuss some of the important concepts and again, I
would emphasize upon this all discussion which I could do here is, I have referred to the book
that is financial management by Prasanna Chandra if you have any doubt or you want further
more information, more problems to be solved about, or you want to have some clarification
about that the discussion I am doing here, which some part may not be clear to you.

Though you can ask in the say question forum later on, when the course will be run. But, if you
want to have further detailed discussion or learning about what is the time value of money and

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how to do it, you can again refer to the same book by Prasanna Chandra, which is a very useful
book and you can make use of it for the detailed and the, say, say you call it is a very clear say
the learning of the financial concepts, concepts, without any kind of the doubt.

So, for this time value of money, and to learn about this entire concept as a whole. Whatever
possible was I could discuss with you. So, I will stop here for this class. And next time, we will
move with the next concept of the next important concept of the financial management, which
will be of a certainly very good use to the say corporates in their practical life for managing their
finances, well. So this is all for today, that is all, thank you very much!

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 Financial Management for Managers
Professor. Anil K. Sharma
Department of Management Studies
Indian Institute of Technology Roorkee.
Lecture 17
Capital Budgeting Part 1

Welcome all, so now we are moving to the next part of discussion in this financial management
and after having discuss the financial planning and the time value of money in detail. Now I will
take you through the say the process of Capital Budgeting. Capital budgeting is a very interesting
process, were we evaluate the different capital investment proposals.

And you would agree with me that say when any investment has to be made in the market.
Especially in the businesses or the business organization or by the business organization.
Whether they are new or they are adjusting ones. Evaluation of the projects is very important
criteria; evaluation of the project is a very important consideration.

And they will try to find out that how much investment we are going to make in this project and
how much return is expected to be there from this project over the number of years. What is the
life of this project, means for how many years is going to sustain or going to remain to active and
say the investment which we are going to make in how many years we are going to get this
investment back?

And there when you talk about the capital budgeting. We do not simply say compare the cash-
outflows with cash-inflows or the series of the cash-inflows. But we have to use a concept of
discounting, discounting of the future cash flows. So, when I was discussing with you the time
value of money. I talk to you that how the time value of money is important.

Now you see that now the use of the time value of money we have started making, different uses
different application of the time value of money. Now we will be making in the future say a
different evaluation processes, decision making processes and investment processes in the
business organization. So that is why I discuss with you in detail that what is the process of say
compounding.

What is the process of discounting and how the time value of money is important? Because in
this concept of the capital budgeting, or in the different techniques or the processes of the capital

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budgeting. The time value of money is going to play a very, very important role, very, very
major role.

When you talk about evaluation of the project, simply we do it on the basis of the cash flows.
Not on the basis of the profit and loss, but on the basis of the cash flows. How much investment
we are going to make. That investment that which goes out from the investors or from the
promoters of the project. That is called as a say cash-outflow or that is normally done in the
current period and that period is called as a 0 period.

And when we start working on that because it takes time to build the project. When we go for
making the investment it will take one full year to give shape to the project or to that new firm,
new project, new organization. It may be the replacement project it may be the say conglomerate
diversification or may be the horizontal diversification or it may be may be say addition of a new
product in the adjusting product lines or anything.

We have to say try to find out, that when you are going for the say diversification it can be
vertical, it can be horizontal. You can means say add up one more step in the entire process or
may be sometimes you can say go for the horizontal just say horizontal integrations of the
different products. It may be possible that currently we are say manufacturing the finished
product.

And for the raw materials or may be semi finish products we have to depend up on the market or
up on the suppliers. But it may be possible that we are evaluating that if we start manufacturing
or creating the raw material also. So our dependence up on the say the external suppliers will be
going down, and the vertical integration will also be possible.

So, it means we can think of that if we make this investment, with that we start making the raw
materials also or may be the semi process material also which we get from our suppliers. So it
will give you many or the multifarious advantages. So itself it is a new project for us, it is a new
investment proposal for us.

So whether it is a vertical integration or the horizontal integration or diversification, or whatever

it is, means if there is a question of new investment, let us say new project for the firms, and if it

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is an existing firm it is a new, but if it is the say new firm itself for the first time the firm is
coming to existence.

For them the capital budgeting is very, very important, because when you say that you have the
say certain limited amounts of funds. When you talk about the funds when you talk about the
finances always funds are very limited in the amount. They are always cares in the quantity and
our objective is because in every business or the objective of every business is the value
maximization.

So, when the value maximization will occur, when you make the best utilization of the given
amount of the resources which are very scares. For example, we have 3, 1, 2, 3, 4 projects in our
mind and until unless we evaluate them that which project is going to give us the maximum
returns or the maximum say net present value.

In the capital budgeting language. Now I will talk to you is that which project is going to give
you the maximum NPV. So, if you do not do the proper comparative evaluation of the projects. It
may be possible that the project 2 was much better as compared to project 1, or the project 4 was
much better as compare to the project 2 or 3. But we did not evaluate all those 4.

We saw that 4 opportunities are there in the market, and we randomly selected 1 and we started
going ahead with that but ultimately, we could not get the desired amount of the results. So the
purpose of the business is to maximization, getting the maximum return from the minimum
inputs or the maximum output from the minimum inputs.

So, in this process we should be knowing that it is s relationship between the input and output.
What is the relationship between the cash-outflows and cash-inflows and here comes up the say
the importance or relevance of the capital budgeting? Capital budgeting is as I told you is more
important for the say entrepreneurs also.

Because, they also have the limited resources with them. If they want to say invest their
resources in such a way where they get the maximum return from the minimum investment or
the optimum investment. Then again, they should be knowing that what is the relationship
between the cash-outflows and cash-inflows and what is the going to be the final outcome.

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One more important here, which we apply here is that, when you calculate the cash flows. We
when you talk about the cash-outflows they are normally means they occur only the current
periods, so that period is called as a zero period. But when you talk about the inflows they come
back to the firm over the number of years, the subsequent years.

So, maybe they are coming back in the next 4 years or next 5 years or next 6 years. So we try to
find out, what is the foreseeable period of that project. It may be possible that the project is going
to last for the next 20, 30, 40 years, but we cannot means predict for the say next 30 years or next
40 years or next 20 years.

But the foreseeable period can be maximum up to 10 years. We can estimate that yes, in the next
10 years the project is going to behave like this, this is going to be total performance this much
investment we are going to make in the current year period. It may be required that over the
subsequent years also, may be in the first year we are making investment of certain amount.

Then second year no investment is required, third year no investment is required but in the fourth
year the investment may be required, then sixth year again the investment may be required. So,
there can be cash-outflows going over the number of subsequent years also. So there also we can
address that kind of problems but if we assume that cash-outflows is going to occur in the year
that is the current or the zero period.

When you are going to build the project, that period is called as a 0 period or the year 0 which is
a current period and the inflows are going to come back to us in the subsequent periods year 1, 2,
3, 4, 5, 6, 7, 8, 9, 10. So now because they are going to come back to us over a say future period
of time. After 1 year after 2 years after 3 years, so you understand now if you recall the say
concept of the time value of money you would understand that now those inflows have to be
discounted.

Because the cashflow which is currently with in our hands. The value of that is 100 but 100
percent but if the cash any cash-inflow which is expected to come back to us after 1 year means
100 rupees in our hands today cannot be equal to 100 rupees coming after 1 year. So, what you
have to do here is? Now you have to apply here the concept of the discounting, discounting the
cashflows.

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If you remember we have discussed one thing in the time value of money and that was
discounting of the uneven cashflows, discounting of the uneven cashflows. So, in the projects
normally the cashflows which come back to us, the cash-inflows specially which come back to
us over the subsequent years, they are normally, they are normally the uneven in the amount.

You cannot expect that every year same amount of inflow is coming back to us. Say 1lakh rupees
1lakh is coming at the end of the first year, second year, third year, fourth year nothing like that.
Because, cashflows means ultimately, anything which is coming back to us. Cash-outflows
means whatever the investment we make in the market.

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(Refer Slide Time: 10:52)

For example, if we are say investing somewhere a sum of rupees says 1 million, 10 lakhs. This
investment we are going to make in the market, this is a cash-outflow. This is a cash-outflow
which is going to take place in the current period this period is called as a zero period and the
value of this zero period, 10 lakhs equal to, this is 100 percent.

But when you talking about the inflows, it may be possible that in the first year at the end of the
first year. You are getting back 1 lakh rupees. Then you are getting 2 lakh rupees, then you are
getting 4 lakh rupees, then you are getting 6 lakh rupees. So, it means these become the uneven
cash-inflows. So, in total if you call it as over the subsequent years over the next 10 years the

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inflows going to come back to us from the, at the end of the first year till the end of the second,
tenth year.

So, in this case you can say that the uneven cashflows, cash-inflows are going to occur for a
period of 10 years. Starting from the first year till the next 10 years, why we are talking about the
10 years because 10 years is the normal foreseeable period. The period which we can foresee
now is up to next 10 years. It may be possible project is going to last for the next 20 years.

But we are not talking about the next 20 years and our main objective is what, when you talking
about the capital investment, or the capital budgeting. Our main objective here is this investment
of the 1 million rupees. I am more concerned about in how many years, this amount of
investment is going to come back to me. First I am more concerned about it, and this 10 lakh
rupee comes back to me. After that whatever the cash-inflows are available from the projects that
is my surplus, that is my net present value. So, I am totally indifferent that whatever the amount
comes to me.

First of all, my question is in how many years, I am going to get my investment back and after
that over the next say foreseeable period remaining foreseeable period, how much surplus is
available from the project. So, the decision making under the capital budgeting techniques
because different say methods and methodology are there different techniques of the capital
budgeting are there.

It may be the say simple your NPV technique, net present value technique. It maybe the benefit
cost ratio, it may be the internal rate of return. Whatever the techniques you apply or may be
simple payback period, whatever the techniques we apply in the capital budgeting. We are more
concerned about that first my investment should be recovered.

What investment I making that should come back to me. After that whatever the cash-inflows are
coming to me they are going to be my surplus. So, here we were talking about the say
discounting the concept of discounting. So, this is uneven cashflows and in case of the see, in the
series of the uneven cashflows, now we have to calculate the value.

If this 10 lakh is, 10 lakhs in the current year in the period zero. So, it means this 1 lakh coming
back to me at end of the next year, or the at the end of the first year is not 1 lakh. It is something

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less than that because time value will reduce it is value. 2 lakh rupees coming at the end of the
second year, 4 lakh rupees coming at the end of the third year, and 6 lakh rupees coming back at
the end of the fourth year.

They are not in the same on the value. So, it means now here the 1 thing you have to start doing
is you have to go for discounting. The concept of discounting is more important here and
discounting of uneven, discounting of uneven cashflows. That we have to do this is a series of
the uneven cashflows. We have to go for the discounting of the uneven cashflows series and
what is objective?

This total of the next 10 years cashflows which are foreseeable this should be discounted value
of that, we will compare with this amount of the 1 million rupees and then we try to find out,
what is the net present value. Net present value is basically what the total amount is you can
calculate is the cash-outflow minus present value of cash-inflow, present value of the cash-
inflow.

This is the or you can call it as a present value of the cash-outflow minus present value of cash-
inflow and the difference is going to be the NPV net present value. So, this is going to be, we are
going to learn that the net present value, the present value of cashflow and the present value of
cash-inflow. It means net present value is going to be what?

We have to put it now for this, in the reverse relationship that you can say, if you want to
calculate this net present value in this case you have to do one thing is that is, in the reverse order
you have to it, because we have to find out which one is bigger for us. So, in this case we have to
do it reverse and if you do it reverse in this case.

Present value of cash-inflow, present value of cash-inflow, minus present value of cash-outflow,
and then we want to find out. So, say for example, when you are going to do it that we are having
this 1 lakh plus 2 this plus this. So, it means how much we are going to have 1 lakh plus 2 lakhs,
3 lakhs plus 4 lakhs it is going to be 7 lakhs plus 6 is 13 lakh. So, if you discount this 4
cashflows for certain discount factors.

And compare with this cash-outflows, so the value which will be there with us, that is called as a
NPV. So, present value of the cash-inflow means all these are cash-inflow 4. We will sum them

279
up means discount them sum them up and that will be known as a present value of the cash-
inflows. Present value of cash-outflow is equal to 10 lakh rupees or the 1 million rupees, we will
try to find out the net present value

So, this is the one technique of the capital budgeting likewise different techniques of capital
budgeting we will, say like to learn here and ultimate objective is that whatever the investment
we are making in any project. Whether it is existing or new, it is expansion or diversification or
maybe it is an existing form or it is a say any project by any new entrepreneur or may be a
startup.

Our objective is that in how many years we are going to get investment back and after that
whatever the cashflows are available that is our surplus available over the project. So, capital
budgeting is a technique which helps us to understand all this evaluation of the different
investment proposals and if you want say yes or no for any investment proposals that largely
depends up on the say evaluation of different projects on the basis of the say different techniques
of the capital budgeting.

(Refer Slide Time: 17:52)

So, in this case when you talk about the techniques of the capital budgeting, we will discuss all
these things under this process of capital budgeting. We will talk about what is importance of
capital budgeting, then what is the process of capital budgeting, we will talk about the project
classification. We will talk about the investment criteria.

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We will talk about the different techniques like net present value, benefit-cost ratio, internal rate
of return. Then is the modified internal rate of return, payback period, accounting rate or return.
These all are the techniques of the capital budgeting and we will learn all about this technique
and by using any of the techniques or jointly some of the techniques, how to evaluate the
different investment proposals.

That is the important point to be answered or different question that is the important to be
answered in this discussion on this case. So, here I will take you to the now the say formal
discussion on the capital budgeting. Capital budgeting means, it is more linked to the capital
expenditure. We do two kinds of expenditure in the businesses or in the businesses organization.

One expenditure is called as a capital expenditure, another expenditure is called as the revenue
expenditure or you can call it as the long term investment or the short term investment or the
long term any expenditure. The benefit of which accrue for a longer period of time and any
expenditure the benefit of which will accrue for a shorter period of time.

And when you say differentiate between the longer and shorter period of time. Longer period of
time is any period of time, which is more than a year and shorter period of time is maximum up
to 1 year that is 12 months. So, when you talk about the capital expenditure, capital expenditure
means any expenditure the benefits which are going to be accrue to the firm or to the sponsor of
the project for a period of more than 1 year.

That is called as a capital expenditure project or that may be the long term expenditure or that
may be called as a maybe medium term expenditure. But not at all short term expenditure and
when you talk about the short term expenditure that is the help of the working capital and for the
short term requirements maximum up to 1 year and say with in a period of 1 year. How much are
going to financial requirement of the firms, and how they are going to be fulfilled that question
has to be answered in a different way, in a different process and there we do not make use of the
capital budgeting process.

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(Refer Slide Time: 20:23)

So here if I take you to the formal discussion, so you can understand here is that the basic
characteristics of capital expenditure. Also referred to as a capital investment or just project, also
referred to as a capital investment or just project is that, it involves a current outlay it involves
current outlay or maximum is current and the future outlays of the funds in the expectation of
receiving stream of benefits in future.

Current outlay as I told you in the, some moment back, that the expenditure may be only the
current period that is called as a zero period or it can be in the subsequent years also, that in the
first year, zero year we made the investment of 1 million rupees. So first and second year no
investment is required, only inflows are coming. Third year again you have to make investment.
Fifth year again you have to make investments.

So, it can be possible that for keeping the say project going on the firm going on the investment
going on giving you the best results. You have to go for the updating also, upkeeping also. So
some capital expenditure is required in the subsequent period also. So, whether it is required in
the subsequent periods also.

Or it is done in the zero period it has to be compared with the inflows available over the
subsequent year or number of say years going to come and in the expectation of receiving stream
of benefits in future, streams of benefit in future means in the coming years. The benefits mean

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the cash flow. So, in the simple language it can be called as it is a simple comparison of the say
present value of the cash-outflows with the present value of the cash-inflow.

And when you make comparison of these, that to in the present value sense, it is called as the
process of a capital budgeting. Capital budgeting means when this capital budgeting technique
was not there, even then say our forefathers were evaluating the businesses or the businessmen
were evaluating the capital investment proposals. When people never knew about the time value
of money or the discounting criteria.

At that time also we were evaluating and in the simple layman’s language, means any investor
would ask a genuine question that okay, if you are asking for an investment of 1 million rupees
in how many years this investment is going to be recovered What we are talking about is, we
talking in terms of the payback period, and payback period is very important technique of capital
budgeting.

So, people knowingly or un knowingly have been using this capital budgeting process in the past
also. But now we have a very formal and very useful process of evaluating the projects or the say
capital investment proposals which we called as the capital budgeting.

Now what is important here, importance of the say capital budgeting. Now why we give so much
of importance to the capital budgeting? Because, when you talk about the any investment
proposal is not only one-day job, it takes some time even months’ time or sometime up to 1 year.
Because, we are going to take a very, very crucial or important decision for the firm, very, very
crucial or important decision for the firm and it is a question of investing hard earned money,
scares resource finance.

We are going to invest the finance very hard earned money in the firm or in the business and
ultimate objective is the value maximization of the firm not value erosion of the firm. So, value
maximization only be possible if the present value of the cash-inflows or series of the cash-
inflows, out ways the present value of the series of the cash outflows.

So, we have to make a thorough process evaluation process for that capital budgeting say that
capital expenditure and we any point of time we find that investment is going to be doubtful

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outflow or the doubtful investment we can, means the simply decide against the making the
investment or not going for the project.

So, that is why very, very say serious investment process and whenever go for this kind of the
process we have to be very careful, that it is a question of millions of rupees we are going to
invest and it should not be something like I discussed with you in the beginning lectures about
the say fruit bear project of the Anchor industry.

They invested 350 crores and finally they say ended up with just nothing because that project
failed. So, it should not be a proposal like that, if it is it happens like that the firm is going to lose
very scares and limited resources and we have to be very careful while making the investment
that is why now days. When I am talking comparing the current say business environment with
the older days.

At that time the say the future was more certain. Because, market was not very competitive and
the requirements of the people could have been easily means forecasted and whatever the price
you are going to charge for 1 unit, if you manufacture and sell in the market, that was easy easily
determinable but all these things become totally you can call it as a say uncertain in the market.

Uncertainty has increased because of the competition because say want and requirements of the
people income level of the people. Business environment is dynamic, so every day changes are
taking place. It may be possible that we started making any investment by the time project has
become ready to deliver the benefits, it has become obsolete maybe within 1 year, new
technology has come.

For example, you talk about the that if you say talk about the LCDs, this color TVs. We had two
kinds of technologies sometime back we talked about the LCD technology but how many days it
lasted in the market it is, means very soon it was replaced by the LED technology. So, people
who invested into that means they could not reap the benefits out of it and LED technology
means within no period of time over took the LCD.

So, it means you can understand that how quickly the changes are going to take place. Today we
make the say investment in the market and I think by the time our project is ready to deliver the

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results. Your things have changed in the market, the environment has changed in the market, the
say people requirement has changed in the market.

New product has come and in case of the IT products, for example, this situation is very, very
say desirable that means that life of the project, or may be any product or service which we are
say going to generate out of the IT sector, in IT sector. The means you have to recover the
investment very quickly otherwise it is not going to be safe investment.

So, because of this peculiar nature of the mis the characteristics of any investment. We have to
be very careful that because of the special characteristics attached to the capital budgeting
process. We have to be careful and that is why we attach lot of importance for the capital
expenditure or the capital investment decisions.

Importance you have to attach why, because long term consequences once you lose any money
that to in the millions of rupees. It will destroy it will means affect the financial health of if it is
existing firm for the years together and if it is new firm or the new group of the promoters they
may lose everything.

And ultimately, they may not get the anything back in return of making that investment in the
market, because everything went down in the drain. So, long term consequences we call the
amount of investment we are going to make is very, very high is a very, very serious. So, and
once you take the decision you cannot go back.

So, because of these long term consequences you start little late but with the proper all
calculation, and whatever risk we are going to take we have to take the calculated risk it is the
first important fundamental rules in the finances or in the financial management. That people do
not say do not take risk because if you not take the risk you will not say be able to maximize
your returns.

Because the risk in returns are inter related, but if you take uncalculated risk. So, what is going to
happen, you are going to lose investment in the market. So, that has to not to be done, second
thing is substantial outlays huge investment we are talking about because, we are talking about
the capital expenditure and if it is a capital expenditure is huge investment.

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And because of that huge investment you have to be means very careful, because if it is small
investment of 20, 30, 40000 to up to 1 lakh rupees. People can bear it but if it is about some say
crores of rupees, millions and Billions of rupees then is a very important question, that we have
to be careful because of it is being substantial nature.

And third one is the difficulty in reversing, it is irreversible investment say process once we
started making any investment, but we are say making an investment short of you can call it as
while started building a project is we created a sinking fund. Whatever the fund we are making in
the that until or unless if competes and start delivering the results to us it has become like a
sinking fund.

And whatever the investment you are going to make it is going to only say absorb that and no
return is coming back because is still in the building stage is in the construction stage. So, until
and unless if say efficiently completes it is process the construction process and start delivering
the goods and services, till then means it is not safe investment and if may be we planned make
100 lakhs of rupees’ investment or 100 crores of investment.

We invested for example, 5 crores but after that we thought no, we should change it some other
area it is not possible. If you want to change it to some other area you have to forget the 5
Crores. And that 5 crores are very big expenditure. So, because of this 3 important say
characteristics attached long term consequences, substantial outlays and the difficulty in in
reversing that investment means we have to be very careful and cautious, while making
investment.

Because, once say invested in the market things cannot be reversed no investment can come back
to us and that means entire process is going to have long term consequences for the firm. Maybe
it is existing or new. So, entire capital budgeting process say helps us to evaluate any investment
proposals and take the things say forward.

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(Refer Slide Time: 30:53)

Now this is the capital budgeting process, when you talk about the budgeting process step by
step, we have to learn about it and we have to go ahead say about each and everything and what
are the different steps involved in the capital budgeting process. First, one is identification of the
potential investment opportunities, then is assembling of the investment proposals.

Then is the decision making, then is a preparation of capital budget and say appropriations, then
is implementation and then is a performance review or the post completion audit. So, all this
points are very, very important. So this all means 1, 2, 3, 4, 5, 6, these 6 steps make the capital
budgeting process from 1 to 6. Every step we have to complete and we have to means
understand.

What is the importance of all this steps, what is the relationship and inter relationship, among us
these different steps and how to take one step after the another, that is say very important for us
and that makes a capital budgeting process complete? So, the detailed discussion over the capital
budgeting process and the minute discussion about all the points involve here.

I will do with you in the next class. This is just beginning of the capital budgeting process, which
is very, very interesting and useful technique in the financial management. So, we should be very
clear about it, we should be means thorough with the process of capital budgeting. Because
evaluation of any capital investment proposal is the first important requirement which is
expected to be means that capability, that quality that capability is expected to be good see for a

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good finance manager or a person who knows finance. So, all this intricacies of the capital
budgeting and the important points and the issue associated to the process of capital budgeting.

I will discuss with you in the discussion over the next few say, say classes. But for the moment I
will stop here and this capital budgeting process. I will discuss with you in the next class. Thank
you very much!

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 18
Capital Budgeting Part 2

Welcome all. So, we are in the process of learning about the capital budgeting, and in the say
previous class, I told you that we will discuss now the capital budgeting process. And we
discussed something about it in the previous class also what is a capital budgeting process? And
what is its importance?

(Refer Slide Time: 0:50)

So, as we can see here that six steps are involved in the capital budgeting process. And it begins
with the first step that is identification of the potential investment opportunities, identification of
the potential investment opportunities. This is very important concept, it is a very crucial step say
how, means any project is going to be worthwhile, any investment proposal is going to be
worthwhile, we have to be very means say you can call it as a careful in identifying the project or
the investment proposals. That where say millions of rupees we are going to shell out. That
should be a worthwhile investment, different ideas because if you talk about the startups or the
new investment say proposals.

In the form of the startups, there what is the most important? Most important is the idea. That if
you have any idea in the mind then we start working seriously on that, and that idea can be

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transformed, can be converted into a business opportunity or a business proposal, provided it has
the business value and the business value is in terms of that their idea when if it is converted into
the business or maximum may be the goods and services. When start coming out of it where is
the market for that? Where is the market for that? Is there any demand for that any market for
that?

Now, if you are talking about the adjusting firm, if they are going for adding a new product in
the existing series of the products, they are very careful in their analysis. They are say highly
professional; they know it how they have been running the business in the past. And how they
are going to now add up the new product.

And there say addition of the new product into the existing series of the products, depends up on
number of factors. Number 1, the first important thing is feedback which they get from their
marketing at the sales force. That we are successfully selling our 3, 4, 5 products in the market.

But there is a demand for a new product in the market. And sometime their channels of
distribution tell their sales force that if your company starts manufacturing this product also, or
start rending this service also there is a quite good amount of demand for this product or service
in the market.

Because manufacturing anything is not difficult these days. Or generating any service is not
difficult these days. We are in Global village. Earlier there was a problem of the say your raw
material, because we do not have the good quality raw material. There was a problem of the
foreign exchange. There was the problem of the good management skills.

There was the problem of say good marketing skills. There was a good of say, shortage of the
good skilled human resources. There was a problem of the good technology, know-how, but
these days all these problems are over now. We are totally globalized economy. We are totally
liberalized economy, globalized economy and even government insist for that whenever you are
going to have a new investment proposal or you are going to make new investment.

You have to make sure for one thing and that one thing is the global sourcing. That whatever the
inputs you are going to make into your business. In India even today’s time you make sure that

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the that those or those inputs they are, they are going to be best in the world. If you have the best
raw material available in India. You make use of that first but if it is not available you import it.

If you have the best technology available in India, fine you make use of that. But if you do not
have the best technology available in India you import that. And rupee is convertible on the
current account. Convertibility of rupee on the current account means whatever the foreign
exchange you require, you can deposit that much of the rupee with the government and you will
get that much amount of the foreign exchange for fulfilling your input requirements, for fulfilling
your investment requirements in terms of raw material, in terms of technology, in terms of know-
how, in terms of even having the better management skilled people or anything.

So, when foreign exchange is not an issue, when the raw material is not an issue, when the
technology is not an issue, in that case, in that case, manufacturing of anything is not difficult.
Anybody can manufacture anything and then the manufacturing is not difficult, it means what is
difficult is the selling of the manufactured product in the market.

Because as there are number of options available for manufacturing the product and different
manufacturers are there in the market. Same way the options with the customers have also
increased it is not like along back a closed India, the steel authority of India is manufacturing
steel for India, it is not that few limited Indian companies are manufacturing the color TVs,
refrigerators and washing machines in India.

It is not the case that BHEL is manufacturing the say the turbines and heavy say the electrical
machinery in India. Today there are the number of alternatives and the sectors which were
reserved for the public sector participation only till 1991, most of those sectors have been opened
up now for the private sector participation including the foreign investors, foreign direct
investors and now it is the era of the globalization, it is era of liberalization.

So, it means manufacturing is not difficult. Generating of any service is not difficult. I gave you
some example some times in the past when we started discussion on this subject for this
particular course. I told you about the general motors, they told that you conceive any kind of the
car. Any kind of the features you want to have in that car and within 15 days means you give that
designs to us and within 15 days we will hand over you the keys of the car.

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This is now the era of this kind of the quick response. So, when the supply side has strengthened
means very heavily in the market, very say you can call it as say to a larger extent it is become
very powerful. The supply side has become very powerful.

Now, the customers have got the choices when the customers have got the choices only those
products and services we will be selling in the market which have the best fit. It is it is era of the
survival of the fittest. We call it as the era of the survival of the fittest and who is fit in today’s
market?

Who understands the market in a country like India very carefully because it is a highly price
sensitive market? It is a highly price sensitive market. So, largely those products will be selling
in the market which are fulfilling the say economic requirement the physical requirements, the
sociological requirements of the people, at a very competitive price.

All kinds of requirements at very competitive price because people have limited income here.
People can compromise for the quality for some amount of time but if the price is seriously
reduced. People go for a product which is very competitive in the price and not very efficient in
the quality. If you want to sell a product which is very efficient in the quality.

But if it is price that is very high, it means people will not be able to buy that product. And
people will largely go for because larger chunk of the population is having a limited income,
which is in their hand, usable income which is in their hands. So, it is price sensitive economy.
So, we have to create a product which is fulfilling all kinds of the requirements of the people
also. Our say potential customers also and it is very competitive in the price also.

So, you have to have that kind of idea, so identification of the potential investment opportunities
is a very important and the crucial step and the success of say investment proposal largely
depends up on that. What is the requirement in the market? And how you are able to understand
the needs of the people? When Karsanbhai created the Nirma, Nirma washing powder initially.

He understood the requirement of the people at that time because cheaper range of the washing
powder was not available in the market. And the washing powder is kind a product which is of
every day’s or everyone requirement. We wear clothes, so we have to wash it.

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So, we were looking for some alternative and when this product came in the market. Everybody
welcomed it with the open arms and product became a huge success in the market. Then
different, now you talk about this in the services sector OLA and Uber. This is a requirement of
say today’s India.

That people want the services so when Uber came to India, means the person who is owning say
IIT Bombay graduate the owner of the OLA he got an idea that with the Uber is the success in
India. Then I can create similar kind of the app similar kind of this say cab say facility. Cab
service in India and I can become a say big service provider to the people fulfill their
requirements.

And today you see that the growth of the OLA it is existing in almost in every say city of India.
It is big competitor to the Uber. For example, OYO rooms when you talk about the OYO rooms
you talk about the Paytm, these all are the products, these all are the services created by the new
young entrepreneurs in India. And it is only the idea which has really worked very well and if
you are able to understand.

What is the requirement of the people? How to fulfill that requirement? How to means serve the
people need at the at a very competitive price. Your idea is going to work very well. Because
when you have an idea and with that idea when to go, when you go out and search of the funds.
We are not going to get the funds for a new idea from the banks.

We have to go to the say different kind of the financial institutions who are called as angel
investors or may be the venture capitalist. And when you go to the venture capitalist if you are a
going to have a start-up. When you go to the say venture capitalist, he first of all likes to know
about your idea. What is your idea?

But you, what kind of the business you wanted to have? Which product you want to
manufacture? Which service you want to say render or generate in the market? That will be the
say the beginning of discussion on that particular point and those people are very smart. Because
they have to make investment in the market in a project in that particular business which has not
seen the light of the day, which is going to be very say risky investment.

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So, largely because they know the world markets. If we have an idea in mind that the product or
service is successfully working in the developed economies. We want to bring that to the
developing economies also. For example, this say packaged drinking water, when Bisleri brought
it from say their home country to India.

So, it means they thought that is a huge country, it was a country of 1 plus, 100 plus say 1.2 or
may be at that time also we were 1.2 billion people. 100 crore people countries are there. So,
drinking water can be a good market, so they started this process long back.

And today you see that it has become big market. We have become so conscious; we have
become so careful that whenever you want to take a say we want to drink some water. We
always preferred to shell out 20 rupees and like to buy a bottle of the water. So, the idea is
working after that so many people are there in the market. So, many brands of the drinking water
are there in the market, packaged drinking water are there in the market.

When Karsanbhai started Nirma after that so many brands of cheaper washing powder are there
in the market. So, one person comes with an idea, he becomes the first mover in the market and
people start following and it becomes a huge success in the market. So, identification of that
idea, conception of that idea is a million-dollar question.

From where the capital budgeting process begins. And if the idea is good I can say that it is if the
beginning is good, end is certainly going to be very good. So, it means your project is going to be
a very successful project. Your product or service is going to be a huge success in the market.
So, this is the first important point. Second is assembling of investment proposals.

Assembling of the investment proposals, so after having an idea, different kind of the investment
proposals can be there. They can be replacement investments, expansions, new product,
obligatory and the welfare investments. So, it means once we have got an idea that we want to
make some say new investment in the market.

So, if we are a new investor in the market. For us we have to look for the say the funds. We have
to go out in search for the funds, we have to look for the funds. And if the idea is workable in the
market. If the venture capitalist accepts our idea. Then we are going to get the funds and we are
going to means convert that idea into the business.

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But if it is existing organization, existing firms for them also may be the idea is not a problem
because they know that they are already into business. So, they might have the different
proposals in their mind. For example, replacement investments can be there, expansion
investment can be there, new product investments can be there and obligatory and the welfare
investment can be there.

But you see all means, for example, they all have their existing firm all they have in their mind
replacement investment is one option available they can do it. Expansion is also possible they
can do it, means replacement is replacement of the existing technology with the new technology.
This is a good idea because the product we are manufacturing.

For example, you talk about the say now the steel authority of India. They having the say 6
plants, 6 steel plants the technology is quite old. For them if they have to means change the
technology if they have to bring the new technology in place. They have, they have to invest
millions of rupees and this a good investment proposal for them.

They know that this idea is there in mind, they want to say change the technology but it is a
question of investment which has to be generated. So, they cannot do all the 6 plants together.
They have to do it one by one. So, this is the one, idea is there but which technology, from where
it has to be taken. How much investment is required? And how that entire process has to be
completed?

Now, it itself is a capital budgeting proposal. Expansion, for example, we are already
manufacturing 4 products we want to add the 2 more products in the market 5 or 6. Again means
it is full-fledged capital budgeting proposal for us. Because you have to evaluate it like a new
project, new investment proposal because success and failure is linked there also.

New product, again expansion new product and sometime we have to do the obligatory and the
welfare investments also. For example, under the CSR requirement also or may be under the
human resource welfare requirement of some existing organization. We want to create schooling
facility for their say children or maybe we want to create the hospital facility for our employees
and their dependents.

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So, though it is a social investment but means we can quantify the benefits coming out of it. So,
they cannot be directly linked to the say the inflow and outflow but still every investment
whether it is a business investment. It is social investment we have to evaluate it like that. One
important example could be in case of the obligatory and welfare investments.

That for example, may be the, we have a location were the plant is existing. The part of the land
is now have started eroding. So, we want to have a retaining wall there so which is say increasing
the life of the project which is means doing away with any kind of the dangers for the say any
kind of the say loss to the projects.

Physical loss to the project so having a retaining wall or creating that safety infrastructure itself
is an investment proposal. So, all these investment proposals first of all identification of an idea
or the opportunity. Second thing is assembling of this different, assembling is more important for
the existing organization. But the first one is equally important for the new ones also and for the
existing also.

If it is new one, idea is the most important but if it existing one, there could be number of ideas
in mind and they have to be assembled together, out of that either they have to rank or they have
to be rationed if there is an investment, limited investment is available. We can say that out of
these 5, 6 investment opportunities. We can take up to immediately and remaining we will thing
about in the time will come.

Then we talk about the decision making. Now finally, after this evaluation, decision making is
what? Decision making depends largely upon availability of the different input requirements and
the consumption or absorption of the output also. Input is that in terms of for example, whether
technology is available, whether say human resources, trained human resources are available.

Whether the land for that particular investment proposal is available. And at the same time the
most important thing here is the demand for that new product or the new service which is going
to come up is there in the market or not? First of all, I think there is first and foremost that if you
want to decide about the success or failure of any investment proposal.

We have to start working with the demand, market and demand analysis. Market and demand
analysis is the most important thing if you make the market and demand analysis and the answer

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comes there from yes, there is a sufficient demand in the market for this new product if it comes
up certainly means it is beginning of say now serious thinking towards the new idea.

After that we have to think about the different inputs. So, all these things are required right for
the market and demand analysis to the technical analysis, to the human resource analysis.
Everything is involved in terms of the decision making. So, we will have to move towards. We
are maturing now, first of all we are identify the idea, then we, for the existing firms we saw that
apart from the new idea. What one the existing investments can be.

After that we are talking about now we are moving towards decision making process. Starting
with the market and demand analysis, technical analysis and then the say human resource
analysis and after that next step is the preparation of the capital budget and the appropriations.

Preparation of the capital budget and appropriations. It is the most important job. In case of the
new projects we will have to prepare the proper capital budget. Capital budget means we have to
assess the total expenditure; we are going to make for building up that particular facility. That
particular project, total outflow of the funds we are going to means this the total outflows of the
funds this project is going to cause.

That means assessing that total expenditure is the, is a million-dollar question. And after that is
appropriations that appropriations and one more thing, I would add here is the projections.
Projections of your total estimates, capital budget appropriations in the form of the projected
financial statements. When you prepare a projected financial statements for a next 10 years’
period of time.

Starting from 0 period to the next 10 years. 0 period this much outflow will be there and now
inflow analysis. So, when you prepare the balance sheet you say talk about the different asset
liabilities. That this much of the investment into the long term asset, land, plant, building,
machineries required. This much of amount is required for running those plant, building and
machinery successfully.

So, we need this much amount as the working capital. So, when the asset side is complete with
us in the balance sheet. So, then we start say looking for the sources of the funds, so we move
towards the capital and liability side of the balance sheet. So, when we go for appropriations and

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projections in the form of the balance sheet. We create a something like that which is going to
cause the cash-outflows and which are going to cause the say means require the cash-inflows.

So, it means total cash flow, outflow, inflow analysis is required in terms of say requiring
assessing the requirement of the fixed assets, current assets and how that requirement will be
fulfilled on the basis of the say different sources of the funds? And we convert that into, it is not
a say you can call it as a Layman's Estimate. Proper your profit and loss account that is the
income statement, balance sheet, cash flow statement has to be prepared.

And that all will depend up on. For example, you are going to talk about now prepare the income
statement. Income statements beginning always is with the sales. And if you do not have the
figure for the estimated sales for the next 10 years’ period of time. You cannot proceed further
with the proper say appropriations and the projections.

And capital budget will also depend upon the market and demand or demand available in the
market. If you know that how many units we can manufacture and sell of a one particular
product. For example, you talk about say talk about say long back 1982. Karsanbhai when he
thought of that if he starts manufacturing the washing powder then what should be the size of the
plant he should have in the beginning?

How many say quintals of the tons of the washing powder he can manufacture and sell in the
market? Because it may be possible that when you go for the market and demand and the
responses are very good. As happened in case of the fruit beer project. But as we come out in the
market with the real say the product or the service sometime people may reject it.

Or sometime at that time because of the technological advancements, new better product has
come up in the market. So, it means we have lost the investment. So, should we make the
initially the small amount of investment, capital expenditure amount should be smaller or should
we go for a moderate level of that or initially we are so sure about the demand that yes, in the
beginning itself we have made a huge investment.

So, that all will depend up on the market and demand analysis. So, preparation of the capital
budget, and appropriations and further projections in the form of the projected financial

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statement, is the next step, after that is the implementation. Once everything is ready because
when we are able to present in front of the say venture capitalist.

Our idea and the projected financial statement for the next 10 years we are able to explain it to
them. That this is the beginning of our say the first year operations this much of the sales we are
going to have in the first year. Then in the second year, third year, fourth year, fifth year, sixth
year something like that and over the years the sales are going to be like this.

Once you have got the sales process, then you start back tracking now this much production is
required for producing this much unit, this much size of the plant and machinery will be
required, this much of the raw material will be required, this kind of the people will be required.
Once all that is shown to them in the form of the projected financial statements and they are
convinced with the say success possibilities of the new product or the new project.

Then what will happen? We have got the idea, we converted that into the proper detailed project
feasibility report that is called as a DPFR. We presented that DPFR in front of the different
sources of the finance and those different sources of the finance including venture capitalist have
approved it. Let us go ahead whatever the investment you have with you fine, remaining we will
make.

So, next step comes up is implementation. We will have to go for the implementation of that
capital budget for that capital budgeting process and for that implementation means the certain
requirements are here like adequate formulation, use of principle of responsibility accounting
and use of the networking techniques are some important requirements here.

When you go for the implementation, adequate formulation means we have means done the
proper preparation when your dummy financial statements are in front of you, you know that
what kind of the plant building and machinery are required, so we are going to arrange for that.
What kind of the materials are required? Raw material is required we are going to arrange for
that.

How many or what kind of the people have to we hired, we are going to arrange for that. So, it
means when we have already formulated a proper DPFR. So, it means adequate formulations

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have already done. So, implementation is not an issue. Then once we create any organization, we
use the concept or the responsibility accounting that that firm.

That business organization that business undertaking which is created. That has to be divided
into different units and sub units. Which are sometime called as departments and sub
departments. So, people have to be made responsible for the different departments and their
processes. There comes the importance of the responsibility accounting.

There comes the say the importance of responsibility accounting. In my another subject which I
have offered through this NPTEL through Swayam, Management Accounting, there I have
discuss the concept of the responsibility accounting in details. So, responsibility accounting and
entails that say making the people responsible of the different units and sub units of a larger
organization.

And holding them responsible in case of any good or bad performance. If the good performance
is there of that unit or sub unit appreciate their performance, if their performance is going to be
bad then you have to take care of that and you have to say advice the people that we are not
going in the desired direction.

Similarly, we can use the say networking techniques. Especially when the project in the building
stage, we use the networking techniques. You must have heard about the PERT and CPM -
Program Evaluation Review Technique and Critical Path Method. Because if we make use of
this PERT and CPM networking techniques then the project can be completed within the
stipulated period of time.

And we have plan, for example, if we have planned that with in the 0 year, in the current year
total risk completion, construction process has to be over in the beginning of the first year from
the first day of the first year. We will have to now say make the, we have to commission the
project. So, it means with the help of the networking techniques.

Especially when the project is very large in size with the help of the networking techniques. We
can complete that construction process within given amount of time. And finally, we can start the
production or may be the commissioning of the project can be possible on the first day of the

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year 1. So, implementation means start building about the that project and then say holding the
people responsible during that even the building process also and even later on also.

Once it starts working then the people are different people are responsible for that and then we
can use the networking techniques. So, that the completion of the project building of the project
is on time. Last step in this is the performance review. And or other way around you can call it as
the post completion audit.

When you talk about the say performance review you answer some important question. One
important question is how realistic were the assumptions, second is document log of experience,
then third is say helps in uncovering judgmental biases and fourth one is desired caution among
the project sponsors, means this is the performance review.

Performance review that when the project is ready we have started building it up when it is
already ready and even sometimes we review the performance. Even when it is commissioned
also, it has started giving the performance also. Production is already there and it has started
delivering the goods. We have started manufacturing and started selling it in the market.

So, we make a then the post completion audit or the post completion review that when we started
building this project where we started from, where we have reached now. We started from the
scratch and now it has started manufacturing and we have started manufacturing and delivering
the goods to the people. So, how means what is the learning process we had in this?

Especially in case of when it is a new project, the entire organization is new, all the sponsors are
new, they have come up for the very first time in this kind of business, for them the post this say
completion audit or this performance review is very important. For them this performance review
is very important.

So, it means they can, they can look back after means once it has taken the shape and the
production started. So, they can look back and they can just start means taking a stock off that
how realistic were there assumptions. They thought that land will be available at this price. Then
the building will be ready by this much period of time.

And then we will be able to do hire the people within this much period of time. Raw material
suppliers will be say very much cooperative and good quality of the raw materials will be

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available. So, this all are assumptions until, unless you practically start making use of them. But
once we have now giving means we have already given the shape and the production has already
started.

So, now you can start looking back. How could be get the land? How the production, this
construction phase was undertaken? Then how, now the raw material available in the market?
And how means people who are working in the organization, how they behaving and how they
are responding? So, it means in the beginning we had some assumption. We go for converting
that into the real thing and then we start making the say evaluation.

So, it is basically comparing the say your standardized performance. Your budgeted say
estimates with the actual performance in the market. And trying to find out the variances.
Document log of experience, it means when you go for the post completion audit. We complete,
create a full-fledged document that now means if same team of the people.

If they have to build the new project. Similar kind of the new project it will be very easy for
them. So, that is why when we want to bring the say we want to hire the people for them
management of any new organization. We like to bring the experienced people so that they
know, how to run a particular kind of organization and how to draw the best results out of the
given say kind of the investment.

Helps in uncovering judgmental biases. Sometimes what happens that people they know that one
particular thing is going to happen in a given fashion, but still they mean become bias towards
that, they say no, they know that normally the land is available at per yard will be at this much of
the price, in this particular area. But sometime they over estimate it or the they over price it or
they underprice rate while estimating the price of the land.

And then they can find out that what was the difference? That what was my judgmental price and
what is actual price available in the market? So, those biases can be removed and finally we
mean because now we have given the shape to that project. So, now we can say that what most
arcuate and the most possible best thing is there.

We have done that and if we have to redo this thing in future also, we have to expand this project
or create a similar kind of the new project. We know how to do it and what are the requirements.

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And desired caution among the project sponsors. It tells us the points or that decision areas
where we were not very comfortable.

Because we thought everything go as planned in the beginning but sometime it may be possible
that the raw material is not available or was not easily available in the beginning, or sometime a
particular technology was not available in the beginning and whatever the technology we had
from the market that did not respond very well.

So, sometime it became risky also that the output of the technology was not up to the mark or
sometime the prices we thought the people would pay, they mean did not respond with that much
of the price. We have to reduce the price also. So, it means important cautions also come in the
mind. Means that experience of the fruit beer project of the anchor.

If we talk that group of the people, who had that experience a long time back, about 20 years
back. If we meet the same team of the people they would be able to give us a very important
cautious points, or the points of caution that if you want to go into this kind of the project for
manufacturing the fruit beer or that kind of the product in the market, be careful this are the
cautions, go ahead there might be demand for the fruit beer now, it was not there 20 years back.
It may be they are in the market today but be careful this are the points of the caution.

So, these 6 steps make the capital budgeting process complete and means if we know this
process very carefully, very cautiously and we learn what are the pitfalls going to be there and if
we go ahead in a very careful manner then certainly we can say our investments proposal is
going to deliver the desired results, and whatever the investment we have made in the market
that is going to be, going to be very productive and useful investment.

So, furthermore, this is just the beginning of the capital budgeting process. Furthermore, about
the capital budgeting say for example, next thing is the project classification.

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(Refer Slide Time: 34:11)

So, different say projects are there mandatory investment, replacement projects, expansion
projects, diversification, research and development and miscellaneous projects this all.

(Refer Slide Time: 34:20)

And then we have the say very important thing which we will discuss start talking about the
investment criteria. Discounting criteria, and non-discounting criteria, so all these things mean
these are the techniques of the capital budgeting and here are some different types of the
projects. Which we can undertake if we want to go for the say identification of the new projects
or really into the capital budgeting process.

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So, all these discussions mean starting from the project classification to the say the investment
criteria and the different say capital budgeting techniques. All these we will learn in the say in
the subsequent classes, in the subsequent lectures. So, for this class this particular lecture, I
would stop here, so we could discuss here the say in detail.

What is the capital budgeting process? What are the different steps involved in this capital
budgeting process? And always be careful that it as a student of finance these steps are very
important. So, whenever we want to make for any kind of the we want to make any kind of the
capital investment or we want to advice tomorrow any firm or anybody for any kind of the
capital investment.

We have to be very careful about the say this step, this process of the capital budgeting, all these
steps involved in the capital budgeting. So, that desired results may be attained from any
investment proposal. So, I will stop here and remaining we will discuss in the next class. Thank
you very much!

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 19
Capital Budgeting - Part III

Welcome all, so we are in the process of learning about the capital budgeting, very important
concept in financial management and in the previous class we had some initial discussion
about the fundamentals of capital budgeting and say something about the capital budgeting
process.

Now, I will take you means to the next level and that is say the project classification that
when we go for identification of the projects or selection of the projects for incurring this
expenditure so it means how, we can identify the projects and we are means the investment
has to made how to take out those projects or those investments say, proposals.

Identification of those proposals and say finalizing those proposals we have some say basic
classification process here. And in this basic classification process we have say some ideas
about where the capital budgeting, investment proposals can be identified.

(Refer Slide Time: 01:33)

So, say for example, some of the projects are mandatory investments, some of the projects are
like replacement projects some of the investments are like expansion projects some are
diversification projects, research and development projects and miscellaneous projects.

So, when you talk about these mandatory investments when we talk about the mandatory
investments so, there are certain kind of investments which becomes mandatory now, first of

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all means the initially mandatory investment will be that, when we are into the new project or
means say starting manufacturing a new product or generating a new service.

So, whatever the investments are required to made there, so because, we have to identify the
project already may be by the existing form or a new form or a new organization may be in
the form of startup or say any beginning business activity by the new entrepreneurs so,
whenever a new project is identified, whether by the existing or by the new firms then some
investments are mandatory investments.

For example, say land, plant & machinery, building so, those investments are mandatory
investments. And we have to means made that so, identification is that which are essential
investments we have to do those are in the new projects or the new capital investment
proposals. We have already identified and on the basis of those identifications we go ahead or
start means a plan to go ahead for giving the shape to the project so, those kind of the
proposals which become the essential investments are called as the mandatory investments.

Then we talk about the next kind of the projects are replacement projects some time what
happens that, say a replacement of the technology or the replacement of the machines
because, when you talk about the any investments we are making and that investments
becomes over dated or may be technology becomes out dated so, we need to replace the
existing technology with the new technology, existing machines with the new machines and
that happens with every fixed asset.

That in the firms in any manufacturing organization in any of the business projects when we
use the plant and machinery that has a limited life normally, say 10 years, 12 years’ life
especially when we talk about the IT equipments, their life is very very short 3 years
sometime 4 years or maximum 5 years.

So, means at the end of that useful life that equipment has to be that plant machinery has to
be replaced and for that replacement process we have to make investment and when we make
investment we call it as a capital investment proposal or the capital budgeting proposal so, we
have to go for the replacement of the machinery or the replacement of the plant and
machinery because, of the out dated technology.

I would share here an example with you of that of the say SAIL Steel Authority of India
Limited, steel authority of India limited, was means even today it is a public sector

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organization and till 1991 it was the sole, steel manufacturer in India though TESCO was also
there but, larger market share was with the Steel Authority of India Limited.

So, they had at that time their own plant technology, they have 4 major plants at the 4
different locations that is Rourkela, Bokaro, Bhilai and one more location so, four locations
they have the plants and to 2 more some locations they have but, these larger locations
Bokaro, Rourkela, Bhilai and this one more plant is there. So, 4 major plants were there
where they are manufacturing.

Converting the iron ore into the say furnishes steel and selling in the country but, after 1991
when the liberalization was accepted in this economy and the steel sector was opened up for
the private sector participation. So, what happen that, Steel Authority of India Limited SAIL
also had to see or face stiff competition from the private sector players.

The major means competition or the major players which arrived or appeared in the market
who are the Jindal steels and the ESSAR steel, Lloyd steel. So, because of the emergence of
these private sector players. Because, now the sector is open up for the private sector
participation also.

So, when they started there or they stablish their plants means the new establishments by
these private sector players may be by Jindal or by ESSAR by the Lloyd steel. So, their
plants, their machinery, there know how was latest that was as per the current market
requirements and the market needs.

But, with the SAILs technology was the age older technology because, they never thought of
replacing it, with the or operating the technology with the passage of time. So, when these
private sector players came with the latest technology it mandated the SAIL also to change
the plant and machinery and means now, huge investment is required to be made.

So, that was called as on the one sense you can say it is a mandatory investment because, if
you do not change your plant and machinery then what will happen, your product
manufacture will be inferior in quality, very high in terms of price so, we may means loose
the market, people will shift from the existing supplier to the new supplier in the market
because, new supplier is giving as the better product at a very competitive price.

So, on the one sense it was the mandatory investment for the SAIL because, they had to stay
in the market and second was you can call it as the replacement projects. So, replacement of

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the existing plant and machinery with the new plant and machinery was a necessitated
because of that change in the market.

Because of the opening of the steel sector for the private sector participation and the private
sector players came up with the latest technology so SAIL was also required to say make
investment. So, for them it became a mandatory replacement investment. So, both these
projects or these capital investment proposals required a proper complete process of the
capital budgeting and here you can say that yes.

Some investments are mandatory because, you have to keep your plant building and say your
machinery going on to keep your organization functional and some are replacement once also
because, we have to move with the time so, replacement talk the old technology with the new
technology, old know-how with the new know-how, that is the important requirement.

Then some time we have to go for the expansion of the projects, whatever we are doing
currently because always when any time a new firm is created or a new business is created
may be by a single individual, his see his say idea is dream is that one day I would like to see
it as a transnational company, multinational company a transnational company.

So, expansion is always one important part of the growth of the firm so, when you start it as a
sole proprietorship, it becomes a partnership firm it becomes a private limited company, it
becomes a public limited company, it starts operating within the country then we start
exporting to other countries then we create the manufacturing facilities in the other countries
when it becomes the multinational company and then, when the number of countries where
the company’s presence is increases it becomes a transnational company.

So, expansion is always the one important moto of the company and for the expansion of the
projects, or the expansion of the company’s business we have to go for the identifying the
new expansion areas, products and services where we can venture into or we can start say
adding of the new products and new services.

So, that the total portfolio of the firm increases and every time when we are adding a new
product or a new service, itself it is a new project and new expansion opportunity for that for
example now, say you talk about Nirma I means always refer to that Nirma when it was
started by Karsanbhai long back it was a one-man organization today it is a international
company and they have diversified also.

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So, every time when they are growing from the one level to the next level they need
additional investment because they want to grow in terms of the product profile in terms of
the market profile in terms of the say your distribution profile. So, when there is growth
requirement certainly we will need the more investments and every investment is an
independent capitally investment proposal and we need to have the say evaluation of that
with the help of the capital budgeting process.

Then we talk about the diversification projects when you talk about the diversification
certainly we are into one area but, now we are to go for that, we have to diversify I refer to
you the anchor story that they are basically or they were into the electrical products segment
but, they then thought of that because of the multinationals competition in their say
conventional area of electrical products.

They have to diversify and they got an idea to diversify towards the consumer products, they
started that means they attempted that fruit bear project but it could not materialize but, still
anchor is into many consumer products and that is only for the sustenance of the company or
company’s business and the brand name.

Though their electrical business has been sold to Panasonic but, they are into other areas also
so, diversification is the other needs of the time and we will have to now, diversify to
different areas because, sometimes what happens that, one area becomes so competitive that
the firm has to think of means moving out of that area so if they have already diversified.

Then, it may be possible there the loss in one area may become the loss in one area and the
profit in the, another area that helps the firms to sustain in those areas also for certain period
of time where they are incurring the loses because they are earning the profits in the other
areas.

So, sustenance is quite possible, so diversification when we want to do, in that diversification
process also we will have to a say make new investments these days we are finding out for
example, that many large manufacturing organizations they are moving towards the services
sector.

And many large manufacturing companies they are into the say education sector and many
good business stablish houses you will talk about the Birla’s, you talk about Jindal’s you talk
about the even Mahindra’s they are moving towards the say even you talk about the Hero

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moto co-op group they are moving towards the education sector and they are stablishing their
own world class universities of the educational installations.

So, ultimately it is a business for them every investment whether that is into the services
sector or whether that is into the manufacturing sector it is a business for them and they have
to means take it like a business and say means consider every investment opportunity as a
new investment, so diversification can be the another opportunity available where we have to
think for the investment opportunities.

Then, research and development, yes, it is a very very serious project and requires huge
amount of investment, all the times because, whatever we have now, today the products
which we are manufacturing and selling in the market that may be sufficient only for a certain
period of time but after that we have to add some new features new qualities to that new
properties to that product and for adding the new features and new properties you will have to
incur the R and D expenditure.

So, when we mean want to say add any new feature to our existing products or may be say
think of introducing new products in the market or new services in the market R and D is a
very very continues and the regular process. So, every R and D project is a new investment
opportunity and we will have to evaluate it in terms of the techniques or the criteria of the
capital budgeting.

Similarly, you talk about the miscellaneous projects these days now the say for example, CSR
has become the very important requirement of the private sector companies and when they
are profit making part of their profit, 2 percent of the average profit of the past 3 years has to
go to the say social sector. So, they have to make investment into the sources sectors and
when they create the facilities for the social requirements, they themselves become the
projects independent projects for them. So, miscellaneous requirements could be there.

Or may be sometimes that say for example, there is a company which is manufacturing shoes,
so their main business is shoe manufacturing company or the shoe manufacturing is their
main say object or objective in the memorandum of association in the object clause they are
created a company for manufacturing the shoes or manufacturing the glass say products and
for a packaging or their products they are say depending upon somebody else who is
supplying the packaging material the boxes, the packaging boxes somebody else is supplying
them.

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But now, the company may decide, that rather than depending upon somebody else for
having the packaging material why not to start manufacturing it, so they may think of a
stablishing a new project new area new investment opportunity so that, there is a you can call
it as the vertical diversification or may be not vertical diversification this will be the
horizontal diversification.

So, it means we will, we looking for the opportunities where the investment say,
requirements are there, and those investments are say possible to be manage in the best
possible manner and then ultimately say every requirement of a good business is going to be
fulfilled from that investment if that kind of the possibilities are there certainly we would like
to look for those kind of the opportunities and those kind of the say proposals.

So, these are some of the areas some of the projects which can be say the ideas can be had for
identification of the projects say in terms of the mandatory investments, in terms of the
replacements, in terms of the expansion, in terms of the diversification, R and D and the
miscellaneous projects.

So, means every project every investment opportunity or every investment proposal is
independent projects and we will have to look like an independent investment proposal and
we will have to evaluate it like an independent project.

Now, we move to the investment criteria which is the very important you can call it as the
backbone of the capital budgeting process. This is a crux of the capital budgeting process
which we call it as the investment criteria, how to make investment, whether to make
investment or not to make investment.

So, criteria means that to say yes for making that investment or say no for making that
investment that is called as the investment criteria, and it is a very very important in the
capital budgeting all your capital investment proposals will be accepted or rejected based
upon this investment criteria and if you look at this investment criteria.

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(Refer Slide Time: 17:04)

You can see that it has two parts one is the say discounted criteria and another is the non-
discounted criteria actually this one is the quit old criteria, non-discounted criteria, discounted
criteria has come is of the recent origin when the time value of money has been invented and
we have realized that the time, this money has the different value at the different points of
time then we started making use of the discounted criteria otherwise normally we make use
of the, we have been make a use of the non-discounted criteria for evaluating the investment
proposals.

So, in this case non-discounted criteria have a two methods here, one is the payback method
and, payback period method and second is the accounting rate of return. Under this payback
method what we will simply trying to find out is, that whatever the investment we are going
to make in any project for example.

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(Refer Slide Time: 18:02)

We are requiring to make investment of how much, say 1 million rupees this is 10,00,000
rupees’ investment is requiring to be made in one project the investment requirements are
10,00,000 rupees right, and then the returns available normally the foreseeable life of the
project is how many years? 4 years.

So, in these 4 years in the first 1, 2, 3 and 4 in these 4 years in the first year we are going to
get back 200000 rupees then we are going to get back say 400000 rupees and then we are
going get back 3,00000 rupees here, and then we are going to get back again to 200000
rupees here.

So, under the non-discounted criteria what we will do, the total a cash outflow the investment
is 10,00000 rupees and this plus this plus this is going to be how much, this is going to be 6, 9
and 11. So, we are going to say here, the simple 10,00000 are going to be means equal to
there, this amount is going to be equal to 11 ,00000 so in this case we are saying that
normally the payback period of this investment of the 1 million rupees 10,00000 rupees is
around 4 years or something less than that.

Approximately you can say because the total inflow available over a period of the 4 years is
that is 11,00000 rupees are there, so you can say in the Laymen’s language we can say that, if
I make investment of 1 million rupees in any project or in any investment opportunity then,
how many years my investment is going to come back me.

So, it means this is very rough estimate but, largely we are concerned with the safety of my
investment because, there is a twin objective of any financial management issue, when we

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mean study or learn the financial management may be of individuals or may be of the
organizations.

We learn it with that twin objectives first objective is that first objective of a good financial
management is the safety of the funds and second one is the growth of the funds. Even when
we make investment of our surplus funds whatever the funds we are left with us means
whatever is the earning, monthly earning of any individual after consuming one part of that
the remaining part whatever is the left out the remaining part is.

If that has to be means invested somewhere in the market means we always remain concern
about it, that what is the safety concern of my investment and second thing is, means first we
are concerned about the safety and second then we are concerned about the growth.

So, in this case also we try to find out here that as a Laymen estimate now the Payback Period
says that is a called as the PBP this method is called as the PBP Payback Period Method and
this PBP methods says in how many years the given investment which is made in the current
period in the 0 period is going to come back to the investor and that is called as the payback
period.

And this is called as a non-discounted criteria because, when you are taking about all these
cash flows, this is a cash outflow and this is the cash inflow all these cash inflow and outflow
they are non-discounted, they are non-discounted here, 10,00000 is equal to 10,00000 and
certainly equal to 10,00000 because it is in the present period we are going to make this
investment and this is the again going to be 11,00000 rupees and some of these 4 values, 4
inflows is going to be 11,00000 rupees.

So, it means we are comparing these 11,00000 rupees with these 10,00000 rupees and we are
saying that the payback period for this investment is close to 4 years. But here, the major
limitation of this is that we are considering 2,00000 rupees coming back to us after one year
is equal to 2,00000, 4,00000 rupees coming back to us after 2 years is 4,00000 6,00000
coming back to us after 3 years is 6,00000 and 2,00000 coming back to us after 4 years is
2,00000 which is not the case.

But, when the discounted criteria were not there we will simply be making use of it even in
our olden days our forefathers even the old business peoples when they were asking by
anybody that if you make investment of this much of rupees or this much of amount in this
project, you are going to get good returns. So, his question means normally was that in how

315
many years I am going to get my investment back, because we are more concerned first about
the safety of our investment.

Second is the growth, growth is important second objective but, first is the safety if my
investment is safe I can expect the growth also but, if the investment is not safe, if I am
investing 10,00000 rupees and if that is not coming back to me, there is a question of the
growth of them. So, first I am saying I want my investment back, later on for the subsequent
number of years. That is the remaining life of the project whatever the returns I will get, that
will give me the growth.

(Refer Slide Time: 23:08)

So, in this case that discounted, non-discounted criteria when the discounted criteria were not
there it was only non-discounted criteria, non-discounted criteria are much older as compare
to the discounted criteria. So, first method was the payback period and second method is the
accounting rate of return.

Under this accounting rate of return we try to find out the accounting profit, we try to find out
the accounting profit by preparing the projected financial statements and then by preparing
the projected income statements profit and loss account, we try to find out the profit before
tax profit, after tax and comparing that profit with the investment we are making. We are try
to find out the accounting rate of return.

And that to again number one, the limitation of the accounting rate of return is that, that is
also non-discounted and second thing is that profit is basically the say that rate of return is
basically the nominal rate of return not the real rate of return because, the profit reported by
the profit and loss account is always nominal not real, so these are the two limitations that

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number one is, payback period is possible to be calculated but that is non-discounted and
second thing is accounting rate of return also it is non-discounted and that is basically the
nominal profit, based upon the nominal profit, not on the real profit.

But, today also even sometimes just to have a rough estimate rough idea about any
investment or any investment opportunity we always make use of the non-discounted criteria
in which the payback period is very very common and very very popular.

Now, after that you talk about is the discounted criteria which is commonly in use because
now we have known the concept of the time value of money, we have identified the concept
of the time value of money, and in this concept of the time value of money, in the discounted
criteria.

We have the 3 methods or 3 ways to say evaluate or say measure the say any investment or
the efficacy of any investment and these 3 are, net present value NPB method we call it as
benefit cost ratio or profitability index. The second name of this method is the profitability
index and the third one is the internal rate of return IRR so these are the 3 important methods
under the discounting criteria and here, when we use the discounted criteria we make use of
the time value of money.

We always say, that the cash outflow in the current period time fine equal to 100 percent but,
the inflows coming over the number of subsequent years in future they have to be discounted
to make it equal to the value of money as per todays value. So, the we discount those cash
flows and then we calculate the NPV we calculate the benefit cost ratio and then, we
calculate the internal rate of return.

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(Refer Slide Time: 26:07)

Here now, when I was talking to you is about the payback period, in the payback period that
the limitation of the payback period was that it is basically non-discounted, it is basically
non-discounted. So, for example, we have the say cash flows here, and we are saying to want
to calculate the payback period.

So, I am saying that the cash flows are like this that in the current year this is how money,
10,00000 rupees minus figure means it is the cash outflow and the inflows are coming up is
the 2, 00000 rupees in this and then it is 4, 00000 rupees in the second year and then it is
3,00000 rupees in the next year and then is the 2, 00000 rupees here.

So, it means I have got these inflows so, this is the year 1, this is the year 0, you can call it as
this is year and if you say this, these years if you take, here year 0 this is the year 1, this is
year 2, this is year 3, this is year 4.

So, this is equal to 1, and then what we would doing, we will be discounting it against the
discount factor because, you can apply the discount factor depending upon the discount rate,
that discount rate may be 10 percent or it may be 12 percent or it may be say 16 percent,
whatever it is, the discount rate these cash flows can be discounted. So, if you discounted
against 10 percent so you can find out that discounted cash flows also and then the discounted
value is can be taken.

For example, I am not taking the original values but for example, this 2,00,000 after
discounting at the rate of 10 percent by calculating the discount factor it becomes, 150000 so
it means and in this amount becomes here, if you discount, means I am not using the real
factors but, we are assuming that because, when you discount it so, the this cash flow value

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will come down and this amount becomes as 175000 rupees sorry, this amount becomes 4, so
this becomes 375000 rupees when you do, this you discount it this becomes is, that is 275000
rupees and this amount becomes 150000 rupees.

So, you can total it up so, you will find it out this amount will become how much, this will
become is a 9.5 total is 9,50,000 this will be total will be the 3,00000 but 3 and 3 is 6 and
then it is 8 and so, one 950000. So, you can say that the payback period under the non-
discounted criteria which was the approximately 4 years for making this investment of
10,00000 rupees.

If you discount it, and the discounted value for example, some of is a 9.5 it means and if after
this there is no inflow available so, what is happening, then the NPV of this project will be
something you call it as if you calculate the NPV, NPV of the project will be becoming here,
as the negative value.

So, we will not be going for this investment but, for example in the fifth year also some cash
flow is available and that cash flow is see, for example 2,00000 rupees and if you discount it,
this amount becomes again, say after discounting it becomes 1,00000 rupees it remains after
5 years.

If you are discounting it for 5 years then the rate of 10 percent, this amount becomes. So, you
will be adding 950000 and then 1,00000 here so this amount becomes 10 and 50000 rupees
and this 10 and 50000 rupees’ amount is now the amount to be considered, which is the
discounted value of the cash flows available from this project.

So, what will happen, now you will compare this 10,50000 with the 10 ,00000 rupees so cash
outflow is 10 ,00000 then cash inflows discounted value is 10,50000 but that to at the end of
the fifth year. So, now what will happen, if you take the discounted value then the payback
period is 5 years approximately.

But, if you take the non-discounted value then the payback period is 4 years so, the limitation
of the payback period method which was earlier there, that it takes into account the non-
discounted say cash flows has been done away and we are using even today also.

Many of firms practically also, many a firms they use this payback period method and the
limitation of non-discounting has been done away and now we discount the cash flows which
are expected to be there. We discount it against certain discount factor and try to find out
what is the discounted some of value of this inflows and try to find out that say, what is the

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total value of the inflows that is the discounted value of the inflows and what is the outflow.
So, outflow can be compared with the discounted value of the inflows and then you can
calculate the discounted payback period.

So, limitation of the payback period which was earlier there, has been done away now, and
now we are not calculating the simple payback period but the discounted payback period. So,
some idea I gave you about the payback period and the accounting rate of return but, more I
will be discussing with some examples later on. First let us talk about the discounted criteria
because, this criterion is a practically more in use these days.

(Refer Slide Time: 31:28)

So, in this criteria first one is the NPV criteria Net Present Value criteria. This is the first one,
and if talk about this if you look at this model of the net present value you will find
something what we have already discussed under the time value of money. Under the time
value of money that I discussed the something with you that is the discounting of the future
cash flows.

Discounting of the we discussed different things under the time value of money one thing we
discussed was the discounting of the future cash flows in that we discussed the discounting of
the uneven cash flows then we discussed the problem of the discounting of the annuities the
cash flows which are in the annuities. So, this model we have already discussed in the time
value of money and same model now we are going to make use here, for calculation of the
NPV because basically what is happening here.

This model if you look at it at, that Ct is the cash flow cash inflow available in the year t and
r is basically the r is the discount rate to be use for discounting those cash flows, n is the

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number of years for which the cash flows are expected. So, summing up those number of
years’ cash flows which is Ct and discounting it against some given rate of interest which is r
in this case power by t number of years.

So, it means we can easily find out the present value of that all those cash flows whatever the
cash flows are going to be there with the business, there is a cash present value can be found
out with this particular part which is in the red can be found out. And from that present value
if you subtract the initial investment then we are means left with something and that is called
as that value that is the total discounted cash flows sum of the discounted cash flows minus
initial investment becomes the, the figure is called as the Net Present Value, that figure is
called as the Net Present Value.

And now, here when you talk about this r discount rate now what should be this discount rate
at what rate this cash flow have to be discounted. So, this discount rate has to be the cost of
capital. It should be based upon it should be linked to the cost of capital and we should try to
find out that, what is the cost of capital, when I am again going to repeat when you calculate
the cost of capital, it is not basically the rate of return you expect but, it is something more
than that.

Means it is not the opportunity cost of capital, that I make investment in the business, how
much return I am going to get, if I making investment in the say bank or any financial
institution how much return I am going to get, in the business, if you are going to get the
returns or expect the returns that should be more than the bank returns because, you are going
to take here the huge risk and premium for the risk is the one important thing.

So, we discount it against the cost of capital, largely it is the weighted average of cost of
capital WACC we will discuss later on. Now, we will talk about the concept of the cost of
capital. So, this r is basically the cost of capital and against that cost of capital we will have to
discount those cash flows for the given number of years.

And those given number of years are largely the foreseeable life of the project. The cash
flows for the foreseeable life of the project. So, we will calculate all those cash flows we
know the cash outflow we will calculate the cash inflows, as cash outflows value again I am
repeating is equal to 100 percent and the cash inflow value has to be discounted for an over
the number of years and both have to be compared.

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So, it means the presented value of the cash inflows minus initial investment that is the cash
outflow and the difference of these two is called as the NPV Net Present Value. Now, if you
are calculating the net present value, that if means we have to then apply certain criteria as
certain rule here, for taking the decision but before that, let us discuss here, that say what is
the decision criteria here and how we take the decision here for.

(Refer Slide Time: 35:34)

Deciding the say means applying this criteria of the net present value, look at here that for
example, we are given the information about something and that is called as some
information some details that the net present value of a project means first is the definition of
it, the net present value of the project is, sum of the present value is of all the cash flows
associated with it.

Sum of the present values of all the cash flows associated with it whether it is a cash outflow
or whether it is a cash inflow it is the sum of the present values, the cash flows are discounted
at an appropriate discount rate and that is at the cost of capital, appropriate discount rate and
that is at the cost of capital so in this case for example, we have taken now the hypothetical
figures here.

And for taking these figures we are taking in the number of years is 5, 0 to 5 and cash flows
are worked out here, discount factor is worked out here and then is the present value
calculated here this discount factor is taken directly from the table that is a same, you can call
it as a present value, interest factor table is there, PVIF that is there, that is at the end of
every book, so from that table we have taken that factor at the rate of 15 percent cost of
capital we have selected here is, 15 percent.

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So, all these cash flows have been discounted against 15 percent and we have got these
factors and then the discounted values are calculated here, these are called as the present
values and finally we have calculated this sum, and this sum is basically what is, 31.96 so
what how we have calculated this.

This is one part this is another part, this part is 100 and minus sum total of these. So, it means
this plus this, then plus this then, plus this then, plus this we have taken so sum something has
come that may be means we total it up, this will work out as 131.986 and the initial
investment is 100, so it means the net result here is NPV of this project is 31.96.

So, what is the now decision criteria how we apply this criteria net present value that what
value we have to look for, while applying this criterion so the simple value is you have to
means simple mode of decision making you have to apply is.

(Refer Slide Time: 38:02)

That, if you are talking about the NPV we have talk in terms of that the means the
fundamental rule of applying this or accepting or the rejecting the project, under NPV
criteria. So, if NPV is a we can call it as NPV is greater than 1, equal to 1, and it can be NPV
can be less than 1.

These can be 3 situations NPV is positive, which is greater than 1, and NPV is equal to 1, and
NPV is less than 1. So it means NPV is more than 1, means the present value of the cash
inflows is more than the sum total present value of all the cash inflows is equal to the present
value of the cash outflows that is why the, Net Present Value is positive, and we are going to
accept the project.

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In this case we will have to accept the project, that yes, the project is going to give us the
positive NPV. So, we can accept the project, so we can go ahead with this, and when the
NPV is less than 1. Negative you can call it as, we have to simply take a decision and we
have to go for then reject the project and in this case, if you talk about the NPV is equal to 1,
we are indifferent, we are indifferent.

Whether to go for it, or whether not to go for it at least it is assured that we are going to get
back the investment whatever the investment is made here, we are going to get this
investment back, so NPV of the project is just equal to the cash means the discounted value
of the cash outflow is equal to the cash inflows and we may go for this investment, we may
not go for this investment.

But, currently the result is we are going to recover our investment as per is the future surplus
is concern that will depend upon the future codes of action or after recovering the initial
investment. So, you can apply this if the NPV is positive, more than 1 you go for acceptance
of the project, less than 1, reject the project and if it is equal to 1, yes we are indifferent
depends upon the circumstances, whether to go for making this investment or not making this
investment.

So, this is how this entire process of the say NPV has been explained here with the help of
this example later on we will do some more problems also, but I am just first of all, of the
opinion that conceptually this set all the criteria must be discussed with you, must be means
communicated to you and then we can discuss some more problems relating to the NPV or
may be the other say a discounting criteria, so that you are means clear about it.

So, with this discussion I will stop here by discussing the first criteria that is the net present
value and still, some more discussion about NPV and some another aspect of NPV are there.
So, that remaining discussion with regard to this first criteria, discounted criteria of the
capital budgeting, I will have with you in the next class till then, till then thank you very
much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 20
Capital Budgeting - Part IV

Welcome all, so we are in the process of learning about the investment criteria and in the
previous class we talked about the certain investment criteria and before concluding we were
discussing the first discounted investment criteria that was NPV Net Present Value and we
saw that how we can calculate.

So, the decision criteria here is, that if NPV is positive we will go for acceptance of the
project if it is negative, we will reject the project and if it is nil, you can call it as the NPV is
0, then certainly we will say that, we are indifferent we can go for that project or we may not
go for that project but, that will depend upon the future cash flows.

That after force even period if some surplus cash flows are available then certainly the 0 NPV
may become the positive NPV, so there we are indifferent we may go for that investment
proposal or we may not go for that investment proposal.

(Refer Slide Time: 01:25)

Here are some pros and cons given here in this if you look at some pros some means positive
points of NPV are given here and first important point given here is the reflex the time value
of money. This is a very important concentration because that is the beauty of that is the basic
merit of the discounted criteria that they take into account the time value of money.

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And that is more important also because, cash flows occur at the future say number of years
and during those number of years means they are far into the future 1, 2, 3, 4, 5, 6, 10 years
up to or may be 20 years up to. So, that time value concept is very important and we should
apply while calculating the discounted value of the or calculating the or comparing the cash
outflows with the inflows.

Second is the important pros is that is the considers in the cash flows in its entirety, entirety
means that we want to say look forward into future and what is the foreseeable period of the
project, what is the foreseeable period of the project, all those cash flows are taken together
we take the some of this.

(Refer Slide Time: 02:34)

Even when we go back in the formula in this modle also this sigma is basically the entirety
means the sigma, sigma is basically the sum of all the cash flows. They are not see in
isolation that in the first year what is the cash flow in the second year what is the cash flow,
in the third year what is the cash flow.

We do not see it like this we see it as a sum of the, the total number of the cash flows and we
discount their values depending upon the year in which their cash flow is occurring sum it up,
and then we try to compare the cash discounted value of the cash inflow with the present
value of the cash outflow and then we try to take the decision. So, sum together we take all
the cash flows here into account this is another important point.

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(Refer Slide Time: 03:15)

And third is, scares with the objective of wealth maximization because, we want to see how
much NPV is available net present value is available, for example here we made the
investment of 100 lacs may be or may be the 100 crores or the 100 million whatever this
investment will be made here.

And the we are there going to have a surplus of after discounting the cash flows cash inflows
we are going to have a surplus of 30.96 crores or 30.96 lacs it means now for example, you
are evacuating three projects A B and C one is giving you 31.96 another is giving you 35
another is giving you 40 lacs or the 40 crores so it means what is our objective.

I want to make 100 crores as much as possible at the end of the foreseeable period of this
project. Value maximization is the objective of every business, so when you want to achieve
this objective of the value maximization NPV when it is taken together in the entirety in the
total all foreseeable number of years in that case you compare there, what is the discounted
value of these the sum of these inflows and we compare it with the outflows so we say, by
making a certain amount of investment of 100 crores at the end of the foreseeable period of
the project, how much that 100 crores are going to be back with me.

So, number one, the 100 crore is safe plus they are growing so, they have become 130, 140,
150 so it means ultimately this is the objective of every business is the value maximization or
the wealth maximization and that is also going to be verified before going for that investment
proposal that yes, I am whether I am going to get back this sufficient return or not, not. So,
this is the three pros and then other cons that it says a NPV is an absolute measure and not the
relative measure. It is not the relative measure.

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(Refer Slide Time: 05:14)

Now how would you explain it absolute measure not the relative measure. For example, there
is a project and the say NPV of the project is we call it as the investment, this is an
investment we are making and this is a NPV available from the project. This investment is so
for example we are making investment of 10000 rupees and NPV available here it is 2500
rupees means after discounting everything and here second project is this is the project A and
this is the project B and here you are making the investment of 50000 rupees and NPV
available from this investment proposal is, 5000 rupees.

Now, if you have to choose between A and B you would as per this criterion we would go for
this project that is given us the maximum NPV that is, 5000 which is double of the NPV
available from the project A.

But here what is the limitation we are talking about is, an absolute measure and not the
relative measure, is an absolute measure we are only looking at NPV, NPV is 5000 and in the
other case NPV is 2500, we are not looking at the investment we are making here, that if you
compare these two investments also, that in the project A, by just making investment of
10000 rupees we are getting back 2500 rupees in the project B just making investment of
50000 rupees, in the project B we are making the investment of 50000 rupees, and then, we
are getting back 5000 rupees.

So, we do not take these two informations into account, it is not a relative evaluation it is an
absolute evaluation and this absolute or relative evaluation the major limitation we look it at,
we look at the projects which are given us the highest NPV and we do not compare it with the
investment or the other projects.

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We see that the projects which giving us the highest NPV that is accepted and the project
which is giving lesser NPV that is rejected but we do not compare it with the investment and
means it should be a proper cash outflow and inflow but, since it is a net present value, since
it is the net present value.

So, advocates of the NPV say, that which one is going to add more values the second project
is making 50000 as 55000 and the previous project A is going to make 10000 as 12500 so,
the more appreciation is, in the project B in the absolute terms not in the relative terms so,
means we will go for the project B which is the major limitation of the NPV criterion but,
despite so many limitations and so many problems we make use of this NPV criterion. Now,
we go for certain other things relating to this criterion of evaluation.

(Refer Slide Time: 07:57)

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So, now we are talking about the properties of NPV rule, and the first property is a NPVs are
additive means this is the very positive and very strength full property of NPV rule that NPVs
of the different projects can be added up together. Now, how they can be done here.

For example, we have three investment proposals here and if you talk about these three say
we have small projects A, B and C and total investment we are making here in these three
projects say for example 10 lac rupees and here the NPV of this project is going to be how
much, the 5 lac rupees this is 5 lac rupees, this is going to be 2 lac rupees and this is going to
be 1 lac rupees, from the C it is going to 1 lac rupees.

So, it means if you want to find out the total NPV available, you can add up this and you can
say the total NPV available, from all the three sub investment proposals is 8 lac rupees. The
sub investment proposals are 8 lac rupees.

So, additive properties are there with the NPV rule which is not with the other investment
criteria if you want to go for say the benefit cost ratio or if you want to go for the internal rate
of return then these properties are not there. So, here if you use this NPV so it means the
multiple proposals or the small proposals of the small investment level the when they are say
discounted values or the NPVs are calculated they can be added together and we can say that
from the total investment which has the multiple sub investment opportunities. What is going
to be total say NPV available.

So, this is additive value that the NPV of the different small projects can be added together
and the total net result can be worked out. Second major property is the intermediate cash
flows are invested at cost of capital, intermediate cash flows are invested at cost of capital.
So, it means when we are talking about the cash flows available here, the total cash flow
available here for example, first year we got this 34 lac rupees’ cash inflow is there, second
year 32.5 third year 31.37 then is 30.53 and then 79.90 cash inflow is available.

So, what we talk is that, we do not get these cash inflows back at the end of very year means
these 34 lac is not rupees not going to be withdrawn. That is going to be re invested back so,
when you make the investment in the say the investment in the at the end of the first year will
be 100 plus 34.

So, that amount will be reinvested back and that reinvested will be at the rate of the cost of
the capital, so intermediate cash flows are invested at the cost of capital so, whatever the cash
flows are coming up, next year for example now if you talk about the cash flow coming up is

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32.50 this is the result of the total investment of this 100 plus 34 so these cash flows we are
not going to withdraw we are only simply calculating what is the cash inflow available.

What is the total say return is available so, if you want to find it out, then you have to look at
here is that intermediate cash flows we are not going to withdraw from the project, we are
simply saying that this cash flow will be available and that can be reinvested back into the
business. So, at the reinvested back into the business at the cost of the capital and finally the
all these cash flows can be discounted and their total value can be calculated.

Then is the NPV calculations permits time varying discount rates, NPV calculations permit
the time varying discount rates. Now, it may be possible that because of the say changes
taking place in the time these days, because of the changes taking place discount rates are not
going to remain the same, when we are talking about the discount rate here in this case what
we are say a writing in this model is 1 plus r t.

So, discount rate when we are writing here is a t it means for the whole of the period
foreseeable period of the project may be it is a 4 year 5 year 6 year or 7 years all the say, for
all the cash flows we are going to use the same discount rate. We are not going to change the
discount rate, discount rate in this model is not time varying but sometimes it may be possible
that because of changes of the interest rates in the market because of the inflation in the
market because of other investment opportunities available in the market the, discount rate
the cost of capital also keep on changing also keep on varying.

So, when there is a change in the rate of interest or the cost of capital. So, your discount rate
also has to be changed and when you have to change the discount rate, so there is a little
change in this model and then the model will be something like this how the model will
become.

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(Refer Slide Time: 13:04)

For calculating the NPV the model will become something like this that this is the sigma n
and t is equal to 1, this part will remain the same and then it will be Ct that is the cash flow
over the year t will be say again, what is there in the previous model this is t but, the
denominator will change and this denominator will become something like this that this is the
now the time because, there is going to be the say change in the discount factor.

So, this will become as the j for the year 1 and that is 1 plus r j, j is basically the time varying
discount rate, j is only for the 1 period this r j is basically, this r it is not rt when it is rt, it
means that you are going to use the same discount rate for all the years for which the cash
flows are going to be calculated and discounted.

But when you are using this model you are using now, the rj the discounted rj and j is equal
to 1 it means in the first year this is going to be a discount rate, in the second year the
discount rate may be different, in the third year the discount rate may be different and in the
fourth year the discount rate may be different.

So, when we have the time varying discount rates then, means how to calculate the NPV that
is also possible to be worked out under the this NPV process so for example, I will solve
some small some here, that we have a say project having the 5 years’ life total, and we take
something here we give the shape to this we start from here and here we say that, this is the
current period.

Then, this is the 1 2 3 4 and we call it as say this 5. So, this is the two things are going to be
here we are going to take one is we are going to take is the discount rate, this is the discount
rate we are going to take here as a discount rates and then we are going to take the second

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thing is the investment, this is we are going to take here is the investment, amount that is the
total this, cash flows you can call it as simple investment/cash flows.

So, we take here as the cash flows that will be better to understand this is the cash flows, now
in this first case that is its current period that is 0 period in this period the cash outflow is
taking place here is 12000 that is I put the minus sign here because , it is the cash outflow so
in the first year we are getting the first inflow and at the end of the inflow which is coming to
us is that is the 4000 rupees then we take it here as the 5000 rupees then is the 7000 rupees, in
the third year then 6000 rupees in the fourth year and at the end of the fifth year we are
getting back the 5000 rupees, these are the cash flows available.

For investment of 12000 rupees we are now getting the cash inflow in the, at the end of the
first year 4000, then second year 5000, third year 7000, fourth year 6000, and the fifth year
5000 and mind it, these cash flows are occurring at the end of the period.

Period may be month year or whatever it is, one period is one year for example in this case.
So, it is not occurring in the beginning of the period basically, it is the ordinary annuity I can
say means ordinary this flow annuity I won’t say it annuity but it is like ordinary annuity that
these have say flows so they are uneven that is why I am not calling it as annuity.

There uneven cash flows but they are occurring at the end of the period they are not occurring
at the beginning of the period. So, this 4000 is coming at the end of the first year, 5000 at the
end of the second year, 7000 at the end of the third year, 6000 at the end of the fourth year
and, 5000 at the end of the fifth year, like wise.

Now, will we take the discount rates, discount rate is 14 percent here, then 15 percent here,
then we take the 16 percent here, discount rate then we take here is the 18 percent because,
with the passage of time discount rates are changing it is rather they are going up, and it
becomes here as the 20 percent discount rate.

Now, if this is the case, how to calculate the present value from these say this situation or
from these cash flows. For calculating the present value from these cash flows we can now,
start calculating it, so now the present value of these cash flows we have to calculate and for
calculating the present value of these, present value of the cash flows for calculating the
present value what we have to do is.

Now, the present value of what, C1 cash flow 1 you call it as a C1, cash flow 1 because it is
time varying what is the C1, in the period 1 it is 4000 and what is the discount rate here, the

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discount rate is simply that is 1.14 you have to discount it against the 1.14. So, if you
discount 4000 with the 1.14, this amount becomes a something called it as 3509. 3509 but,
this discount rate of the 14 percent is valid for the current period only, not for the future
period.

Then the present value of the C2, cash flow number 2, if you have to calculate the present
value and what is C2 here, that is 5000 and how will you calculate now the present value for
this, the present value for this, will be calculated 1.14 multiply 1.15.

And then you have to calculate the present value of this amount and if you calculate the
present value of this amount this works out as 3814, then the present value for the C3, if we
calculate what is C3 now C3 is 7000, and if you calculate the present value here, this
becomes 1.14 multiply 1.15 multiply then the next one is how much is 1.16. So, if you
calculate the present value of this amount this becomes 4603, then the PV of present value of
the C4, and if you calculate the present value of C4 what is this C4, 6000.

So, you have to discount it and for discounting again you have to take something like this 1
multiply 1.14 then 1 multiply 1.5 and then multiply 1.16. And then it is the last one is how
much, 1.18 you have to take this so, these 4 you have to take multiplying these and for
calculating these values you will be finding it out the present values like, 3344 will be the
value. Here it is the 3344 is going to be the value and then we can calculate the present values
of the PV of C5.

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(Refer Slide Time: 20:26)

So, it is how much is the C5 here, if you want to calculate the C5 so, value of the C5 is going
to be 5000, this is the cash flow and will be divided by what, it will be divided by 1.14 then it
will be say 1.15, then it will be 1.16 then it will be 1.18 and then it will be 1.20, so it will be
this value will become as 2322 now we have to find out the sum of these values. If we
calculate the sum of these values so, we have to calculate now the.

NPV of the project, NPV of project for calculating the NPV of the project, what you have to
do is, you have to take all the values so what is the first value, first value was 3509 second
value is how much, second value was 3814, 3814 and then the say what was the next value
4603, 4603 and then fourth value was how much, fourth value is 3344.

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This value is 3344, and then it is 2322 and now from these values if you now sum them up,
what is the investment we have made here is, 12000 rupees. Minus 12000 rupees this plus,
this plus, this plus, this plus this minus 12000 rupees so, NPV of the project becomes how
much rupees, 5592 this is the NPV of the project.

It means by making an investment of 12000 rupees discounted value of all the cash flows
available means after adjusting for discounted cash flows calculating the cash flows and
discounting it against the say time varying rate of discount. If you find out the sum total value
of it, this works out as the NPV is the net present value of the project is, 5592 rupees so it
means, means if you want to find out the total amount which is coming back to us that will be
equal to the 12000 plus 5592 rupees that surplus will be available to us.

So, the net present value of this project can be calculated where the discount rate is not stable
is not a one discount rate single discount rate but, it is the time varying. But it is the time
varying discount rate so it means in case of the time varying discount rates you can apply the
NPV and this is one of the important property of this model, where literal change has to be
done, and in this change what we have done is, here it is r t but, now it will not be r t it will be
r j, because for every period the discount rate will be different and how we have to take it, it
has to not to be taken as a single discount rate but, it has to be taken as the product of the two
periods, product of three periods, product of four periods or the product of five periods.

So, that change is there so, NPV calculations permits time varying discount rates they can be
applied here, and then is the say some limitations are also there some when we talk about the
limitations of the this NPV method, first limitation is the scale of investment, and that scale
of investment, I have already discussed with you that how that scale of investment is not
taken care of is, that in this case for example when we are talking about the two projects here
where the one investment we are making 10000 rupees.

NPV is 2500 rupees, second investment is 50000 rupees, NPV is 5000 rupees so we will not
look at the means while evacuating the projects we will only look at the NPV and we will not
look at the scale of the investment. Though there is a 5000 rupees absolute NPV available
from the project B but, the investment also we are making 50000 rupees which is 5 times
more than the investment we are making in the project 1.

So, while making 5 times more investments you are getting the amount of NPV which is just
double of the investment which is being made in the project A, and that is the one fifth of the
investment of the project B.

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So, that we do not take care of sometimes which is the, some major limitation we always look
at the NPV value and that to in the absolute form, and though it has an additive value but,
looking at only the NPV and that two without comparing it with the investment is one of the
say sometimes considered as the limitations of this criterion of the evaluation.

(Refer Slide Time: 25:28)

And then the second is the life of the project, life of the project, is very very important
criterion here, how you can explain it how you can understand the life of the project, which is
a major limitation you call it as say, for example we are making, we are talking about this
project here and this project is requiring the investment of 1 crore.

This 1 crore rupees of the investment we are making in one project and whatever the means
number of years we are calculating the inflows for, that is for the next 5 years 1, 2, 3, 4 and 5

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years because, they are the, there is a foreseeable period as per the information available as
per the data available.

So, we will see there what is the cash inflows available, at this point, at this point, at this
point, at this point and this point. So, you will sum them up, discount them and then finally
the discounted value of all these 5 will be compared with this but it may be possible that this
project is going to have total life of a 20 years, total life of 20 years.

So, it means when the total life of 20 years is going to be there, why do not you take the total
cash inflows of the next 20 years and why only you are restricting your decision or basing
your decision only upon the next 5 years, that is the major you can call it as the drawback of
this method, and this all is not being done because, looking forward in to future for the next
20 years, the sometime does not become possible.

Only we depend upon for decision making under this criterion or any other criteria of
decision making we only take the cash inflows for the period of time which is the foreseeable
period of time which is identifiable period of time and the time which is the total life of the
project.

Since, it is not our hands we do not have the data we cannot look beyond a certain point of
time, maximum you can make it not 5 years but you can go for the 10 years but the total life
of the project is 20 years, you can now look forward that what is going to happen say beyond
10 years, what is going to happen.

Let say 10 years beyond 10 years that is sometime not possible so in this case, you can go up
to 10 years, you can go up to 5 years so this is the major one of important limitation also,
some people say that we should be able to find out the say the total life of the project and the
cash flow should be taken for the whole life of the project not for the only foreseeable period.

So, that is one of the important limitation but, see even say keeping all these limitations into
consideration where there is a scale of investment or it is a life of the project. This criterion is
very important very useful and it helps us to evaluate the different proposals and the decision
criterion is based upon the absolute NPV or the NPV calculated in the absolute value which is
calculated after say subtracting the discounted value of the cash inflows sum of the cash
inflows from the cash outflow and then we try to see that how much is going to be the net
present value available.

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Decision criterion is that if NPV is more than 1 or you call it as positive, then we accept the
project, less than 1 or negative we reject the project and if it is 0, then we are indifferent
whether we go for this investment or we do not go for this investment.

So, this is some discussion about the first discounted criterion of the capital budgeting and
that is net present value method remaining two criteria that is the benefit cost ratio and
internal rate of return, they are also very interesting and useful criteria but those two criteria I
will take up and discuss in the next class, thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 21
Capital Budgeting Part 5
Welcome all. So, in the process of learning about the Capital Budgeting process, now, we are
going to learn about the next method of evaluating the investment proposals and that is the
benefit cost ratio. Benefit cost ratio, we call it as sometime as the PI also profitability index also,
and after this net present value method, we have the one more say option available, one more
method available for evaluating the capital investment proposals and sometimes, when NPV we
are not comfortable with we can have this method also.

So, this is not as good as the NPV method is there but still this method is available. So, being a
student of finance and when we are talking about the capital budgeting or evaluating the capital
investment proposals, we must be aware about that there are three important methods, which are
called as the, say the part of the discounted criteria.

So, NPV we have already talked about at length, we have discussed at length, some questions
pertaining to this NPV and other methods I will do after we complete the conceptual discussion.
So, after having talked at length about the NPV net present value criterion, or the net present
value method under the discounted criterion, now, I will discuss with you the BCR this is the
Benefit Cost Ratio.

Benefit Cost Ratio and net benefit cost ratio, we have the two ratios, we can calculate the two
ratios and we can evaluate any investment proposal depending upon the cost involved in raising
that project that is a cash outflows and the cash inflows coming back. So, means depending upon
this, we can easily evaluate the project any investment proposal, by using this method also.

So, either we can use the say NPV and this method together, or this method and the next method
IRR together that is possible but being a student of finance and when we are talking about the
capital budgeting we must be aware about this method. So, how we evaluate the investment
proposal by using the benefit cost ratio, or profitability index that we are going to discuss here
with the help of this particular example.

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(Refer Slide Time: 02:41)

So, a benefit cost ratio is basically, the ratio between the say you can call it as the present value
of the benefits divided by the initial investments. So, here we have this say, you can call it as the
model which is given to us PVB is basically the present value of benefits.

Present value of benefits means the cash inflows coming over the subsequent years the present
value, discounted value of those cash inflows we have to calculate and then is the initial
investment that is called as the cash outflow.

So, initial investment is equal to hundred percent and the cash inflows coming over the
subsequent years have to be discounted against the cost of capital and finally we have to means
calculate this ratio dividing the sum total of the present value of the benefits with the initial
investment and with the help of that we can calculate this ratio which is called as the benefit cost
ratio and what is the net benefit cost ratio? Net benefit cost ratio is given here buy this model and
this is like benefit cost ratio minus 1, benefits cost ratio minus 1 is known as the net benefit cost
ratio.

So, as in case of the NPV criterion, we are not directly calculating NPV, we are calculating the
PV first, present value first. Present value of the cash inflows or the cash outflows both, present
value of all the cash flows and then when we are subtracting the present values of the cash
outflows then the balance is called as NPV net present value.

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So, what is the net present value? That is the present value of all cash inflows means that is the
discounted value of all cash inflows minus present value of all cash outflows is known as a net
present value. Similarly, this is the benefit cost ratio and the net benefit cost ratio. So, benefit
cost ratio is basically PVB divided by I, Present Value of Benefits divided by the initial
investment and when we have to calculate the net benefit cost ratio.

So, there we simply BCR minus 1 or we means for calculating this whatever the benefit cost
ratio is calculated from that we subtract 1. So, it is called as, this 1 is basically it represents
basically the initial investment because initial investment is consider as 1 and benefit cost ratio is
considered as basically the say, which is calculated based upon the present value of the benefits.

So, BCR minus 1 gives us the value of the net benefit cost ratios. So, two things are there,
benefit cost ratio, the net benefit cost ratio and for understanding the concept of this how we use
this concept or this particular method for evaluating the investment proposal you can just look at
it here.

So, we have written here, to illustrate the calculation of these measures, let us consider a project
which is being evaluated by a firm that has a cost of capital of 12 percent. So, now this is the
information available where we have the initial investment of the 100,000 rupees and then we
have the over the years we have the cash inflows. First year is 25,000, second year is 40,000,
third year is 40,000, fourth year is 50,000.

So, now we have these four inflows, this is the outflow and now we have to make a comparison
of these two and try to find out whether the project is feasible or whether the project should be
taken up or not. We could have used the NPV criterion also that if you discount this and the
discounted value of a sum total of these four is say, from this the initial investment is subtracted.

So, you can calculate the NPV also but we want to evaluate with the help of benefit cost ratio
BCR. So, the benefit cost ratio measures for the this project are given to us here as BCR - benefit
cost ratio here is, 25,000 is a first cash flow and then we have to see here is that is to be
discounted with this.

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So, when we have to discount this, we are discounting it with the help of 25,000 divided by 1.12
and then it is the 40,000 divided by 1.12 power 2 because it is the second year and the 40,000
divided by 1.12 power 3 that it is coming in the third year and then it is the fourth year.

So, it means discounted value if it is coming in the immediate one year, next year. So, it is,
means 1 divided by, the inflow is divided by 1.12 but if the cash inflow is coming two years
later. So, it means it is to be divided by 1.12 power 2, 1.12 power 3 and then divided by 1.12
power 4. So, 0.12 is basically the cost of capital. So, it is basically you understand is 1 plus R.

So, when you calculate this so you can say that the total present value of the benefits we have
already calculated and divided by the initial investment which is in this case is 100,000 rupees.
So, you calculate the final this figure comes up as how much? That is 1.145 this 1.145 is what?
This is called as the benefit cost ratio and in this case we are finding out is that the benefit cost
ratio is more than 1.

So, it means when you calculate the net benefit cost ratio you can say that this is equal to 0.415
so it means from this you have this from the BCR when we are subtracting 1 we are getting
something which is called a 0.145. So, this is called as the net benefit cost ratio. Now, how we
have to arrive at a decision whether the project should be taken up or not?

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(Refer Slide Time: 08:48)

So, for that we have the very clear cut criterion here if we are talking about the BCR Benefit
Cost Ratio or we are talking about the net benefit cost ratio and then we are going to talk about
here is the rule, the rule of thumb. So, whether you are taking the decision on the basis of BCR
or on the basis of NBCR or on the basis of anything else.

So, it means the rule we have to find out is, we have talking in terms of the 1, so BCR if it is
greater than 1 and NBCR is greater than 0. So, what is the rule here? That is accept the proposal,
accept the proposal and similarly, if it is equal to 1 and if it is equal to 0, so what is the case

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here? We are indifferent whether to go for this project or not to go for this project because the
net benefit cost ratio is 0.

So, it means the initial investment, the present value of the initial investment and the present
value of the benefits we are arriving at, means the total cash inflows the present value of those
sum total of those cash inflows, the present value of all the cash inflows and the present value of
all the cash outflows when they are means compared with each other. So, we are arriving at
NBCR net benefit cost ratio is 0, it means there is no loss, no gain.

So, we are indifferent, so it may be possible that in the foreseeable period of next 4, 5 years this
NBCR is coming up as a 0, but when we take the project forward we can say that there will be
some positive NBCR or more than 1, greater than 1, NBCR can be generated. So, that is why we
say, we can take up the proposal or we may not take up the proposal but if we have to not to take
up the proposal then the rule simply says here is that if it is less than 1, and if it is less than 0 if
the benefit cost ratio is less than 1 and the net benefit cost ratio is less than 0.

So, in this case the decision has to be clear cut, it is reject. So, the decision criterion under the
benefit cost ratio depends upon the benefits cost ratio, and the net benefit cost ratio. Benefit cost
ratio revolves around 1 and net benefit cost ratio revolves around 0 and depending upon these
two ratios, if it is greater than 1 and second one is greater than 0, equal to 1, equal to 0, and then
it is the less than 1 and less than 0.

So, one is revolving around 1, another is involving around 0 and on the basis of that we have to
take the accept or reject decision and in between if they are equal to 1 or equal to 0 then we are
indifferent. So, it is a very important simple criterion that we can easily make use of it but largely
it is comparable almost as same as NPV method, but as compared to NPV method this method or
this criterion suffers from certain limitations that is why we do not use it generally.

In the practice we do not use this criterion because largely the process is as same as NPV but if
you talk about the benefits pros and cons, then I think cons are more than the pros. So, that is
why in practice this method is not very much there but yes it is one of the important method in
the discounted criterion along with NPV and the next one which we are going to talk about is the

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internal rate of return in between these two this is the one method and very important method
and very relevant also if you want make use of it we can make use of it.

So, what are the pros? Measures NPV per rupee of outlay this is the most important advantage of
this benefit cost ratio, but how we are calculating it here? Present value of benefits divided by I,
initial investment. It means we are calculating the net present value of the project, or from the
project per rupee of investment because we are dividing it by the whole investment.

In NPV we subtract the initial investment from the sum total of the discounted value of all cash
inflows, the present value of the cash outflows is subtracted but in case of this ratio present
means benefit cost ratio here we calculate net present value, present value benefits means
basically it is the present value.

So, NPV when you calculate or the net present value when you calculate, for example we have
calculated here net benefit cost ratio that is BCR minus 1 it is basically NPV. So, we are
calculating this and calculating NBCR is possible with the help of BCR.

So, BCR is calculated per rupee of investment, so, per rupee of outlay. So, it means in that case
the NPV of the project is possible to be calculated per rupee of investment which is not possible
under the net present value criterion. But the cons are very serious here and very even call it as
say, creating the serious issues here that provides no means of aggregation.

For example, when we were talking about the NPV. So, if you are, we are talking about say
taking of some investment proposal which has smaller parts A, B and C. So, if you want to make
investment of say 10 lakh rupees. So, for that 10 lakh rupees we have three different projects we
can take up, where the 5 lakh can be invested here, 3 lakh can be invested here, 2 lakh can be
invested here. So, it means that way means we do not have the bigger project, one bigger project
of investing 10 lakh rupees together but we have the smaller projects. So, we want to invest total
10 lakh rupees or 1 million rupees.

So, we can say what we can do is, we can calculate this NPV of A, NPV of this B and NPV of
this C and what we can do is we can sum it up and when you sum it up you can compare that the
total investment is 10 lakhs and what is NPV available here. So, it means aggregating say,

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properties are there in the net present value method as we discussed in the previous class which
is not there in the benefit cost ratio.

So, this is the one important limitation of this method and when cash flows occur beyond the
current period means you cannot take into account the cash flows occurring beyond the current
period. For example, this current period is a foreseeable period, any cash flows when they are
occurring beyond the foreseeable period, beyond the current period they are not taken into
account.

They are not taking into account so these are not taken into account even in the net present value
also but still the net present value we go far beyond but here when you talk about the cash flows
occurring beyond the foreseeable period they are not taken into account.

So, it means present value of benefits and the benefit cost ratio when we calculate, we calculate
it on the basis of whatever is the readily available information that is with regard to the cash
outflow and the cash inflow. So, if the inflow is available for the next 4 years, we are taking into
account 4 years, or 5 years, we are taking into account 5 years but what about the next 5 years?
For example, the life of the project is going to be say 10 years, or 15 years. So, we are not, means
taking into account the total period.

So, this is one important limitation, this limitation is second one is there in the NPV also but in
the NPV the aggregations property is there. So, you, if you do not want to make total investment
into one bigger project you can divide it into the smaller projects, some can be expansion,
diversification, different kind of the projects can be taken up. So, or there may be a company that
want to introduce a new product they can introduce a 1 or 2 products or they can introduce 1
product only.

So, depending upon the opportunities available it will be better for the company to invest into
new two to three products. So, that even one fails, other two survive, but if the entire investment
is invested into one project and that project does not work well, then what will happen?

The entire investment will go down in the drain and that will create a serious problem. So,
aggregation we want many times that we do not want to put all our apples in one basket. We
want to means have different baskets and different investment opportunities available.

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If you want to tap them then by investing the fractional amount, part of the amount into the
different smaller projects, you can aggregate them and aggregated NPV can be calculated which
is the facility available into the NPV method but not under the benefit cost ratio but the major
advantage here is that you calculate the NPV per rupee of investment but because of the lack of
aggregations property, or aggregating property we do not use this measure and we only take the
very limited values that is only for the foreseeable period not for the remaining period.

So, that is also one important limitations which is common with NPV but the aggregating
property is a very big property which is there with NPV and which is missing in the benefit cost
ratio or in the profitability index. So, this is one method, but still because we should be knowing
being a student of finance that this is the one important criterion in the discounted criterion. So,
that is why I could discuss it with you means at length.

(Refer Slide Time: 18:30)

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Now, we go to the next and the third important criterion and that is the very very important
criterion, internal rate of return. If you talk about the limitations, there are so many limitations
under the internal rate of return also but it is most preferred method out of the three methods
given in the discounted criteria. Three methods given are net present value, benefit cost ratio, and
internal rate of return.

This is the most preferred and usable method of discounting or calculating the discounted cash
flows for any investment proposals or evaluating any future investment proposals. So, why,
means it is a million dollar question?, that why it is so popular even as against the NPV method?
This is because it gives you the estimates in the percentage terms.

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It gives you the rate, internal rate of return in the percentage terms which is not possible in case
of NPV, NPV gives you the absolute value. So, when you make, want to make any comparison
because if we talk about the inflation we talk in terms of the percentage, we talk about the
interest rate, we talk in terms of the percentage, we talk about the growth rate, we talk in terms
of the percentage.

Similarly, when you are talking about the internal rate of return available from any your project
or investment proposal and even your cost of capital is also in terms of the percentage terms so
comparing two percentages is much better as compared to comparing one the percentage and
second is absolute value that is sometime its difficult.

So, internal rate of return though it has many limitations it is cumbersome some times to make
use of this method but it is the most widely used method because the viability of the project is
interpreted in the percentage terms. So, here how it works, the internal rate of return and what is
a major benefit amongst the present value method and the internal rate of return method?

The basic difference is, the basic difference is that under the net present value method, the
discount rate is given to us. For example, we have a certain information about the cash outflow,
then for the cash inflows over the subsequent number of years and it is always given to us that
the cost of capital of the firm is 12 percent, 15 percent, or 10 percent.

So, that discount rate, the cost of capital is basically what? That is the discount rate, when you
use the formula that is CT divided by 1 plus R. So, what is R there? R is basically the cost of
capital and it is given to us. So, we against that cost of capital using it as a discount rate, we
discount the cash inflows and finally we arrive at the discounted value of the future cash flows.

But in case of the internal rate of return this rate is not given to us the cost of capital is not given
to us, discount rate is not given to us, cost of capital is there that we can find out but the discount
rate we do not use as a cost of capital. We have to find out the discount rate that R is missing in
this internal rate of return, R, we have to find out that. Under this internal rate of return what we
do is, we try to find out that the, say, there is the present value of cash out flow and it should be
equal to the present value of cash inflow.

(Refer Slide Time: 21:58)

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So, it means, what will happen? Present value of the cash outflow is equal to present value of the
cash inflow, what is NPV? NPV or net present value is going to be 0 here. For example, the
present value of the cash outflows is 1 lakh rupees and the present value of cash inflows is also 1
lakh rupees.

So, what is NPV? NPV in that case is 0, so we want to find out the rate of discount which is
called as internal rate of return at which we can discount the future cash flows or cash inflows at
a certain rate of discount after which the sum total or the aggregated value of discounted cash
inflows is equal to the present value of the cash outflows.

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Means we have to find out that rate of discount where the NPV is 0, where the net present value
is 0 where the present value of the cash outflow is equal to the present value of the aggregated
cash inflows.

There that rate is consider as the internal rate of return, means that, that is the minimum rate we
want, that at least whatever the investment anybody wants to make in any investment proposal
that should be recoverable and for that means first our focus is on the recovery of the investment,
later on if in the subsequent years also if further surplus cash flows are available then that is the
surplus value that is the you can call it as additional return available on that investment.

But first we want to calculate that if I am investing 100,000 rupees in any investment proposal,
first my objective is in how many years I am going to get that investment back, that is the say
focal point under the payback period method also and that is a focal point under the NPV also,
and that is a focal point under the IRR also and same is the case with the benefit cost ratio also.

As I told you that in case of the benefit cost ratio what decision we take? We are indifferent here
as this level, we are indifferent means when the benefit cost ratio is equal to 1 and the net benefit
cost ratio is equal to 0 or in other way round you can call it as NPV is equal to 0 it means we are
indifferent, it means we can go for it or we cannot go for it.

But I am saying we are in different here when this NPV is 0 up to the foreseeable period but
what about the remaining period or the life of the project? If the project is going to last for the
number of say 5 more years or 10 more years then whatever the cash flows are coming back they
are going to be the above returns.

So, internal rate of return is that rate of return where the present value of the cash outflows is
equal to the present value of all cash inflows put together. Present value of all cash inflows put
together is equal to the present value of the cash out flow, that rate of return is called as the
internal rate of return.

(Refer Slide Time: 24:43)

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So, it means, it is written here also the internal rate of return IRR of a project is the discount rate
that makes its NPV equal to 0, it is represented by the point of intersection in the above diagram.

Now, we have this above diagram here, we are taking on this X axis we have taken the net
present value and on the, this Y axis we have taken the discount rate. So, if you for example, if
you have this discount rate here may be the NPV can be something up to this but when you
increase the discount rate.

Now, we are going to increase it will come down, when you increase up to this it will come
down and when you are up to this point of intersection the NPV is this, it means NPV at this
point is 0. If you further keep on increasing the discount rate it will become negative. This NPV
will become negative.

So, it means we want to arrive at this rate, we want to find out this rate where the net present
value it means we simply are concerned that we want to recover our investment made in the
project. We are only concerned up to that particular period of time, beyond that the remaining
life of the project is certainly going to give us the cash inflows and that is going to add up into
the positive NPV.

So, in how many years I am going to get back, the company is going to get back their investment
that is the first important point and that we have to find out the discount rate which is not given

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to us and for that finding out that discount rate we have to use one method which is known as the
Trial and Error method.

Trial and Error method, for example, in this structure if you use this particular discount rate your
NPV will not be 0 but will be more than 1, more than that, if you further what you have to do is?
Higher the NPV you have to further increase the discount rate so then the NPV will come down.
The moment you keep on increasing the discount rate NPV will come down. So, lesser the
discount rate NPV will be high, and higher the discount rate NPV will be low.

So, you have to increase the discount rate, so NPV will further come down and finally we have
to find out that rate which is the one which is making the present value of the cash outflows
equal to the present value of all the cash inflows put together. So, NPV at that point has to be 0
and the method we have to find out is because we do not know whether it is 10 percent, 15
percent, 12 percent, or 18 percent.

So, how to find it out? You have to try different rates, and under the trial and error method, by
using the trial and error method you have to follow this process and the rate which gives us the 0
NPV that rate will be called as the internal rate of return available from the project.

So, in this case before going it further we can talk about the two methods, net present value
method, and internal rate of return method, if you make a comparison between these two, so
what is the basic difference? Net present value method what says? Assumes that the discount rate
cost of capital is known and we are given there also, we have seen in the problem we did that the
cost of capital is the discount rate and that is known to us.

In this also cost of capital is known to us but the say, discount rate that we are not satisfied with
that means we do not want to go for that discount rate. We want to see that or even if we apply
the say, cost of capital rate here, for example our cost of capital is 15 percent and we discount the
cash flows with the 15 percent it may be possible NPV is not coming 0. So, we have to increase
it. It may become 18 percent or may be 20 percent and 20 percent NPV become 0 so it means we
are not talking in terms of the cost of capital.

There, it is a decision criteria that our cost of capital is 15 percent, the internal rate of return
available from the project is 20 percent so it is very good, go ahead but that is also not the basis,

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cost of capital is not used here as the basis or the criterion whereas in the NPV this is used as the
basis or the criterion for discounting the cash inflows. Calculates the net present value given the
discount rate. So, whatever is the discount rate or the cost of capital is given to us using that we
discount the cash inflows over the number of years.

So, we write cash flow divided by 1 plus R power the number of years, if it is the first year no
power, then second is power 2, three years power 3, four power 4, power five. So, that with the
NPV process goes on, whereas in case of the internal rate of return what is there? Assumes that
the net present value is 0, it means that rate we want to find out that we want to make the net
present value means the between two outflow and outflow.

The present value from the total of the net present value, present value of the cash inflows minus
present value of the cash outflows NPV is 0 and figures out the discount rate that makes net
present value 0. We, have to find out that rate which makes a net present value 0 and that is
possible by trial and error method, we do not know which one is exact rate. So, for finding it out
you have to apply different rates and that rate which makes it say, equal to 0 both the values one
minus other that is known as the internal rate of return.

(Refer Slide Time: 31:16)

Now, for example we talk about here is the calculation of IRR, you are given the three different
proposals. So, we are applying the three discount rates here and what is the amount given to us is
we are given here the years 0 to 5 years are given to us. We are given here the cash flows that is

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minus 100 and then the cash inflows, subsequent cash inflows are given to us for the next 5
years, 1 to 5 years.

And then we are given the discount rates, one is the 20 percent, second is the 24 percent and then
the third is 28 percent. So, these discount rates are given to us, when we discount these particular
cash flows of this series of the cash flows with the 20 percent discount rate NPV comes up as
15.88. So, this is the positive NPV, we are not satisfied with this rate because under internal rate
of return NPV has to be 0.

Then we increase the discount rate. When you discount the rate from 20 to 24 percent, again the
cash flows remaining the same, years also remaining the same, but the discount factor changing,
present value is changing, still the NPV is coming up is 5.13 which is more than 0. Then we went
ahead and we increase the rate from the24 percent here to 28 percent here and when you apply
the 28 percent discount rate we could find out that this NPV is minus 4.02.

So, it means now it is clear that your discount rate lies somewhere between this and this, it is
somewhere between 24 percent and 28 percent but we do not know what is the exact rate ,
whether it is 24 percent or whether it is 28 percent, because at 24 percent NPV is positive, and at
the 28 percent NPV has become negative. So, it can be 25, 26, 27. So, we have to find out that
exact rate, we have the method also for finding out that exact rate.

So, how to find out that exact rate means what is the process of finding out that exact rate, we
will discuss that also we will learn about that also and for that I will discuss with you the process
of finding out the exact discount rate, there is a method, there is a process. So, means at least we
could discuss till now that 24 and 28 the rate is here, but finding out the exact rate of discount or
may be how to find it out what is the process for that? What is a method for that? That I will
discuss with you in the next class.

At the moment I will stop here and we could discuss two important things, benefit cost ratio and
we just began the discussion on the internal rate of return, but this is not the end of the internal
rate of return, it is very peculiar method, very very important method. So, remaining part of
discussion with regard to internal rate of return I will have in the next class, till then thank you
very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 22
Capital Budgeting Part 6
Welcome all. So, we are in the process of learning about the internal rate of return and till the
previous class discussion we could discuss that internal rate of return can be calculated by
discounting the cash flows against a certain rate which can be calculated with the help of a trial
and error method.

And we were talking about this particular situation that in this case we have the inflows and
outflows and when we are discounting it under the different rates means we tried first 20 percent,
then we tried 24 percent, still the NPV is not coming down to 0 and when we increased it straight
away from 24 percent to 28 percent then the NPV became negative. So, it means the idea we
could get here is that the internal rate of return in this case is somewhere between 24 percent and
28 percent.

(Refer Slide Time: 1:27)

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Now, how to calculate the exact rate that was the question we left the discussion in the previous
class. And here it is the process for calculating the internal rate of return which is the exact rate if
it is between the two rates. Because it is very common that any rate of interest cannot be
certainly absolute rate that 12 percent or 13 percent or maybe 15 percent. It sometime say,
something like that 12.37 percent, it can be sometime 12.54 percent or it can be 14.13 percent.

So, it is possible that because we are not talking about anything which is decided in advance that
internal rate of return depends upon the cash inflows available from a particular project
comparing those inflows with the outflows, so when you compare the inflows with the outflows
and vice versa you can come out with any rate and that rate does not mean to be in the absolute
value all the times, it can be somewhere in the fractions also.

So, when you are talking about this if we have seen 24 and 28 we have found out here is that
now the formula is given to us, what is the formula, smaller discount rate, smaller discount rate
in this case is what? That is 24 percent where the NPV is 5.13 it is not 0, but it is more than 1.
So, smaller discount rate plus NPV at the smaller rate, NPV at the smaller rate is 5.13 and
divided by the sum of the absolute values of the NPV at the smaller and the bigger discount
rates.

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So, sum of the NPV, so what was NPV there? You have to simply forget the sign, the sign was
there was minus 4.02. So, you have to forget this sign, this sign is negative sign that we are
getting the negative NPV minus 4.02, so you have to forget that while summing it up.

So, in this case, we are finding out the NPV at the smaller rate plus sum of the NPV at the two
rates, you can call it as smaller and the bigger rate. So, at the smaller rate it is 5.13, at the bigger
rate 4.02, it was minus 4.02, but simply forget this sign, multiply it by the bigger discount rate
minus the smaller discount rate.

So, what is a bigger discount rate? 28 percent, smaller is 24 percent. When you solve this entire
process, this comes out as 5., first of all you calculate the ratio of the smaller value to the sum of
the two and then you multiply by this and then you will get something.

For example, in this case what we have got here is? We have got here is 24 plus 2.24, we have
got is 2.24. If you solve this, if you first of all calculate this ratio and multiply then by 4 that ratio
multiplying with the help of that ratio the difference of these two and that comes up as the 4
percent. So, the value must have come up as 2.24.

So, it means the total interest rate which comes up here as this 26.24 percent, if you use the 26.24
percent for discounting of all these cash inflows here and say comparing it with the present
values of the cash outflow NPV will certainly be 0, you can apply the check also. So, if we apply
the check and we use the 26.24 percent as the interest rate certainly the NPV will become 0.

So, now I will discuss here with how this entire process works, it is in a very summarized form
given here, but we will do a problem and then we will try to learn that how this say discount rate
can be calculated in a situation particularly when the exact internal rate of return lies between the
two absolute values say discount rates, if it is to be in the fractions how to calculate that.

So, what we are doing here is, for example, there is a project and it has the foreseeable life of 4
years, so we make investment in the say 0 year in the current period which is 0 and say 4 inflows
are available first at the end of the first year, second at the end of the second year, third at the end
of the third year, fourth at the end of the fourth year. So, if you have the 1 outflow and 4 inflows
and if we have to find out the internal rate of return, we do not know the cost of capital at what
we should discount them so that the NPV becomes 0.

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So, if we have to find out the internal rate of return from that kind of the inflows and comparing
them with outflows how to do this process and if particularly the discount rate falls between the
two absolute values then how to calculate it in the exact in terms of the say, absolute plus from
fractions.

(Refer Slide Time: 6:15)

So, we are taking here is as the in this case for example we take here is as years and then we take
here is as the cash flow. So, years are 0, 1, 2, then it is 3 and then it is 4 these are the 4 years and
cash flow when we take here is as in the 0 year the cash flow, out flow is going to be 1 lakh
rupees that is 100,000 I am putting in the bracket because it is negative.

So, in the first year, at the end of the first year we are getting back how much? 30,000 rupees, in
the end of second year also we are getting back 30,000 rupees, then we are getting here as the on
the third year we are getting 40,000 rupees and then we are getting here as back as 45,000
rupees. So, this is the out flow and these four are the inflows available.

Now, making these two equal to each other in terms of the present value if you want to make
them equal to one in the present value. So, it means how we can do that, for doing it we have to
now discount it against a certain rate and for discounting against a certain rate we will have to
now find out that discount rate.

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So, how can you do it? So, normally the formula here is we are going to find out the normal
formula is for discounting this is the putting the cash out flow on this side. This is rupees 1 lakh
has to be equal to how much? This is the first inflow, this is 30,000 and it has to be discounted
against something which is known as 1 plus r because it is only 1 year.

So, it is only you can call it as, put it as a 1 also but sometime we not put anything which means
1, then second is plus 30,000 second year and here again we have to discount it against this 1
plus r power 2 because it is for the 2 years period. Discounting is for the 2 years period of time.
Then in this case you have to is 40,000 and you have to discount it 1 plus r power 3 and then it is
45,000 and discount it with the something which is known as 1 plus r power 4. So, you have to
now discount it against a certain discount rate r which is not known to us.

So, now we will be doing it, if you start doing it, for example, we assume this r is say in this case
if you take the r you can take it as 10 percent, 15 percent, 16 percent or anything. Let us take it
here is as the 15 percent. So, if you take it as 15 percent so what will you do is 30,000 divided by
1.15 power 1.

And in the second case it is 30,000 we have to take this as 30,000 and divided by 1.15 power 2
this is one. I think this has become something else. So, you may not misread it. So, I will make it
again 1 so this is 1.15 power 1 then this is 1.15 power 2 30,000 plus, 40,000 divided by 1.15
power 3 and then plus 45,000 divided by 1.15 power 4.

And we have to now calculate make it equal to this the discounted value of this equal to 1 lakh
rupees or the 100,000 rupees. So, if you say, discount these cash flows so this will become
100,000 is equal to a 100,801. This value of all these total calculation if you do it this value
becomes 100,801 rupees.

So, if you calculate the NPV what will be the NPV here? If you calculate the NPV, NPV will be
rupees 801 which is greater than 0, in this case it means NPV is positive greater than 0 it means
this discount rate of the 15 percent will not do, you have to, now what you have to do is. Since
because the NPV is positive it is 801 it is positive not 0 it is more than 1.

So, in this case what we have to do is we have to now to reduce the NPV value from 801 to 0 we
have to increase the discount rate and if you increase the discount rate maximum what can you

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do is? You can make it something you increase it by 1 percent and if you increase it by 1 percent
it will become say for example 16 percent.

(Refer Slide Time: 11:05)

So, what it will become like? 1 lakh is equal to first year cash inflow is how much? 30,000, so
you discount it against 1.16 power 1. Second is 30,000, then it is divided by 1.16 power 2, then
plus 40,000 divided by 1.16 power 3 and then it is 45,000 and divided by 1.16 power 4. We have
increased the discount rate and once you calculate it this becomes something like 1 lakh is the
out flow this is equal to 1 lakh and this value comes up as 98,636 rupees.

This is rupees 1 lakh is the investment and it is rupees 98,636 is the discounted value of all the
cash inflows, when they are discounted at the rate of 16 percent. So, it means now there is a gap
when you calculate this so you can say NPV at 15 percent is how much? That is 801 and NPV at
16 percent is how much? That is minus 13 this is this minus this is how much it comes up as?

This comes up as 1364, this is negative, one is positive, one is negative it means the internal rate
of return from this project is IRR in somewhere it is 15 percent and 16 percent but exact we have
to find out our job is to find out the exact discount rate and that has to be say somewhere
between 15 and 16 percent and we have to find out this. Now, how can we find out this we have
a process for this.

(Refer Slide Time: 13:17)

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So, first of all say, what is the process involved in this? The process involved in this is, the first
step is calculate NPV at different discount rates. So, this is the first step which we have already
calculated and when we calculated the NPV at this, at one it was 801, in the second case it was
1364 and that was negative. So, we have calculated. This is the first step in calculating the exact
internal rate of return which will be making the NPV 0.

And the step number two is now you sum it up. If you sum it up what you have to do is you have
to sum it up and what is this, this is 801 plus the now you have to again forget the sign, it is
minus 1364 but forget the sign and you make it 1364. So, this will become how much? This will
become as 2165.

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And in this case it will be something like this now just let us call back, this is the say, formula
which we are going to make use now and when we are making use of this so we have calculated
the sum and now after this we have to calculate now the ratio, first of all we have to calculate the
ratio. So, ratio of this is 801 divided by 2165 and this ratio comes up as how much? This ratio
comes up here as 0.37, 0.37 percent.

So, what was the formula? Formula was smaller interest rate that is 15 percent. I am taking you
back to that formula 15 percent smaller discount rate where the NPV is positive and that is 15
percent in this case and then plus, we take it as plus 15 percent plus this ratio, this ratio is going
to be how much? 801 divided by 2165, this ratio became 0.37 here this ratio is this much and
multiply it by, multiply it by what was there? Say, bigger discount rate where the NPV is
negative minus smaller interest rate where the NPV is positive.

So, bigger discount rate where the NPV is negative has become negative that is 16 percent in this
case and the smaller discount rate where the NPV is positive 15 percent. So, this becomes 1, if
you try to find out so what will be here? Finally, the interest rate, exact rate of discount or the
discount rate in this case will be how much? 15.37 percent, this will be known as 15.37 percent.

So, very simply, in a very simpler manner you can easily calculate the discount rate and if you
calculate this discount rate 15.37 percent because we were calculating here 15 percent is giving
you a positive NPV 801 and at 16 it becomes negative 1364, minus 1364 it means we are sure
about that discount rate at which the NPV between the two cash flows will become 0 that is
somewhere between 15 and 16 percent.

So, to find it out there is a process so we could see the process with the help of this formula also
this model is given to us and simply by applying this model you can find out the say the exact
discount rate, but if you want to know the process that how it all has happened. So, what you
have to do is? You have follow the three important steps.

First step here is calculate the NPV of the smaller discount rate and the bigger discount rate
means where it is positive, and where it becomes negative, two discount rates. Second step then
you sum them up all the, both the NPV positive as well as the negative, ignoring the negative
sign and you calculate the sum total value which is 2165 in this case. At the step 3 you calculate

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the ratio between the say two say NPV, one is NPV at the smaller rate of interest, and second is
the means the denominator has to be the sum of the two that is NPV at the smaller discount rate
and the NPV at the higher discount rate.

So, that is a step number 3 calculate the ratio between the NPV at the smaller discount rate and
the sum of the two NPV. So, you calculate this ratio, this is the third step and after this you place
all these values in the formula. So, it means what will be there? Lower discount rate, the lesser
discount rates, smaller discount rate at which the NPV is positive plus that is ratio and multiplied
by the say bigger discount rate, higher discount rate minus smaller discount rate.

So, you multiply that ratio with the difference of these two and add it up into the discount rate
which is coming up or which is a smaller discount rate. So, finally you will be able to find out
the exact discount rate, if you discount. Now, for example, in this case if you discount all these
cash flows at the rate of 15.37 percent certainly this NPV that is the 1 lakh 100,000 cash out flow
will be equal to the 100,000 of the cash inflow some total of all the inflows if discounted with the
help of 15.37 percent then some total of all the 4 cash inflows will be equal to the 100,000
present value of the 100,000.

So, 100,000 cash out flow and 100,000 is the discounted value of all the total four cash inflows
put together, summed up at the rate of, discounted at the rate of 15.37 percent will be 0 and that
is the objective that is internal rate of return we want to find out and that is how we can do it. So,
we can, where means in one go if we are able to find out as absolute rate 15 percent, 16 percent,
17 percent, fine, very good, but in there is any problem or the rate is coming between 2, it means
it has to be infractions 15.37 percent, 15.40 percent.

So, for that purpose calculate two NPV at the smaller and the higher rate of interest and with the
help of this model you can find out the exact rate. So, in this case we have found out the exact
rate 15.37 percent and we have explained the steps also how to do it. First of all calculate two
NPV, then you sum them up then you calculate the ratio between the sum and the smaller NPV,
means NPV at the smaller discount rate and then you apply all the values you put into this model
that is smaller discount rate plus the ratio between the two and then multiply it by the difference
of the two discount rates.

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You will find out the exact, in this case we have found out is 26.24 and in the our new means this
other problem which we did here we have found out is it was lying somewhere between 15 and
16 and when we applied this concept it is clearly found out as 15.37 percent.

So, exact internal rate of return can be found out with the help of this say process, so ultimately
what is the internal rate of return at which the net present value of the two cash flows, out flow
and inflow, the present value we are talking about becomes 0 where the NPV becomes 0 that rate
of return or that discount rate is called as the internal rate of return. How you have to take the
decision, whether to accept the project or you not to accept the project by using the internal rate
of return.

Simple here is the that you compare the internal rate of return available from the project against
the cost of capital. For example, our cost of capital is 13 percent and the in this say calculation
we did our internal rate of return available from the project is 15.37 percent accept the project
because IRR is greater than the cost of capital.

But if the reveres happens that the cost of capital is 16 percent and IRR available is 15.37 percent
then you reject the proposal that is not possible and when it is equal, it means the cost of capital
is equal to internal rate of return again we are at the state of say indifference we can a go for it or
we may not go for it.

Then the decision will depend upon that this IRR we are calculating which is making its IRR
equal to the cost of capital just on the basis of the foreseeable cash flows but if we talk about the
future cash flows which we are not now taking into account. So, if you take those into account at
the latter stage it may be possible that internal rate of return say, becomes more than the cost of
capital.

So, it means we have to decide on the basis of that but if it is more than the cost of capital, clear
cut decision go for it, but if it is less than that simply reject it, if it is equal then we are at the
point of indifference. So, this is the basically the internal rate of return and the decision criterion
depends upon the comparison between the cost of capital and the internal rate of return.

Now, there are some problems with the IRR which should be clear about and what are the
problems because those are best criterion means I told you that as compared to NPV benefit cost

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ratio hardly we use. Either we use NPV or we use IRR but still IRR is much say highly used rate
of return as compared to the NPV and for that purpose say, means still some limitations are there
but we should be clear about that though we are using IRR at the say best possible extent or in
most of the projects but still some limitations are there what are those limitations?

So, that if we know the limitations associated to IRR will be probably in a better position to use
this particular criterion of say discounting the cash flows or calculating the net present value or
evaluating the capital budgeting proposals.

(Refer Slide Time: 23:36)

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So, first limitation is first problem is the non-conventional cash flows. Now, what is the non-
conventional cash flows? This is the non-conventional cash flow, here now, what is a non-
convention, here it is the cash out flow minus 160 for hundred sixty thousands then is a cash
inflow 1000 and then it is the again cash out flow. So, one is cash out flow, cash inflow, cash out
flow, this is not a conventional cash flow.

In the conventional cash flows what happens? First we have the cash out flow in the first or
second year or in the initial period and after that there is no cash out flow, total cash out flow in
the present period in the current period and over the subsequent years there are only inflows. So,
that is a conventional.

But when it is non-conventional it means you have first out flow, then inflow, then out flow,
inflow it means regularly the investment is required to be made it is not one time investment, it
has to be made regular investment time and again we have to make investments and inflows are
also coming and out flows are also going. So, in that case it becomes the unconventional, non-
conventional cash flow how to calculate the internal rate of return.

Now, in this case for example, if you discount these cash flows you are getting two discount
rates 25 percent and the 400 percent, means at this point also here NPV 0, at this point here NPV
is 0, which one out of the two you have to accept? That is a problem because here we have non-
conventional cash flows. So, two IRR is coming up, one is 25 percent and other is 400 percent, at
this point also NPV is 0, then it starts going up and further it comes down at the 400 percent also
this NPV is becoming 0.

So, it means because of this basic limitation what we have to do is that we have to now find out
that which discount rate to use it is not possible whether to go for 25 percent or to go for the 400
percent that creates the problem. So, this is a first important limitation of the internal rate of
return which reduces its use.

(Refer Slide Time: 25:45)

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Then second is the mutually exclusive projects. For example, there are two projects under NPV
how we evaluate the projects, under NPV we simply evaluate the projects on the basis of the
NPV higher the NPV better the project. Though there is a also a limitation there that we do not
make the relative comparison, relative comparison in terms of the investment.

Sometime as I gave you the example in some previous class while talking about the NPV that in
one project the NPV is 2500, but the investment is 10,000 and in the other the NPV is 5000 but
the investment is 50,000 but under the NPV criterion we will accept the project which is given
you the NPV of the 5000.

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So, we are not comparing there the projects with the investment with the outflow. So, that
limitation is also there but here in this case mutually exclusive projects for example, now this is a
situation. We have got project P and project Q two projects are here. Two projects are here and
in these two projects, here one is giving a cash outflow 10,000 and then this is the cash inflow
20,000 and then if you calculate this the second one is 50,000 cash outflow, and inflow is 75,000
C1 in the say, year 1 and at the end of the first year.

IRR is coming up here as 100 percent and this is coming up as 50 percent. Whereas, when they
are discounted at the rate of these cash flows are discounted at the rate of 12 percent which may
be the cost of capital. This comes up as this and this value comes up as this.

Now, under the internal rate of return criterion project P is better because it is giving you the 100
percent IRR, under the NPV criterion for example, if you look at this is giving you the better
return that is 16,964. So, though there is a limitation the NPV also that here the you are getting
the higher NPV but the investment is also very high, here you are getting lower NPV so
investment is also low.

But in this case mutually exclusive projects which are giving you lower NPV means the
limitation here is the projects which give the lower NPV sometimes IRR selects them indicating
that here the internal rate of return is higher as compared to the other project which is giving you
the higher NPV but the IRR coming up is the lower. So, it means in this case we are proving it
that though the NPV is lower as the 12 percent but the internal rate of return is 100 percent.

So, that limitations is with both the method because they are not comparing it with the
investment here, but say if you look at the say your NPV criterion then the project Q is better
under IRR project P is better whereas NPV under the project or from the project P is in the
absolute value is lesser than the much lesser as compared to the project in the say as compared to
the project Q.

So, this limitation is there that sometime say you can call it as not very clear results are there,
confusing results are available because of the say lack of clear cut values/interest rate, so internal
rate of return coming up comparable with the net present value. So, this is a second limitation.

(Refer Slide Time: 29:07)

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And lending and borrowing, next thing is now you look at this situation if you look at this
situation here. Now, this project is we are investing 4000 and the internal rate of return available
is 50 percent, here we are borrowing 4000 same amount and the internal rate of return is 75
percent.

Now, if we do not know the background and means not make the entire analysis in the light of
the total information available. So, what we will do? We will take a decision in the favor of
project B that the project B is better as compared to project A because project A’s IRR is 50
percent and project B’s IRR is 75 percent.

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So, we will go for the project B, but you see the meaning of it is clear from these two values, this
value and this value, here you are investing and the internal rate of return from that investment is
50 percent, here we are borrowing and this rate is not say, the rate of return rather this is a rate of
payment. This is the borrowing rate and this is the lending rate. So, we are lending at the rate of
50 percent. So, we are earning this return and we are paying this cost here.

So, it does not differentiate, it only gives you certain percentage and in this case it is 50 percent,
75 percent. So, it is does not differentiate whether it is a lending rate or a borrowing rate so you
have to have a complete background information available for arriving at a very logical
conclusion. So, that confusion is always there with the internal rate of return.

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(Refer Slide Time: 30:51)

And one more limitation here is that is with regard to the difference between the short-term and
the long-term interest rates. Sometimes what happens because for the short-term borrowing
interest rates are different and the long-term borrowing interest rate are different. So, it means
which cost of capital you have to take as a common denominator to compare the internal rate of
return because cost of capital changes.

So, when you change the cost of capital for the short-term borrowing , because both the funds are
invested in the business, funds from the short-term sources are also invested, funds from the
long-term sources are also invested and because of the term structure of interest rate these days
the moment say maturity of the loan increases or the borrowing increases, interest rate goes up.

So, here cost of capital is one is lesser, another is more, so which one to means take as a base rate
for comparing the internal rate of return that also is a confusion, but I tell you one important
thing here despite all these limitations, all these short comings internal rate of return is the much
preferred way of or the method of evaluating capital investment proposals or the capital
expenditure proposals.

And as compared to NPV it commutates the better results or means results in the sense that when
you talk in the percentage terms, because all other comparable items are in the percentage terms,

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inflation is in the percentage terms, your interest rates are in the percentage terms, your growth
rate of any organization is in the percentage terms.

So, since this internal rate of return is also in the percentage terms and it is comparable to the
cost of capital which is also in the percentage terms and. So, despites two, three important
limitations associated to this method, this method is more in use is in (())(32:38) as compared to
the net present value method because there you get the result in the absolute value. Sometime
the comparison of the absolute value with the percentage becomes difficult.

So, if it is both the things cost of capital and internal rate of return if both are in the percentage
terms it is the better way of comparing of two things and if facilitates a better comparison. So,
this is the process of internal rate of return and this is how we can make use of this criterion, this
method.

So, here now the question arises is there any improvement over the internal rate of return which
can be done or these limitations which are associated to the internal rate of return, can these
limitations be removed? Is there any method, is there any way out available for that? Yes, the
way out is available and these days rather than using the simple internal rate of return we use the
modified internal rate of return which we call it as MIRR.

And with the help of MIRR, most of the limitations of this that non-conventional cash flows
problem can be tackled there. Mutually exclusive projects can be also taken care off because
under the MIRR the results of MIRR and of the NPV are comparable they are almost same and
there the problem of lending and borrowing also does not come into the picture and since we get
only one interest rate.

So, one discount rate, so short-term and the long-term say interest rates problem is also resolved.
So, we have some solution but ultimately it is a internal rate of return whether it is internal or it
is modified internal rate of return. It is a much better criterion as compared to the NPV because
the modified internal rate of return can be calculated in the form of the percentage terms.

So, what is a modified internal rate of return, how to calculate that and how to take decision with
the help of that with regard to the acceptance or rejection of a one particular capital investment
proposal that I will discuss with you in the next class. Thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 23
Capital Budgeting Part VII
Welcome all. So, in the process of learning about the capital budgeting process, now we are
moving towards the completion on discussion of this particular topic or in this particular
concept. But still we have some two, three important things to be discussed or to be known
about.

And another important thing which I am going to talk to you about is that in the discounted
criteria, we discussed the three methods till now that is NPV, Benefit Cost Ratio and the
Internal Rate of Return, and in the previous class itself we discussed that the internal rate of
return, though it is very good, very appreciable mode of evaluating the capital investment
proposals. But it has some inherent limitations and these inherent limitations are in terms of
non-conventional cash flows or mutually exclusive projects how can you evaluate them?

(Refer Slide Time: 01:18)

Or whether the rate given by any evaluation is the lending rate or the borrowing rate and
sometimes we have the different rates of interest like short term and long term borrowings
interest rates are different?

So, there are some inherent limitations of the internal rate of return. So, if these limitations
are there then it creates the problem or it creates the handicaps while using the internal rate of

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return as the, say very important discounting criteria or the discounted criteria for evaluating
any capital investment proposal.

So, in that case to remove those limitations or to do away with all the limitations of the
internal rate of return we have one more way of evaluating the proposals.

(Refer Slide Time: 02:06)

Capital investment proposals or the new projects with the help of not IRR but with the help of
MIRR. MIRR is basically the Modified Internal Rate of Return. So, we can say, calculate the
internal rate of return which is considered as a modified internal rate of return, not as a pure
internal rate of return and for calculating the modified internal rate of return we have to
follow certain processes or certain steps.

And these steps are required because, one major limitation of the , IRR was that if there are
the non-conventional cash flows, especially that when the cash outflows occur not at one
point of time but at the multiple points of time then how to take care of that?

And because normally in the NPV we consider that outflow occurs in the 0 period of time or
in the current period and inflows occur over the subsequent years where as in case of internal
rate of return also we are considering that outflow is occurring only at the current period of
time and inflow is occurring over the subsequent years, the future years. So, if that is the case
that is the conventional cash flow.

But the non-conventional cash flow is that when the cash outflow occurs time and again. So,
as we have seen the first year there is cash outflow, then inflow then outflow, so we have to
calculate now there some values of those outflows which are occurring, because one outflow

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is occurring at the 0 period, then other is occurring at 2 years down the line, then 3 years
down the line so it means we have to count for all those.

So, we will have to apply the concept of not internal rate of return but the modified internal
rate of return and if we apply the modified or we use the modified internal rate of return so
what we can do? We can take care of the, cash outflows also at the multiple levels, at the
multiple points and inflows are automatically taken care of. So, we can follow the process
and we can calculate the MIRR.

So, we have explained it with the help of this particular structure, Modified Internal Rate of
Return and in this case what we are assuming here is that the outflow is occurring not at the 0
period but at the, this is the 0 period and the outflow of this 120 lakhs or the crores is not
occurring in the one period, in the 0 period but in the next year also.

In the year 1 also there is outflow and again the 80 crores are going out. So, you are investing
the total sum of 200 crores at the 2 different points or the in the 2 different years, in the
current year as well as in the, in the next year, in the first year also there is outflow because
building of the project takes time. And inflows start coming after that.

So, after that second, third, fourth, fifth and sixth years, the inflows are occurring and these
are the inflows which are coming back to us. But what is happening? These inflows are again
reinvested back into the business. Nothing is taken out of the business. They are again
reinvested back into the business.

So, there is a clear-cut demarcation that the first two years, 0 and 1 year there is a cash
outflow and then the subsequent 5 years there is inflow so total 6 years of the life of the
project is given to us. Whereas in case of the IRR what was given to us is that only cash flow
is occurring in the 0 period.

After that the subsequent years, first year onwards till the sixth year or fifth year or fourth
year there are the inflows. So, it means outflows are not occurring at the future points or at
any future year and very generally you can think about, that outflows occur at the different
points of time in future also because sometimes the maintenance of the project is required,
sometimes the up keeping of the project is required.

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So, you need to spend money on running the plant or equipment properly or efficiently. So,
all the times it does not happen that in the 0 period only once you construct the plant and then
you keep on using for the next 10 years that does not happen.

Sometimes we have to incur the capital expenditure, revenue expenditure we have to incur
every year no doubt about that, but capital expenditure also we have to incur sometimes, may
be some part of the plant goes out of order. So, you have to change that, you have to replace
that with a new component. That is a capital expenditure.

Or sometimes to say, keep it going on we have to maintain it. So, we maintain the capital
expenditure. So, this is a very practical situation that capital expenditure does not take place
only in the first year or in the current period but sometimes in the future years also.

Even once the project has started working or the plant has been commissioned, after that also,
first year you use the plant for the one full year. Second year also we use the plant for one full
year. Third years we need to, say invest something in terms of up keeping maintenance or
may be any other kind of expense for up keeping, for maintenance or any other kind of the
expense that has to be incurred and for those expenses if they are large in the quantum then
they are called capital expense.

So, it can occur means you incurred the expense for the first year. We used a plant for two
years and then third year we have to incur some huge expenses and then the inflows again
start coming up. May be sometimes we have to shut the plant for maintenance and that
remains shut for days together, so and when any expenditure is incurred for maintaining the
plant that expenditure is called as the capital expenditure.

So, outflow is there, means very natural it is that outflow also occurs and after the inflow has
started coming in, so how to take care of that? So, there we go for the modified internal rate
of return. In this modified internal rate of return we have to follow certain steps.

First step here is that we have to calculate the present value of the cost. All the outflows
which are occurring at any point of time, we have to calculate the present value of all those
outflows and their present value has to be worked out and for calculating the present value of
those outflows we have to follow certain process.

And when we follow certain process, because in the 0 period, in the current period whatever
the investment we are making that is equal to 100 percent, but in the subsequent years when

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we are incurring any further investment so that investment which will be incurred 3 years
down the line, may be in the third year, so it means in the third year investment is going to
incur but what is the present value of that cost?

So, we have to calculate the present value of the cost and then at the same time we have to
calculate the present, say this terminal value of all the benefits. This is the second step that
whatever the benefits are going to be there in this case.

For example, this is the project. In the first year there is a cash outflow of 120 crores. Second
year also the cash outflow of 80 crores is taking place. So, total investment we have made in
the first two years and that is to the tune of 200 crores and after that next second year
onwards there are the inflows coming up.

But the 20 crores which we earned, which is the inflow in the second year, this is reinvested
back. Then in the third year we got 60 crores, reinvested back. Then 40 crores, reinvested
back, 100 crores in the fifth year, reinvested back and in the sixth year, that 120 crores inflow
is available.

So, when this amount is getting reinvested back what you have to do is you have to calculate
all these terminal values, add the discount rate of the 15 percent and we have to calculate the
compounded value of the future benefits. We have to compound them.

So, now because we are reinvesting them back. So, it is not discounting. This is the process
of compounding so we have to compound them at the cost of capital or the rate of interest
which is expected to be available. So, it means when we are going for compounding it means
that 20 crores which is earned in the second year reinvested back for 4 years and after
compounding it becomes 34.98 crores.

Then at the end of third year any amount which is earned i.e. 60, reinvested back at 15
percent, this amount becomes 91.26 crores, and then 80 crores which is earned in the fourth
year and reinvested back into business at the 15 percent compounding, it becomes 105.76.

Then the 100 crore earned that becomes 115 crore after one year, at the end of the sixth year.
And then sixth year whatever the amount we are earning as a cash flow that is 120 will be
120. So, if you sum it up that becomes a terminal value, means at the time when the project
will be terminated, at that time whatever the terminal value of the benefits is available, that
will be calculated and summed up.

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This value is with us that is the 467 which we have calculated and in this case when you try
to find out here the total amount which is available after calculating the terminal value that is
467 crores.

Now, we have to calculate the present value of this. 467 crores which is going to be earned
over a period of 6 years we have calculated and when we discount this 467 crores we have to
calculate the present value of the terminal value.

So, first we calculated the present value of the cost and that present value of the cost is 189.6.
So, what we have done is we have taken the 120 as 120 for calculating the present value of
the cost but the remaining is, that is the 80, if you discount this 80 at rate of 15 percent for the
period of 1 year this amount becomes here as 69.6.

So, 120 plus 69.6 becomes 189.6. So, against the total investment of the 200 crores we are
making if you calculate the present value of that cost that works out as 189.6 crores and when
you calculated the present value of all the terminal value of all the cash inflows coming over
the subsequent years reinvested back and compounded at the given cost of capital.

So, the total terminal value becomes 467 as a result of the calculating the future compounded
value so this becomes 467 and when you discounted it at some rate just to make it equal to
189.6 so that the NPV becomes 0 here so that MIRR has come up here as the 16.2 percent.

So, when we have discounted it, this 467 has become 189.6 at the 16.2 percent. So, modified
internal rate of return available here from this project is the 16.2 percent. I will explain it to
you further in a more transparent as well as in a better manner how this all works.

(Refer Slide Time: 14:20)

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So, for calculating the Modified Internal Rate or Return MIRR you have to follow certain
steps and then will do one problem also, so that the entire process is clear to you.

There are different steps are involved, so step 1 is first of all you have to calculate the
present value of the cost. So, whatever the cost we are incurring at the different points of
time, we have to calculate the present value of the cost.

Cost means the investment we are making in any project over the different durations. It may
be in the current period, it may be in the third year, it may be in the fifth year so current
period is equal to 100 percent but the investment made over the subsequent years has to be
discounted back and we have to sum it up so that the present value of the total cost can be
calculated. So, this is the first step.

Then is the step number 2, now we have to calculate the terminal value TV of the future cash
flows which are expected from the project.

So, for calculating this PVC, Present Value of the Cost you can calculate like this, sigma total
number of years which is the life of the project and t is equal to 0 and here you have to take n
sigma t is equal to 0 and you have to take the cash outflow occurring over the number of
years and this we are taking here the t, that in which year the cash flow is occurring, and then
it has to be discounted for 1 plus r power t.

So, with the help of this model, present value of the cost can be calculated. So, for example
cash outflow occurring at the year t, if it occurring in the 0 period, so the value will be equal
to 100 percent. If it is occurring in the third year, the year t will become year 3 so cash flow

383
occurring in 3, so you have to discount for 3 years. If it is taking place in the beginning of the
third year you have to discount it for the two years i.e. first and the second .

So, you have to take that say, t value and after this you have to calculate the terminal value of
the future cash flows expected from the project and for that what you have to do is, this is the
model here, that is the sigma n, t is equal to 0 again and then it is the cash inflow which is
occurring over a period of time or cash inflow over the number of years and you have to
calculate the terminal value.

So, you have to calculate the future compounded value of these expected cash flows and this
is n minus t, total number of years n , means the life of the project for which the cash inflows
are occurring and t is that particular year for which the compounding of the cash flow is
taking place.

So, if you are taking say, in the third year it will be 3 as total number of years are 6, it will
become the 6 minus 3, so it means the power accordingly you can work out. So, the power 3
will become here. So, we have to calculate the terminal value of all these, means after
compounding it at the given cost of capital or the rate of return, you have to compound the
future cash flows expected from the project and then you have to calculate the step number 3.

Step number 3 here is, calculate the MIRR, Modified Internal Rate of Return and for
calculating the modified rate of return you have to use this model, PVC is equal to TV
divided by 1 plus MIRR power n. This is the model with the help of which the MIRR can be
calculated. This present value of the cost we have already calculated, this is with us, then the
terminal value of all the future cash flows with the help of compounding we have done.

It is available with us and then only this thing we have to find out, so if you know this value,
if you know the number of years then easily the MIRR can be worked out after solving this
this model. Let us now do a problem so that you are very clear about that how we can
calculate the modified internal rate of return.

(Refer Slide Time: 19:43)

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For example, we have here 6 number of years. We take here as the years, and years here are
0, 1, 2, 3, 4, 5 and 6. Now, we talk about the cash flows. These are the cash flows in the 0
year, 120 crores we are investing here, then it becomes the, minus 80crore in the first year.
So, these are the two outflows.

So, this is the demarcation clear here. And the inflows coming up here are 20 in the second
year, 60 in the third year, then it is the 80 in the fourth year, then it is 100 in the fifth year
then is 120 in the sixth year. So, these are the inflows occurring.

385
(Refer Slide Time: 20:38)

So, means the entire thing what we have done here is I have shown in the particular
calculation, I am doing it now personally and then we will show it how this entire calculation
will work and will be giving us the results.

(Refer Slide Time: 20:58)

So, now what you have to do here is, in this case first of all we have to calculate the present
value of the cost. And the present value of the cost can be calculated how?

386
(Refer Slide Time: 21:04)

We have seen here the in this formula we have (())(21:05) to calculate the present value of
the cost we have to use this cash outflows over a period of t and then divided by 1 plus R
power t the number of years. So, in this case if you try to calculate the present value of the
cost, so how you can do it, that will be possible that 120 is 120 in the current year in the 0
period.

And then plus and what is it, next cash flow is 80 but we are investing 80 when? at the end of
or during the first year. So, this means this is the 80 and 80s value which is going to take
place after 1 year is not 80 it is something less than that, so we have to discount it and we are
discounting means we are assuming here as the cost of capital is equal to 15 percent.

387
So, that is why I am discounting it with a 15 percent 1.15, so 80 divided 1.15. So, if you solve
this so this becomes how much? 120 plus 80 discounted at the rate of 15 percent this total
amount becomes means 120 is 120 plus this amount becomes as 69.6 80 has come down to
means 80 invested after 1 year is equal to 69.6 of the current value and if you calculate this
this amount becomes here as 189.6 crores and this is the total investment we are calculating.

So, we have calculated the first thing here which is given to us in the model that is the present
value of the cost we have calculated. Now, we will go for calculating the terminal value of
the cash inflows which is occurring from the second year onwards.

We have to calculate the Terminal value of the cash inflows here, so what we are getting in
the first year is 20 and compounded with the cost of capital of 1.15 and number of years are
how many, if you are investing at the end of the second year.

So how many years are left 1, 2, 3, 4 so the power here will be the 4 then plus 60 into 1.15
power will be 3 because 60 crore inflows will be only for 3 years because only 3 years left
now.

Plus the remaining amount here is 80, so, 80 into 1.15 and power here is 2 as you are
investing this amount only for the 2 years plus the compounding for the this 100 which is in
the next year has to be done for how many years? The compounding of this has to done only
for 1 year.

So, it is 1.15 and last amount last cash inflow that is of the 120 crores is equal to 120 crores
because it is occurring at the end of the sixth year and you are going to terminate the project
now. So, this value of the 120 crore will be equal to the 120 crores, so if you solve this you
will find out the values here, these values are going to be 34.98 crores then this going to
become 91.26 crores.

Next value is going to become 105.76 crores, this value is going to become 115 very clear
and this value is already 120, these values are available, so it means our next job is to
calculate the MIRR Modified Internal Rate of Return, and which will be calculated how?

It will be calculated with the help of this model that is PVC is equal to TV divided by 1 plus
MIRR power n. So, for calculating this, now what you have to do is, PVC. Present Value of
the Cost is how much? Present Value of the Cost is 189.6 and that is equal to how much? If
you calculate this total sum this total sum becomes how much?

388
If you total this up, this becomes 467 crores. So, this is the present value of the cost and this
amount is 467 crores divided by 1 plus MIRR power number of years are how many? If you
take here as the MIRR is going to be the 6.

So, this is the total number of years are 6. It is, now the finally we have put the values in the
model, 189.6 is equal to 467 which is the terminal value of the benefits, this is the present
value of the costs 1 plus MIRR power 6. If you solve this, so this will become something like
this, how it will be?

(Refer Slide Time: 26:15)

It will be 1 plus MIRR, power 6 is equal to this if you subtract this, this value will come as, if
you divide 467 by 189.6, so this value will become 2.463. So finally it will be 1 plus MIRR is
equal to 2.463 but now the power will become because it has come this side, 1 by 6 and if
you resolve this, this amount will become how much? 1.162.

So, this is equal to, means this is the 1 by 6, if you calculate it, 2.463 power 1 by 6, this will
become 1.162 and finally if you want to calculate from this calculation the MIRR you can say
that is 1.162 minus 1 is equal to 0.162 and if you convert that into the percentage term so you
call it as it is 16.2 percent. So, MIRR Modified Internal Rate of Return available from this
project is the 16.2 percent.

(Refer Slide Time: 27:45)

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And that is what we have calculated here. If you look at this entire say, structure here, this
pictorial presentation here, we have calculated the present value of the cost. So, how this
189.6 is calculated? 120 is taken as 120 and the remaining 80 which is invested in the next
year so they are discounted for 1 year so total value becomes, discounted 80 at 15 percent
becomes 69.6.

So, total becomes 120 plus 69.6 becomes 189.6 we have seen that how it has been worked
out. Then we got all the cash inflows over the subsequent years and when we say, calculated
the terminal value, means after compounding these cash inflows against the cost of capital or
using the cost of capital as the rate of return, so we compounded them that is the 15 percent.

So, we found out the total terminal value i.e. 467. Total amount is the 467 we have found out,
and then we had, means calculated the present value of the terminal value. In this case we
have calculated the present value of the terminal value. If you calculate the present value of
the terminal value then at the 16.2 percent it will become equal to 189.6 and this is the
present value of the cost, this is the present value of the terminal value, so finally the NPV is
0.

So, means ultimately we want to find out that rate of return where the, say present value of
cash outflows is equal to the present value of the cash inflows. So, 16.2 percent is the internal
rate of return which has come up as the discount rate at which we are going to discount the
terminal value of the, cash flows, terminal value calculated on the basis of compounding of
the cash inflows.

390
If you are going to discount it for the 6 years at the rate of 16.2 percent going to be equal to
189.6 percent and NPV is going to be 0. This is one way of means doing the things, you are
looking at the things but I have explained it to you how this entire process has worked.

(Refer Slide Time: 29:56)

Here we have taken the same example here again back. Cost of capital we have taken here is
that is 15 percent. The cost of capital we have taken here is again 15 percent. So, if you look
at this, COC Cost of Capital it is 15 percent so it means number of years we have taken is 6, 0
to 6 cash flows we have taken, first two years we have taken as the, outflows, 120 and 80 and
remaining 5 years we have assumed there are the inflows.

Then we followed the same process. We calculated the present value of the cost which
became 189.6. Then we got the terminal value of cash inflows which finally, total amount
became 467 crores. Then we applied the model of the MIRR which I just discussed with you
and that model is, that is the present value of the cost is equal to the terminal value divided by
the 1 plus MIRR power the number of years that is 6.

And then when you solve this entire process, we got here some value and that value was
0.162 and in the percentage terms it comes out as, that is 16.2 percent. So this calculation has
helped us find out something which is called as modified internal rate of return.

So, if you have this modified internal rate of return of 16.2 percent then whatever the
investment we are going to make here, this investment of 200 crores which is now finally
after discounting has come down to 189.6 crores will be the total future value of all these

391
cash flows which is coming and when after calculating the terminal value when you discount
that terminal value of the future cash flows then that value is 467 crores.

If you discount it as 16.2 percent, say in term rate of return, then it will be equal to 189.6
crores so present value of the cost is 189.6 crores. Present value of the, say the benefits which
are available from the project, means all the inflows, present value of all the inflows is equal
to the 189.6. So, outflows value is equal to inflows value, discounted value of the outflows is
equal to the discounted value of the inflows and finally the NPV available here at this rate of
16.2 percent is 0.

So, it means we want to find that rate in the internal rate of return also where the, the NPV of
any project becomes 0. We want to find out that. So, the limitations of internal rate of return
can be done away with the help of the modified internal rate of return. Process is little, say
cumbersome, little tedious but it is a very good solution and all the limitations which are
there, all the shortcomings which are there in the internal rate of return, they can be done
away by using the concept or the method of the modified internal rate of return.

So, with discussion I complete the discussion on the discounted criteria where we discussed
three methods but in fact four methods. One was the net present value method, then was the
benefit cost ratio, then was the internal rate of return and because of limitations of the internal
rate of return we have to sometimes use the modified internal rate of return.

And when we use the modified internal rate of return, all the limitations, shortcomings of the
internal rate of return can be done away, and internal rate of return is the largely used way of
comparing any capital investment, other with the inputs, with the outputs and for evaluating
the capital investment proposals as compared to the other two criteria.

Internal rate of return is widely used because it is in the percentage terms and comparison of
any return available from any investment with other important parameters like growth rate of
the project, the rate of interest in the market, the inflation rate is possible.

That is why, internal rate of return being in the percentage terms, we largely make use of it.
This is the most widely used mode of evaluating the, or discounted criteria of evaluating the
capital investment proposals. These are the three methods.

After this I will have some discussion on the non-discounted criteria where I have discussed
already, some part of that with you, just I have given you a feeling about that what are the

392
non-discounted criteria. These are the two, payback period and accounting rate of return. So,
a detailed discussion about the non-discounted criteria I will have in the next class. Thank
you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 24
Capital Budgeting Part VIII
Welcome all. So, in the previous class we discussed in detail the modified internal rate of
return. So, before we move to the next part that is the non-discounted criteria, that is payback
period and the accounting rate of return, I would like to throw some light on the positive
points or strengths of the modified internal rate of return.

Though I have discussed at length in the previous class but still some more points came to my
mind that how it is a better rate of or better measure of the project profitability or may be the
better criteria of discounting the cash flows or may be evaluating the capital investment
proposals.

Some important points are here worth discussing so I thought I must share with all of you.
So, first important point as given here is that is MIRR is superior to the regular IRR in two
ways.

(Refer Slide Time: 01:16)

How it is superior? Number 1, project cash flows are reinvested at COC, not at the any other
rate of return, means when you talk about the internal rate of return we assume that the
project cash flows are reinvested back at the internal rate of return available from the project,
whereas in case of MIRR we talk about the cost of capital and whatever the cash flows are

394
available from the project, they are reinvested back as the cost of capital. That is why you
might have seen that when we calculated the terminal value.

(Refer Slide Time: 01:53)

They are at the cost of capital and we have shown here that 15 percent is the cost of capital.
So, this is one important thing. In IRR we reassume that, the cash flows are reinvested back at
the internal rate of return available from the project. So, second important thing is it gives us
the better profitability because then you compare the return available with the cost of capital
because that is the ultimate objective that as a investor, anyone expects that the rate of return
available from the project should be at least equal to the cost of the capital or the cost of the
borrowings.

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So, when you compare the rate of return available with the cost of capital, it means the better
profitability is reflected from any project rather than simply, finding out the rate where the
present value of the cash outflows is equal to the present value of the cash inflows. Then
multiple rates do not exist in MIRR.

This is another important property that you have only one cost of capital, not the multiple
rates. In case of the NPV also we have seen the multiple discounting rates are there, or they
keep on changing. We have assumed one thing that if the multiple rates are there in NPV that
for example, discount rate changes in the year one, in the year two, in the year three or not at
least in all the regular years but one after the another year, may be after the gap of one year
when the discount rate changes, then there is a problem.

Similarly when you calculate the IRR then you try multiple rates means with the help of trial
and error method you try to find test multiple rates and only one rate we have to find out and
with the, for the precision we have to now use that further more you can call it as the
precision formula, so that for example if it is coming in fractions, 16.5 percent.

So, 16 and 17 we can calculate but to make it 16.5 percent or 16.4 percent we have to use
another formula. So, multiple rates, means the trial and error method is not required while
using the modified internal rate of return. So, that is another property.

Second important point is it is a distinct improvement over IRR. So, is it as good as NPV in
choosing mutually exclusive projects? It is a very important consideration here, is very
important question also, that certainly we say that it is improvement over the IRR.

So, is it as good as the NPV in choosing the mutually exclusive projects because mutually
exclusive projects you cannot select with the help of the simple IRR. It is possible to select or
take a decision with regard to mutual exclusive projects with the help of NPV but IRR, means
that was the major limitation of the IRR that in case of the mutually exclusive projects we are
not able to find out which one is better. So, that was the important limitation in that IRR
process.

So, once we have replaced the IRR with the MIRR, now the question arises, is it better than
NPV? because in NPV also mutually exclusive projects can be chosen and with the help of
MIRR also the mutually exclusive projects can be chosen. So, here are the two important
points to be borne in mind. If the mutually exclusive projects are of the same size NPV and
MIRR lead to the same decisions irrespective of the variations in the life.

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There can be variation of life, one is having the foreseeable life of 4 years, another is having
the foreseeable life of 5 years, another is having the foreseeable life of the 6 years, but the
size is same in terms of the investment we are going to make, may be the life of the projects
is different.

Both the criteria’s, MIRR and NPV are going to give us the same results that which one is
better out of the two, out of the three, yes it is applicable. But if mutually exclusive projects
differ in size then conflict may arise in decision, because one is requiring different amount of
investment, another is requiring different amount of investment. Then yes, then the MIRR
may give the different results, NPV may give the different results.

So, if the size is same, life is different both are replaceable with each other, NPV and MIRR,
but if the size is different then we cannot use MIRR in the same way as we can use NPV, so it
means the results will differ. So, these are the two important conditions here. And third
important point here is, finally we can say that MIRR is better than the regular IRR in
measuring the true rate of return.

However for choosing among mutually exclusive projects, it’s advice here, however for
choosing amongst the mutually exclusive projects of different size, NPV is a better
alternative in measuring the contribution of each project to the value of the firm.

Different sizes of the mutually exclusive projects are there then you always use the NPV
criterion though MIRR is better improvement oblique IRR but NPV and MIRR will give the
same results in case of the mutually exclusive projects if the size is same, investment size is
same.

If the investment size is different, overall size of the project is different then always it is
advisable that we should use the NPV criterion, not the MIRR criterion but in other cases
MIRR is a better option as compared to the internal rate of return and easily we can replace
the IRR with the MIRR and especially in the projects where the cash flows are non-
conventional.

Means at the different durations the cash outflows are occurring, automatically cash inflows
occur at the different duration but outflows are also occurring at points more than one, at
points more than one then certainly we should make use of the MIRR because that limitation
of IRR not allowing to use IRR in case of the projects having the non-conventional cash
flows is done away with the help of MIRR.

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We can easily calculate the say, with the help of modified internal rate of return, the projects
having the non-conventional cash flows can also be evaluated? So, this is all about the
discounted criteria where we discussed largely three methods NPV, benefit cost ratio and
IRR. MIRR is improvement oblique of the IRR.

So, but in the real practice we use either the NPV or IRR, benefit cost ratio because of
number of its limitations, because you cannot aggregate the projects of the smaller values or
the smaller projects put together done at the same time by the firm. If you want to club them
together and evaluate then the total investment is not possible. Aggregation is not possible.

Though it is giving you the better estimates in terms of that it evaluates the present value of
benefits against each rupee of investment but it is not much in use. Only either we use the
NPV or the IRR criterion, so then we talk about the MIRR also, that is also in the normal
layman language we call it as that, sometimes we use NPV, sometimes we use IRR, but IRR
because being in percentage terms is more wider in use as compared to even NPV. So, this is
all about the discounted criteria.

Now, we move forward with the next part and some discussion on the non-discounted
criteria. Whatever the three methods we have discussed till now, NPV benefit cost ratio and
the internal rate of return, they pertain to the discounted criteria, and now some discussion
upon some of the methods which pertain to the non-discounted criteria.

So, these are the methods like payback period method. First is the payback period method
and one more method under the non-discounted criteria is the accounting rate of return. So,
everything is given here about the payback period method, how it has been done or it is
normally used, everything, pros, cons and some positive points, reasons for the popularity of
the payback period, everything is given here in this slide, means at length. So, what is the
payback period? Payback period is the length of the time required to cover the initial outlay
on the project.

(Refer Slide Time: 10:58)

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We are only concerned with the recovery of the initial outlay which we are going to make in
the project and that is also the major limitation of the payback period because payback period
is only limited up to that much number of the future years where we are going to recover the
initial investment. Once the initial investment stands recovered then further beyond that any
amount of the cash flows are available, we do not pay much attention towards those cash
flows.

So, we are only comparing how much cash outflow going to take place over the number of
subsequent years, future years, how much cash inflow is going to be there and then we try to
calculate the sum total value of those future cash inflows and where, those the value of those
cash inflows is equal to the cash outflows we say this is the payback period.

After that how many years life is there, how many cash inflows are going to be there, we do
not pay much attention to those subsequent cash inflows coming over the subsequent years?
So, here for example we have explained with the help of this example that we have got here
the 4 years, period of time 0 to 4 years and then we have got the cash flows.

In this year we are going to make the cash outflow of 100 crores. This project requires the
cash outflow of 100 crores and then over the next 4 years, we are going to have the cash
inflows. In the first year, at the end of the first year the cash inflow is 34 crores, second year
32.5 crores, then 31.37 crores and 30.53 crores.

Now we have to calculate the payback period. It means we are only concerned about this
particular part, 100 crores investment which we are making in the current period we want to

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recover that. We want to recover that investment and over the subsequent years when we are
finding out the cash inflows available this information is available.

So what we do is we now move to the third column and third column is cumulative cash
flows. When you go to the cumulative cash flows so what we see? We are now going to say
that first we had minus 100, then plus 34 it means when we recovered out of 100, 34 so now
the cumulative value has come down to 66 crores which need to be recovered.

Then minus this much, so now the amount remains to be recovered is 33.5 crores, then
amount remains to be recovered is 2.13 crores. So, it means in the first 3 years, first, second
and third year larger part of the amount is recovered. Only at the end of the third year 2.13
crores are required to be recovered, which are recovered in the beginning you can call it as
the fourth year.

So, in this case for example if you find out then the payback period at max you can say is the
four years for this project and, the total amount which we invested, first year we are going to
recover the 34 crores, then we are going to recover 32 crores, then we are going to recover
31.37 crores and remaining balance, this amount becomes how much?

This becomes is 7, so yeah remaining balance somewhere you call it as 2.13 crores that is
recoverable from the cash flow coming from the fourth. So, it means maximum you can say
the payback period of this project is 3.5 years or 3.25 years or if you do not want to calculate
in fraction so you can say as a rough estimate that maximum within a period of 4 years we
are going to recover the total investment made here, that is of the 100 crore Rupees.

So, payback period for this investment of 100 crores is 4 years? But the major limitation here
is that as compared to the discounted criteria which we discussed earlier the three methods,
now the major limitation of this non-discounted criterion is we do not discount these cash
inflows. 100 is equal to 100, fine but remaining these four cash flows, they have to be
discounted against the time value of money.

So, this criterion, payback period is of that time, olden time when the concept of time value
money was not there in practice. People never recognized this money has the time value. So,
when this was not in practice, time value of money concept was not in practice we were using
even years and this method is ages old, we were using at that time also.

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So, payback period method, because of being very old, the oldest one in the evaluation of the
capital investment proposal methods so we are not discounting it. But this limitation also now
these days has been done away and now we have started using the discounted payback period
method.

Maximum what you can do is, you can add one more column here and for the given cost of
capital we can discount these cash flows and then we calculate the discounted payback
period. So, that is also possible. So, that limitation of the payback period also has been
removed now but if you know the payback period in the beginning as the first method then it
was considered as a non-discounted criteria and most popular non-discounted criteria or the
method is the payback period method.

Now, we talk discuss some important points pertaining to this. In this case two points are
important or to be taken into account. First thing is the constant cash flows. So, if you have
the constant cash flows, constant cash flows means here we have the cash flows which are
different. At the end of the first year it is 34, then it is 32.5, then it is 31.37 and then it is
30.53.

(Refer Slide Time: 16:59)

Constant means that if you have for example the cash flows of 25000 each or 25 crores, total
investment we are making in any project is for example 1 lakh rupees. And in the next 5
years you are getting constant cash inflow, you are getting every year the same, cash inflow is
constant which means it is 25000.

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So, what can you do is simply you divide this 100,000 by 25000 and it comes up as simply it
is the 4 years. So, easily it can be worked out, means, if the cash inflow is constant over the
subsequent years, every year we are going to get the same amount back, then for getting the
payback period simply divide the cash outflow with the constant value of the cash inflow for
1 year and you can find out that easily the payback period can be worked out?

(Refer Slide Time: 17:54)

Second thing is specification of the maximum payback period by the firm. Normally what
happens, that every firm specifies the normal payback period, that maximum we have 1 crore
Rupee available or 100 crore Rupees available for the period of 4 years. That is pre-specified,
normally.

If it is done, if in any case, if it is pre-specified how many years you can spend these 100
crore Rupees? For 4 years. Then you try to find out that investment proposal where the
payback period of that total project is 4 years. So, if it is pre-specified then easily we can
make use of the payback period because we know for how many years we can spare this
investment.

We have to find out a proposal which has a normal life of that much number of years. So,
both, if are comparable we can, with the help of the payback period method we can means
easily find out those kind of the proposals where the investment can be made. At the end of
that given period of time, pre-specified period of time, the investment can be liquidated.

So, either you have already known those specified years or you have to specify it. Both ways
it can be done and if we are able to do it, for example we have the 4 years specified period,

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we can evaluate the proposal. If any proposal is going to give us the total investment back in
4 years we are happy. We can go and make the investment, means in that proposal or in that
particular project. So, these two important points are to be born in mind that constant cash
flows and specification of the maximum payback period by the firm. This can be done. These
points are very helpful.

Now, we talk of the pros and cons of the payback period method. Pros are, it is very simple,
and anybody can very easily use it, provided you have the cash flows. If you have the cash
flows information, both cash outflow and cash inflow then it is very easy to use.

Second, rough and ready method for dealing with the risk because risk comes up with the
uncertainty, it is associated to the uncertainty and uncertainty comes up with the future course
of action. How many years the project is going to last?

So, if you want to minimize the risk from any investment proposal then our objective should
be to recover any investment made as early as possible. The recovery of our principal
investment should be as early as possible, so with the help of the payback period we can find
out the payback period.

So, we are going to evaluate the project proposals which are going to give us the shorter
payback period. In one case it is a limitation also, that is only concerned with the recovery of
the investment, nothing else. It does not take into account the future cash flows after recovery
of investment. There is a limitation also but the, say if you want to minimize the risk we
should be knowing that I am making investment today and in how many years I am going to
get back the investment.

So, that project which is giving you the minimum period, number of years, future number of
years, 4 years, 3 years, 5 years, there the two proposals, one is going to give you the return
back in 6 years, one is going to get your return back in 4 years. So, the project which is going
to return your investment back in 4 years is going to be the better option. So it means rough
idea of managing the project risk because longer the duration of any project, higher will be
the uncertainty and higher will be the element of the risk. So, we want to minimize that.

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Third is, emphasizes on earlier cash flows, it means we are concerned about the early
recovery of investment so we are more concerned about the earlier cash flows. We are not
concerned about the later cash flows.

So, it means how quickly we are able to recover, and because of that say you can call it as
unaware manner, we can say we are talking in terms of the time value of money because
delayed recovery of any investment reduces the value of the investment or that inflows
coming up. So, early recovery means the value of those inflows is going to be much higher as
compared to the inflows coming at the later date or the later time. So, these are three positive
points.

Cons are, limitations are fails to consider the time value of money. That is clear we have
already discussed it. But that limitation has been removed now. That now we can have the
discounted cash flows also. So, it can now be part of the discounted criteria also but largely
we consider it as a part of the non-discounted criteria. So, this is the limitation.

Ignore the cash flows beyond the payback period. I discussed with you number of times that
it is only concerned, for example in this case about, it may have the life of further subsequent
years also, here 3 more years or the 4 more years. We are not concerned about these 4 more
years. We are only concerned about that in how many years we are going to get these 100
crore rupees back and subsequent cash flows we are not concerned because it is payback
period. In how many years our investment is going to come back to us.

It is a measure of project's capital recovery, not profitability. It only helps us to find out the
recovery of the capital that in how many years my investment is going to come back, not the
profitability whereas in case of the NPV method what is the net present value? Net present
value is the surplus available after recovering the initial investment by way of the inflows.

Because there evaluation criteria is what? The evaluation criteria is that the higher the NPV
better the project is. Minimum it should be 0, but higher the NPV we accept the project,
lower the NPV we not go for it. And mutually exclusive projects also when we want to select,
we also base the selection on the basis of the NPV.

So, that is quite possible because an NPV is basically, in a way you can call it as the
profitability. Similarly, the benefit cost ratio, the name itself is the profitability index. And in
case of the internal rate of return also we talk in terms of the profitability whereas in this

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case, in this method we do not talk in terms of profitability. We talk only about the recovery
of investment, not about the profitability. So, that is the second major limitation.

It is a measure of project capital recovery, not profitability. And fourth one is that it only
measures the project's liquidity and not of the firm, means it only concerned with the one
project, not of the firm as a whole.

How it will contribute towards the liquidity of the firm, overall cash flows of the firm? No, it
is not going to give you that kind of information because it is not focusing upon the whole
life cash inflows. It is only focusing upon that much limited number of year’s cash inflows
which are going to help us to find out the recovery period.

So, when the total cash inflows we are not taking into account, how much value it is adding
into the value of the firm it is not possible to be found out. So, in that case the liquidity
position of the project can be known. That is why we are able to sum up those liquid cash
flows and to get the investment back. But its contribution towards the firm's liquidity, that is
not possible to be known.

So, these are the four limitations and three points of the merits are, we have just discussed
here. Then we talk about some important reasons that despite all these limitations and some
shortcomings of the method it is very popular. Even today we make use of it and knowingly
or unknowingly, even ignorantly many a times when we talk of any investment proposal, any
new investment proposal, the first criterion which comes in the mind, whether knowingly,
consciously or unconsciously, it is the payback period.

Everybody thinks about, if I make investment even as an individual, anyone wants to make
investment on his savings in the bank or maybe in any investment proposal he is more
concerned about, in how many years my investment is going to get back to me? So, it is most
popular and some 2-3 important points are worth knowing here, considering here that,
number 1, it is reciprocal of internal rate of return when the cash flow is constant and the life
of the project is fairly long. It is reciprocal of internal rate of return.

In the internal rate of return also what we calculate, we calculate that in how many years, the
net present value of the project is going to be 0. That is only rate we find out where the
present value of the cash outflows is equal to the present values of the cash inflows and same
thing we are going to do in the payback period method.

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So, it is the reciprocal of the internal rate of return. So, it is very very important property
because it is comparable to some method which is a part of the discounted criteria. Second is
akin to breakeven point. Here we are calculating the breakeven point, almost because
understanding the concept of the breakeven period is very easy. So, here also we are talking
about the breakeven point. Breakeven point is the point where the total inflows are equal to
the total outflows, no profits. It is a point of no profit, no loss.

So, in the payback period also we are talking something of the same thing, a point of no
profit, no loss. How much we invested in how many years, it is going to get back to me? I am
not concerned beyond that. And third important thing is uncertainty associated with the
project may be resolved earlier because by using this method we emphasize upon the shorter
payback periods.

So, shorter the period of recovery of any investment, is going to reduce the uncertainty of the
project or the cash inflows available from the project and the risk associated to that project.
So, if the risk is lower, when the risk is lower? When the period of recovery of that
investment is lower, and if the period of recovery of investment is lower, certainly we can say
that uncertainty can be minimized, risk can be minimized and we are more concerned here,
we are more focused upon that in how many years or how quickly we are going to return the
investment made in any project back and that is the point of concern here.

So, talking about all these say pros and cons and some points of concerns here or the reasons
of the popularity of the payback period method means whatever the total discussion is done
here when the discounted criteria was not there, when the NPV was not there, when the IRR
was not there, when the benefit cost ratio was not there, payback period was there.

Even our forefathers, when they were, means illiterate, they were doing business but they
were not management graduates or maybe they were not knowing the formal language of the
business or how to do the business as we do it today, long back we have been doing.

For example we talk about the say, this family businesses in India, Tata’s, Birla’s and their
forefathers because when they started the business 100 years back, 150 years back,
sometimes 200 years back, at that time this discounted criteria, NPV, IRR, benefit cost ratio
nobody talked about that but payback period was at that time also the one important criterion
prevalent even at that time also.

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And even our forefathers also, how literate or illiterate they were, they always also used this
and first question always came in their mind also, we are going to make investment of 10000
rupees in this project, in how many years I am going to get this investment back?

And that is ultimately the payback period method so it is evergreen, it is used today also and
we do not use one single criteria for evaluating any investment proposal. So, it always goes
with discounted criteria also. We can use NPV and payback period together, we can use IRR
and the payback period together but it is never a case where we never use the payback period
method.

So, this is all, everything about the payback period method, first method in the non-
discounted criteria and one more method that is the accounting rate of return plus other some
important points of concern with regard to the evaluation of the capital budgeting proposals
that I will discuss with you in the next class. Thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Lecture 25
Capital Budgeting - Part 9

Welcome all, so in the process of learning about the Capital Budgeting techniques or the
investment criteria in the capital budgeting. In the non-discounting criteria now this is the last
technique which we are going to discuss and after this, after completing this discussion on the
different discounting and non-discounting techniques. After talking about this last one, we will
discuss some problems and solve some problems which are relating to the Capital Budgeting.

And then we will learn about that how if any situation comes up of evaluating any investment
proposal, then how to deal with that. Maybe whether it is by calculating the NPV, IRR, modified
IRR or maybe the benefit cost ratio or maybe using the non-discounted discounting criteria, like
payback period method or maybe this one which is now the last method, which is in the non-
discounting criteria.

(Refer Slide Time: 01:26)

And this is the last one is called as Accounting or Average Rate of Return. So when we will
solve some problems, some sums then you will be able to understand that how we can
implement these different techniques, different methods, different criteria to solve these

408
problems or some of the capital budgeting problems or some problems relating to the capital
expenditure. So this is the last technique now, we will be discussing it and after that I will take
you to the some problems.

Accounting or Average Rate of Return, this is after payback period. In the non-discounted
criteria, one was the payback period method, very popular, largely used and this is a technique
which is used in almost in evaluation of any kind of proposals. And the second technique which
is there available with all of us is accounting or the average rate of return. This is a second
technique or this is a second method called as a non-discounted method for evaluating the capital
investment proposals.

So, what is the formula for say calculating or using this? This is the formula which is called as
average PAT divided by the average book value of investment. Average PAT that is the average
profit after tax, we take the average profit after tax, so how we take the average profit after tax?
That we will learn. We have to see that how many numbers of years say cash flows are
forecasted. For example, we are going to say start a project today or maybe in the current year in
2019 and 2019 is called as the investment year and after that for the next 5 years the project will
be working, or will be giving us the cash inflows. So it means we will be having the next
foreseeable period up to next 5 years and we can look forward that yes, the projected profit after
tax will be known to us.

And the average investment will also be known to us that is a discounted, you can call it as the
depreciated value of the investment. So at the beginning of the year, what is the investment there,
that will also be known to us and we will be, means able to calculate and find out the average for
this investment. So in this case, when you try to implement this accounting or the average rate of
return.

As we have seen in this model that average profit after text divided by the average book value of
investment that is in the beginning of the year, what is the value of the investment is there, after
calculating the depreciation whatever the value is left at the end of one particular year, that
becomes investment in the beginning of the year so that investment we have to take. And now
we will understand that if any investment we are making in the fixed assets of any company or in
any project.

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Then we are applying the depreciation, because we are not adding any new asset now, capital
expenditure is taking place only in the current period that is in the 0 year. So it means if we are
investing any amount.

(Refer Slide Time: 04:34)

For example we talk about that we are investing 100 rupees in any project, and the depreciation
rate is how much? 10 percent. So what will happen next year and we are charging the
depreciation as per the SLM, Straight Line Method, so it means this amount 10 percent becomes
10.

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So it means this amount will come down to 90, next year it will come down to 80, this next year
it will come down to 70, so it means it is 90, 80, 70 and 100 and then, this is outflow, and this is
the investment, so you can say that this is the 90, 80, 70 then it will come down to 60, so it
means over the years this investment is going down. This investment will increase if you make
further capital expenditure, but that we are assuming under this method that no further capital
expenditure we are making.

Maximum expenditure we are making here is 100 and we will be using this 100 rupees, so
naturally say this investment is made by way of capital and converted into fixed assets, so when
fixed asset is depreciated, their value will come down, so in the beginning of the 0 year this is the
investment, in the beginning of first year this is the investment, in the beginning of the second
year this is the investment, in the beginning of the third year this is the investment, in the
beginning of the fourth year this is the investment.

And if you talk one more here, then say this is the total we are left with how many, 4 years after
the investment year. So it means total number of years is 5 and you have to take this, plus this,
plus this means these values, we have to take these values and divide it by number 5, so it means
you can easily calculate the average investment by taking the investment at the beginning of the
years.

So same thing we are talking about here is that we have are showing here investment at the
beginning of the year is how much? That is 100 rupees or 100 crores, after depreciation next year
it has come down to 80, then it has come down to 65, then it has come down to 53.75 then it has
come down to 45.31. So this way this investment is depreciating but we are going to take the
average of this investment so average of these how many?

5 values we are going to take, so what you are going to do this, plus this, plus this, plus this, plus
this and divided by 5, so that will be called as the average investment and then we have
calculated the PAT for the year 1 and year this 2, 3 ,4 and 5, this PAT is available so if you
divide this PAT by 5, so what will be there? You can calculate the average PAT. So we have to
means take it, like this is the requirement of the model, average profit after tax, average book
value of investment, but the investment in the beginning of the year.

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So, now we have got this information for the project that is called as the Mohan’s Enterprises
Capital Project and here we have got the years, we have got the book value of investment, we
have got the profit after tax, and now what we are calculating here that is called as the average or
the accounting rate of return, how it has been calculated? Accounting rate of return is calculated
here that we have taken the PAT in the numerator and we are summing it up the 5 values
dividing it by 5 and then we are talking about the information given here and then we are
summing it up, dividing it by 5 and then we are getting calculating some percentage rate in this
case it has come up as 28.31 percent, 28.31 percent is the average or accounting rate of return
available here from this project.

So very simple, means there is nothing complex about it. Complex part is only to forecast the
cash flows and then to calculate the profits and then to calculate the investment, that is the
complex part. So this will all depend upon the detailed project feasibility report because when
any new project is taken up, and this deciding or working out this amount of investment of 100
crores and then say the operations of the first year and the profit at the end of the first year, profit
at the end of the second year.

So for this entire process we have to prepare the projected financial statements. Until and unless
you prepare the profit and loss account for the first year, you cannot get the PAT. Until and
unless you prepare the profit and loss account for all the 5 years, you cannot say get the profit
after tax. So what we have to do is, we have to prepare the projected income statement or
projected profit and loss account. So if the projected income statement is ready, but I tell you,
preparing the projected income statement is a million dollar question is very complex job and
there we need so many other kind of information.

One important information is the forecasting of sales, because if we have the sales figure with us,
for example that we have identified that if we go for any investment proposal and we are able to
sell for the first year say goods worth rupees 50 crores. Second year we are going to increase it to
60, then it is going to become 65, then it is going to become 70, then it is going to become 75. So
this growth rate can be worked out and this is very-very important because this all depends upon
the market and demand analysis.

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So, we need a Detailed Project Feasibility Report based upon the DPFR, we will get the sales
figure, and once you have got the sales figure then we will start backtracking. And now, for
example when you are preparing the profit and loss account, here we are preparing the profit and
loss account, so what we do is, we for example write here as the income statement.

This is a income statement and in this income statement what we write here is that it has two
parts, one part is called as trading and profit and loss account. So here we are going to prepare
the profit and loss account like this, this is called as the particulars and this is the amount, this is
particulars and this is amount. And this is the debit side, this is the credit side. So what we are
going to do here is now we are starting with the by sales.

So if you have forecasted the sales then this figure will be there. Then we write here by closing
stock, if we have the closing stock figure, we will calculate here and this will become the total
amount and this will give you the total production value and this side we need the information
about the cost, that is the direct material, direct labor and the direct overheads. This cost will be
available, and the difference of this will be called as the to Gross Profit.

So you will calculate first the gross profit, and then you will say take the statement forward, and
when you take the statement forward so how you do it?

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(Refer Slide Time: 11:27)

You prepare then the profit and loss account continuing the trading account, so you will write
here what? By gross profit and then by indirect incomes, other indirect incomes, you can call it
as non-operating incomes, you will keep on adding, something becomes here and then it will be
called as indirect expenses or non-operating expenses.

So this all expenses you will take here and then it is a sales figure finally means the closing
revenue figure, you will total it up, you will close it and then you will get here something that is
the true net operating profit before tax PBT. This amount will come here, then it will come as To

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Tax, it will come here and then it will be called as the To Profit or you will be able to find out
here the true net operating profit after tax. And this will be the figure.

So arriving at this figure which we are taking here in our case of the 14, 17.5, 21.12, 22.09 and
23.57, this will depend upon this so much of the analysis, and this analysis begins from where?
This analysis begins from this sales figure and getting the sales figure depends upon the market
and demand analysis. If you do the proper market and demand analysis, then only the things can
be taken care of.

So it means now in this whole case when you try to find out, it looks very easy that
implementing this method is very easy, that we have got on the one side the investment figure,
on this side we have got the PAT figure, but look at getting this PAT figure and getting this
investment figure is very complex job. If we have this information available, then after that
calculating the average rate of return is very easy and it can be done, but getting this information
is very-very complex.

For that we need to have to prepare the total detailed project feasibility report and once that
DPFR is ready with us, then only you can apply this method and finally you can calculate in this
case for example, we have taken the one fifth of the profit after tax and then we have taken the
one fifth of the book value of investment that is in the beginning of every year and this is the
total rate we have worked out which is called as average or the accounting rate of return and we
have calculated in this case is 28.31 percent.

Now, to take the decision if you want to apply this method for evaluating the capital investment
proposal what we have to do is you have to now compare it with the required rate of return, this
is the expected rate of return and then you have to compare it with the required rate of return and
required rate of return depends upon my cost of capital. So if for example, the required rate of
return is 35 percent or maybe 30 percent and available rate of return from this is 28.31 percent,
we will reject the proposal.

But if my required rate of return is for example 20 percent or 25 percent and available rate of
return is from this is expected rate of return EROR, expected rate of return is 28.31 percent then
we will accept the proposal because my requirement is 25 percent and it is available here it is
28.31 percent. So certainly I will go for this and I will means accept this proposal and I will go

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for this capital expenditure. So one rate is available, one we have to find out that what our
requirement is then we have to compare that available rate of return with the required rate of
return and finally we have to take the decision accordingly.

So, this is a very simple method and depends upon the availability of the profit for the future
number of years and the availability of the investment for the future number of years. And then
taking the average PAT and then the average investment here. Now, we will compare it with the
discounted criteria, as compared to discounted criteria and as compared to payback period
method, there are some points of comparison with the discounted criteria like NPV, IRR and the
benefit cost ratio and some points are here of the comparison with the non-discounted criteria
means the other method that is the payback period method.

So, when you talk about the pros, merits of this method is very simple. Simple means once you
have got the profit figures or the investment figures after that, calculating the average rate of
return is very simple. Second thing is, it is based upon the accounting information, business man
are the familiar with.

Everybody knows that what is the profit after tax, how to calculate the profit after tax and how to
interpret the profit after tax, availability of the profit after tax, how to interpret that, that can be
easily found out, that can be easily evaluated. So it means, in this whole case you can easily
apply this method, this is a second important merit. Third one is, considers benefit over the entire
life of the project.

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(Refer Slide Time: 16:43)

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If you talk about the payback period method, we have seen in the payback period method that
we are talking about here is that we are taking the payback period method only is considering the
cash flows for the period up to which this basic investment of the 100 crores is recovered. This is
cash out flow in the 0 year and till the time this investment is recovered after that how many, or
how much cash inflow is available from the project, we are least bothered about.

So we are only limited about that much amount of the cash flows which are sufficient for
recovering the initial investment. We do not take the cash flows of the entire life of the project
into consideration in the payback period method. But in the accounting rate of return, we take
this into account and then we try to find out that yes that the average rate of return depends upon
the entire projected period of the project.

We are not only limiting our analysis up to recovering our investment, we are taking it up to the
total foreseeable period, and if the total foreseeable period is available for the information is
available for the next 10 years then we will calculate the investment, average investment for the
10 years and the average profit for the 10 years and then we will calculate the say accounting rate
of return.

This is one important you can call it as improvement over the payback period or maybe other
way around you call it as a limitation also that you have to have find out the cash flows for the
total or the profit after tax for the total foreseeable period. Whereas it is not the case in the
payback period there we are only finding out till the investment is recovered. Here in this case,

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what is the total foreseeable period, we are calculating the cash flows, profit after tax, investment
and then we are calculating the average or the accounting rate of return.

So, these are 3 important merits or the important positive points of this particular method. And
then we have the cons, means demerits of this particular method. That is why it is not very
popular because in the non-discounted criteria, most popular is the payback period method and
remaining are the discounted criteria, and there also two are very popular NPV and IRR.

Since there are some limitations of IRR which have been done away with the help of MIRR but
largely because IRR is in the percentage terms and NPV is also having so many positive points.
So in the discounted criteria we largely use NPV or IRR and in the non-discounted criteria we
use PBP payback period method but this method is also available that is why we are discussing
here.

So cons are based on accounting profits, not cash flows. So we are calculating this average rate
of return we are calculating upon the accounting profit. Accounting profit as I just explained it to
you, how to calculate the accounting profit and then by preparing the projected profit and loss
account and balance sheet, we are calculating this average rate of return and we are not
concerned about the cash flows largely.

Though we are indirectly concerned with the cash flows also, because with the help of this profit,
we can calculate the cash flows and then we can take the decisions but largely if we do not have
even the total cash flows, you do not have to work out, we can calculate the cash flows but you
do not have to work out the cash flows even by simply calculating the profits you can say apply
this method, this is a con.

So, it means cash flow is a wider term and the profit is limited term and here also, one important
limitation of the profit is that it is the only profit whether it is a cash profit or it is a non cash
profit that is not discussed here. Because when you calculate this profit, when you are calculating
this net operating profit after tax, this net operating profit after tax is normally nominal in the
value. This is the nominal in the value and this is not the real, why is it nominal, because when
you talk about here this by sales, when we are calculating the sales figure, the sales figure is not
only on cash.

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These sales when we are including in trading and profit and loss account, not only the cash sales
we are including, this are the total sales and in this sales the part of the sales are on the credit
also. So, it may be possible that 80 percent of the sales are on credit and only 20 percent of the
sales are on cash. So it means, if 20 percent of the sales are on the cash it means whatever the
profit you are working out here, this profit, only 20 percent of the profit will be on cash.

(Refer Slide Time: 21:29)

So this is a major limitation because we are here depending upon something which is called as
the accounting profit and accounting profit itself has some inherent limitations and when you talk
about the cash flows, it is a different thing, it is the real thing. Cash flows are real, accounting
profits are nominal, so taking some decisions on the basis of the accounting profits sometime
may not be wiser step.

Then, the next one is, does not take into account the time value of the money, certainly because it
is a non-discounted criteria. Like payback period method, it does not take into account the time
value of the money. It does so it is not discounting the cash flows, whatever the profit we are
calculating here, these profits are even to be to be to be discounted, we are not discounting these
say profits.

Number one, they are not cash flows and second thing is they are only profits so we are not
discounting these profits. Internally inconsistent, this is a very-very important point here as a
limitation of this accounting rate of return, why is it internally inconsistent? I now explained it to

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you that when you talk about this profit, this profit is the profit after tax and here we are talking
about is the investment which is average book value of the investment, so it means, how can you
interpret it?

(Refer Slide Time: 22:52)

You are talking about the method says that it is the average profit after tax divided by the
average book value of investment . When you are talking about this average profit after tax, this
average profit after tax is the profit now left only to the, to whom? To the owners or the to the
equity shareholders, that is available only, this profit is available to the providers of the funds
called as equity share holders.

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So when you calculate the profits in the profit and loss account here, you are subtracting to
interest cost, to interest on loan. So it means any kind of the borrowing, what is the cost of that
borrowing, it has already even subtracted, after this subtraction, we have got this profit. So once
you have already paid the amount due or the cost of the borrowed funds or the loan funds it
means, after that whatever now the residual value left as a average PAT, that is only sufficient
for the equity share holders.

But when you talk about the denominator here, this denominator as a investment that includes
the total funds coming from all the sources, whether coming from the share capital or coming
from the borrowings in the form of the loans from the financial institutions or in the form of the
bonds and debentures issued to the different investors. So this investment is the investment
coming from all the sources.

Whereas this profit is the one which is now only the residual profit left for the equity share
holders for the internal resource providers. So it means sometimes it is called as inconsistent that
the funds coming from total sources are dividing the residual profit available only to the equity
share holders to the internal say owners of the firm. So it means, sometimes it becomes
inconsistent, either it should be taken the total cash flow here that is without paying the interest
against this total investment.

Or we should make some change in the denominator where you can do one thing that you can
only take the equity capital not the borrowed capital but that we are not doing. This we are taking
as the total investment because in the balance sheet, when you are making investment into the
land, then it is the plant and machinery, then it is the buildings. So whatever the investment you
are making, that investment for example we are making here 1000, here it is 1000, here it is 500
rupees.

This investment has come from both the sources that is one is the equity plus debt, there we are
not segregating that only equity capital will be invested here. And here this time, this side, you
write here as share capital and then you call it as the long term loans and then you can call it as
the debentures. So this side becomes the total capital, this side becomes the total liabilities. So
these total funds are making these total assets or causing or requiring the investment in the total
assets.

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So it means these total funds are involved for this side of the total assets, then here it is the same
case that average book value of this investment is sum total of all these three or sum total of all
these and then it becomes the denominator. But in the numerator, this is available only to the
share capital providers and this PAT is left only to the share capital providers, so it means their
claim has already been settled so why it is included in the denominator.

So this is why it is sometimes called as the inconsistent method but still we have to take a broad
idea of calculating the accounting rate of return or the average rate of return and largely even the
accounting rate of return is calculated like this. So it means we means use this method sometimes
but because of so many limitations because time value of money is also not there, it is internally
inconsistent also and takes the cash profit for the entire life of the project also which maybe
sometime not possible to calculate the correct profits for the total life of the project and then is
too much weightage to the distant benefits.

Too much weightage to the distant benefits is given and how it is to be talked about too much
benefit to the too much weightage to the distant benefits. I will explain it to you.

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(Refer Slide Time: 27:29)

Here for example, now you look at this these two projects, this is a project A and this is a project
B, now if you look at here, the some total of these values is same. If you take sum total of these
two values it is same.

It is also 100000, it is also 100000. Investment required, cash outflow required for the two
projects is same in the 0 year, 100000 rupees, 100000 rupees and then we calculate here, the cash
flows coming, profit after tax and then the cash flows coming. So if you take here into account
we are again getting the total amount is how much? Total amount becomes again 200000 in both
the cases. This is the 200000 and this is also 200000, in both the cases it is 200000 rupees.

But in this case, if you talk about the project A, here it is within first 2 years the cash flows are
very high and here in this case for example if you talk about we have to go up to for recovery of
this amount of the entire investment of this amount and this 200000 rupees, initially the cash
flows are very less and in the later year the cash flows are increasing. So if you talk about, the
accounting rate of return, if it is a payback period method we will only limit our analysis up to
first 2 years because our investment is recovered in the first two years.

But here because here we are talking about taking the entire life, so you can call it as, as per the
time value of money, if you calculate the time value of money of this project it will be much
better as compared to this. So it means, we are saying both the projects are giving us a equal

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returns because it is also giving us 200000 rupees, it is also giving us 200000 rupees but here the
profits and cash flows are coming at the distant years and it coming in the beginning year.

So because it does not differentiate between the two, it does not differentiate that this project is
better than this project, so it gives the equal weightage to the cash flows coming either in the
beginning or coming at the end or in the later years. So that is the limitation of this that though it
takes into account the cash flows of all the years.

For example, if we calculate the average rate of return of this and average rate of return of this it
will come as same, but here there is large difference because here the cash flows are coming in
the later years it is coming in the beginning years, so any cash flow, any profit earned much in
the higher amount in the beginning years and lesser in the later years, that makes a difference.
But in this method, this difference is not taken into account. So, this is the one another important
limitation.

(Refer Slide Time: 30:05)

Last one is the no information about the target rate of return. So it means we are only getting that
from this project only 28.31 percent is available or expected to be available. But what is our
required rate of return? That we have to calculate separately, that is not given by this. For
example, when you apply the NPV method. In the NPV method, we say that we know the cost of
capital and when you discount the cash flows, cash inflows and cash outflows with the help of

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that cost of capital, you know that this project is ending up with the positive NPV, 0 NPV or
negative NPV.

In case of the internal rate of return, we are going to find out some rate of return, which is
available from that project. So there is no point bothering about anything. But in this case we are
not having any target rate of return, so it means it is giving us only 28.31 percent and that too not
based upon the cash flows, it is based upon the profit after tax. So, there is a difference in the
cash flows and profits and since the target rate is not available that how much target profit is
there we are not able to find out of it.

So it means say another limitation that now you have to calculate your cost of capital and then
you have to find out that yes my cost of capital is 25 percent, accounting rate of return is 28.31
percent then yes, I can go for it, but otherwise I will not go for it. So because of so many
limitations associated to this method, this method is there as one of the non-discounted criteria
and when the discounted criteria was not there, we were equally using it along with the payback
period method.

But now, since very effective and logical and genuine discounted criteria are available where
NPV and IRR are the much better replacements of this method. So we depend less on the
accounting rate of return in the non discounted criteria, we largely use the payback period and in
the discounted criteria we use NPV or the IRR method so as we do not use much the benefit cost
ratio in the discounted criteria, similarly we do not use the accounting rate of return in the non-
discounted criteria.

So with this I complete the discussion, conceptual discussion on all the 5 criteria. 3 methods are
in the discounted criteria, 2 methods are in the non-discounted criteria. After having talk about
all these 5 methods, we are now going to be clear about that how to evaluate the capital
investments proposals, how to take decisions about the capital expenditure proposals and how to
decide whether to go for one particular investment to be made anywhere in any case or not.

And, whether we should accept that investment proposal, whether we should make that
investment, we should not make that investment. By taking into account the time value of
money, we can apply the discounted criteria and just to have the rough idea about the recovery of
that investment we can apply the payback period method. So this is the all about the different

426
methods of the investment criteria, evaluation of the investment can be done if you quickly want
to take the idea about the recovery of investment always use PBP and then in the detailed
analysis we can use the discounted criteria.

But I would tell you that normally we do not use either of the method in isolation, we use this
method together. Every project where we use the discounted criteria, we use the payback period
method also, so both the criteria go hand in hand. And if you ask me, then we can say, three
methods are more popular NPV and IRR in the discounted criteria and the payback period
method in the non-discounted criteria. So, this is something about the different methods in the
investment criteria.

(Refer Slide Time: 34:09)

Now, we have to discuss some important points here that in the practice which one of the
methods are most popular or popularly used in India that investment appraisal methods in the
practice, which ones are there, so this particular component and some problems with regard to
the some problems where we can learn about the evaluation of the capital expenditure and
applying some methods that we discussed here, NPV, IRR, Benefit Cost Ratio or Accounting
Rate of Return or PBP, how to apply them?

We will do certain problems sum, practical problems, some sums and then we will be clear about
that if we have to evaluate any investment proposal, how we can do that. So this particular part,
investment appraisal in practice, and then some practical problems I will discuss in the next 2-3

427
classes and then I will close the discussion on this particular topic that is the capital investment
evaluating the or techniques of evaluating the capital investments proposals. Till then, thank you
very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 26
Capital Budgeting Part 10
Welcome all. So, now, we are in the process of completing the discussion on the capital
budgeting techniques or the evaluation of the capital budgeting proposals or the capital
expenditure proposals. So, in the last part of the discussion, I completed the discussion on all
the methods that is three discounted criteria and the two non-discounted criteria. And now,
as I told you that in the next two, three classes we will discuss some practical problems.

But before that I would like to conclude it the discussion on that with some observations
about say investment appraisal in the practice or which criteria, which method and how the
investment appraisal in practice takes place that I am going to discuss with you this criteria
which is in the practices is reported in the book “Financial Management by Prasanna
Chandra”, I have taken these points from that book only.

And that is because that book is regularly updated book, means Prasanna Chandra regularly
updates that book. So, it provides us very interesting and updated information I would advise
you all of you to means purchase that book and make use of that. So, in that book, the results
of the practical surveys are given here.

(Refer Slide Time: 1:49)

So, some important observations which are here with regard to the investment appraisal
criteria in practice, they are here and the first important point if you look at overtime,

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discounted cash flow methods have gained in importance and the internal rate of return is the
most popular evaluation method. So, one observation is that discounted rate of return are
more popular because of the important consideration there the time value of money.

So, they are the most important things and the internal rate of return is the most important
criteria there. So, this is the one important observation. That is why I told you many times
that internal rate of return being in percentage terms, it facilitates a comparison, more easily
and more you can call it as logically as compared to the net present value, which gives us the
NPV in the absolute terms.

So, because IRR though it has number of limitations, so we have to find out or we have to
calculate the modified IRR. If the simple IRR is not possible to be worked out, because of the
cash outflows or the investment to be made in the multiple durations or at the multiple points
even after the launching of the project.

So, there we can use a modified internal rate of return, but IRR is the more popular as against
NPV, but in overall you can say discounted criterias are more acceptable and popular to the
people as compared to the non-discounted criteria. Firms typically use multiple evaluation
methods. This also I have discussed with you that is not only the discounted criteria, but for
the reference we use the non-discounted criteria also and the PBP method is largely used. So,
we can normally, what we do?

We can use either of the methods of the discounted criteria either NPV or the IRR and some
of the methods of the non-discounted criteria like payback period method. So, it means in that
way we can evaluate the investment proposals by using more than one methods, not only one
method and then we can try to find out that how the project is responding or expected to
respond and how it will be financially looking like. So, we have to use the multiple criteria.

Third important point here is, accounting rate of return and payback period are widely
employed as supplementary evaluation methods. I told you already that accounting rate of
return and payback period are widely employed as the supplementary evaluation methods.
So, in these two also, payback period is more important as compared to accounting rate of
return.

Because in the accounting rate of return this analysis is based upon the accounting profit and
the difference between the accounting profit and the real profit I have discussed with you,

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that is not the cash profit. Because when you talk about the payback period method, we take
into account the cash flows which include the profit also.

But in the accounting rate of return, we take into account the profit after tax, average profit
after tax which is only nominal profit, accounting profit, not the real profit and sometime
because of that limitation we do not use that. So, you can say some of the internal rate of
return and then along with that payback period method we normally use.

Weighted average cost of capital is most commonly used as a discount rate. I have already
discussed with you that how to discount your cash flows. We have to find out some discount
rate and discount rate is basically the weighted average cost of capital and we discount the
cash flows with the help of WACC.

We will have a long discussion on the weighted average cost of capital that while there is a
separate part, I have put assigned some hours. For discussing the cost of capital there is the
independent topic called as the cost of capital and how to calculate the cost of capital? What
are the important considerations to be borne in mind while calculating the cost of capital?

So, there weighted average cost of capital concept we will also discuss and entirely it will be
a full-fledged discussion on the cost of capital because it is a independent topic and financial
management and in our course plan also. So, there I will discuss, I will throw light on the
WACC. But here for the reference, that discount rate that when we say that cash flow in the
first year is 1 lakh rupees divided by 1 plus R. So, what is R? R is basically the discount rate
and that discount rate is basically the weighted average cost of capital.

PBP is the most common method for risk adjustment because we talk in terms of the time
duration. I discussed with you that longer the time of the recovery of the investment from any
project higher is the risk involved.

Because if you are going to recover the investment from any project in the next 6 years, and
in any project in the next 3 years, So, which one is less riskier, where the lesser time period is
involved? So, we check with the help of payback period method. We try to find out in how
many years our investment is going to get back and shorter the period better it is for the
evolution of the project and say preferring the project.

Because first of all, every investor is concerned about the recovery of his investment. Later
on, we talk about the growth, first is the recovery that how much I am investing that should

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come back to me, after that if there is any surplus or inflow is available then fine, very good,
that will be called as my NPV.

But first I would like to know that when the NPV is going to be 0. So, 0 NPV, I am more
concerned about it. And here when you are talking about the risk and the returns. So, it is
directly linked to the duration of the project. It means longer the duration of the project, it
means you can say more risker the project is and shorter the duration of the project, lesser
risk of the project.

And it means in this whole case, when we talk about the duration of the project, you can
directly find out with the help of payback period method that which project is helping us to
recover the investment in the shorter period of time. That project is less riskier.

So, that is why we are more focused and concerned about by using the payback period
method about the recovery of the investment, where you can say that project is attaining the
breakeven point, project is having the NPV 0. So, it means we are concerned about the
positive NPV, but first we are concerned about the 0 NPV where my outflows are equal to the
present value of inflows or vice versa and my investment stands recovered. So, these are
some important points about the investment appraisal in practice.

So, you can understand that how out of the 5 methods, 3 are the discounted criteria methods
and 2 are the non-discounted criteria methods, how they are being used in the practice or they
are in the walk. And if we want to really evaluate any capital investment proposal tomorrow
in our life, which method to use, how to use it, and how to take the decisions. So, with this, I
complete the conceptual discussion.

And now, as I have already told you, in the next two, three classes, we will do some practical
problems with regard to the capital budgeting proposals. And after that, we will close the
discussion on this particular topic. And I will move to the next topic that is the assessment or
evaluation of the cash flows of the capital investment proposals.

(Refer Slide Time: 9:31)

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So, now, when you talk about some practical problems with regard to the capital budgeting, I
have got this one problem here. And this problem is a very simple problem, but you have to
calculate all the five things. So, this is a very simple a proposal and capital investment
proposals are otherwise very simple.

But only complexity comes here for calculating these values, for calculating these cash
inflows, you have to do a thorough analysis. And then this also is not easy job, because
capital investment, for calculating that you have to do the market and demand analysis,
technical analysis, then profitability analysis, means this financial analysis.

So, all this analysis require, required to be done and this this all is means what we are
involved here, showing here is the part of the DPFR - Detailed Project Feasibility Report. So,
calculating these cash flows is not very easy job, once these cash flows are available and this

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is we are going to learn in the next say topic. Next topic is the assessment of the cash flows
and the capital investment proposals.

So, we learned there that how we identify or how we calculate the cash outflows, the
investments to be made in any capital investment proposal and how to work out the cash
inflows available from those capital say investment proposals.

So, this, if it is available with us if the cash outflow and cash inflow information is available
with us, then we can easily apply the discounted or non-discounted criteria of the capital
budgeting or out of the capital budgeting techniques and we can take the decision that
whether to go for the project or whether not to go for this particular investment. So, in this
case, we are given here that the expected cash flow of a project are as follows.

Cash outflow in the 0 period is 1 lakh rupees and then other cash inflows over the next five
years are, in the first year it is 20,000, second year it is 30,000, third year it is 40,000 and
fourth year it is 50,000, fifth year it is 30,000 rupees. These cash flows are available. This is a
1 lakh rupees. So, out of this outflow of the 1 lakh rupees we are talking about here is that
how much is inflow available over a period of time, we have the inflow of the 20000, 30000,
40000, 50000 and 30000 rupees is available.

So, against this outflow of or the investment of 1 lakh rupees, we are getting this much back.
So, we have to evaluate this project, if the cost of capital is 12 percent. If the cost of capital is
12 percent, then we have to calculate the net present value, benefit cost ratio, internal rate of
return, modified internal rate of return, payback period and the discounted payback period,
we have to find out all the one, two, three, four, five and six things here. So, information
about the cash outflow and inflow is given to us and we have to evaluate this.

So, for applying this concept here, what we have to do here is, we have to solve this and we
have to find out the answer to all these problems. So, here when you go ahead with this
particular part, we have the next problem here also, but first we will solve this and then we
will move to the second problem.

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(Refer Slide Time: 12:44)

So, in this case, let us solve this and try to find out. So, first of all, what is the first
requirement? What is the NPV? The NPV of the project or the net present value out of this
project, how much investment we are making? 1 lakh rupees, and how much is the inflow
available that is different figures over a period of next 5 years and the cost of capital is how
much? Cost of capital is 12 percent.

So, the discount rate which we have to use is that is 12 percent. So, it means in this case how
can you do it? You can apply the formula simply that for calculating the NPV, how you have
to do is? NPV of the project is equal to minus 100,000 which is the initial investment we
have made here. Plus what is the cash flow available from the first year? It is 20, 30. So it is
20,000 available cash inflow, 20,000 in the first year. Discount rate by 1.12 that is 1 plus R

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and since it is first year so no power, only 1 and which we do not write here, plus we have got
here is 30,000 and you have to discount it also and it is 1 plus 0.12 power 2.

And then we have to take the next inflow and this is 40,000 it is 1.12 and it is power 3, then
the next cash flow is 50,000 divided by 1.12 power 4 and then continuing with the next part
and so, what is the cash flow? 20, 30, 40, 50; 20, 30, 40, 50 and then it is 30, then it is 30,000
and it is 1.12 and power it is 5.

So, if you want to take here is now, this is minus 1 lakh then it is plus, now we have to find
out the values of this. When you find out the discounted value of it, 20,000 has come down to
17,860, this is the one value 17,860, then it is 23,910, if you do this, this value is this is
because of this and second value is because of this.

If you discount 40,000 after discounting for a period of 3 years, by 1.12, so it means this
amount comes up as 31,800 and the next one we have got is how much? First one we have
got is 17,860, this is because of this, second one is we have what is the 23,910 and in the third
year the cash inflow is how much?

Third year cash inflow is going to be this inflow is 40,000. So, when you are discounting the
40,000 you are left with something called as 28,480. And then you have the next one and next
one is 50,000, when you are discounting at 1.15 this is called as remaining or coming down to
31.800.

And then is the next figure if you talk about the next figure 30,000. So 30,000 when you are
discounting you are getting back is how much, the time value of money is 17010. So, you can
find out what is now the NPV of the project. So, let us again check it up, when you are
making the investment of 1 lakh rupees in the 0 period, then when you are getting the first
inflow of 20,000 rupees and discounting it at the rate of 12 percent with 1.12, dividing it by
1.12, it is coming down to 17,860.

Next is 30,000 discounted at 12 percent, 23,910 and then we have got 40,000 discounted by
1.12, so it means the next figure is coming up at 28,480 and the next figure, inflow is 50,000
discounted at 12 percent. This is 31,800. And then the last is 30,000 when discounted at 12
percent, this amount comes down to 17,010.

So, if you total it up, if you calculate the total NPV these are the 5 positive figures and this is
the 1 negative figure, if you sum these up and minus 1 lakh rupees, so NPV of the project

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comes up here is somewhere 19,060 rupees, 19,060 rupees is the net present value of this
project. Very simple means you have you should have the information about the cash
outflows and cash inflows and applying the discounting criteria after that or evaluating their
proposal is not a difficult job.

Next thing is the benefit cost ratio, BCR, next requirement is calculating the benefit cost ratio
what is required here? Calculate the benefit cost ratio. So, if you calculate the benefit cost
ratio here, so how much you are getting here? It means, if the NPV is 19,060 it means in this
case benefit cost ratio, we are not talking about the net benefit cost ratio, we are talking about
the benefit cost ratio. So, we have to apply the formula present value of benefits divided by
initial investment. So, what is the present value of benefits? 19,060 is NPV and the total
investment is 1 lakh rupees.

So, it means this has come up, it is clear to us that the present value of benefits must be
119060 and divided by the initial investment, what is the initial investment that is 1 lakh
rupees. So, this ratio comes up roughly as 1.19 this ratio is called as the 1.19. So, it means if
the benefit cost ratio is 1.19, so if you calculating the net benefit cost ratio, what you have to
do is the benefit cost ratio BCR minus 1.

So, if you do this, so, it means benefit cost ratio is 1.19 minus 1 is equal to 0.19, this ratio is
0.19. So, it means this ratio is more than 1. So, you can say the ratio is positive and the
benefit cost ratio is 1.19 which can be easily calculated with the help of the present value of
the benefits whatever the discounted cash flows you have calculated.

For example, if you forget this 1 lakh rupees for a moment, then this plus this plus this plus
this plus this becomes 119060 and from when you divide this 119060 which is called as the
present value of benefits, if you are dividing it 1 lakh rupees, the benefit cost ratio is 1.19 and
net benefit cost ratio is benefit cost ratio minus 1 is equal to 0.19. These are the two questions
we have answered here.

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(Refer Slide Time: 20:10)

And then what is the next thing we have to try to find out here? To find out the internal rate
of return and for calculating the internal rate of return here, we can apply or try the different
rates. And our job is to find out the internal rate of return - IRR.

So, because the processes you know, that is the trial and error we have to apply, you have to
apply different rates and then you have to see that where the present value of the outflows is
equal to the present value of inflows, we have to find out the point where the NPV of the
project is 0. That is called as the internal rate of return.

For calculating the internal rate of return here, for example, we have already tested and tried
it here. So, if you apply the 18 percent internal rate of return, then NPV comes here as 1750,

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and if you apply a discount rate of 19 percent, not 18 percent if you apply the discount rate of
19 percent, so this NPV will become negative.

Means you can do the detailed calculation and if you try to find out, it will become as minus
780. So, this is positive, this is negative, it means it is very clear cut idea, that IRR is
somewhere between 18 percent and 19 percent.

It is somewhere between 18 percent and 19 percent and we have to find out the exact rate
now here that is the exact internal rate of return. So, how can you find it? 18 percent that is a
lower rate of return at which the NPV is positive and then you have to take 1 plus sum of
these 2 ignoring the minus sign this amount becomes is the what is NPV at the lower rate of
return, that is the 1750 and sum is 2530 and then the higher rate of return minus lower rate of
return and in this case this becomes the 1 percent.

So, if you solve this, you will get some interest rate here internal rate of return which will be
very clear something like 18.69. So, internal rate of return available from this investment
proposal or this particular capital expenditure proposal is 18.69 percent.

So, it means it is clear and we learned how to calculate the NPV, how to calculate the benefit
cost ratio, how to calculate the internal rate of return, we have already discussed this process,
we are applying it to some project evaluation process and we have calculated it and we have
done it.

439
(Refer Slide Time: 23:18)

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Now, next thing asked to be done in this case is how much Modified internal rate of return?
If you have to calculate the modified internal rate of return, so it means, in this case, if you
want to find out the modified internal rate of return, you have to find it out that how much is
the investment available here. And if you try to find out the investment out of this entire
process, you have to calculate for modified rate of return you have to calculate two important
things.

One important thing you have to in the modified internal rate of return, what we are required
to calculate? Present value of the cost and second thing is the terminal value, we have to
calculate the terminal value, we have to calculate the two values here and if you calculate the
terminal value, and then you calculate the say present value of the cost. So, ultimately we can
apply this modified internal rate of return.

So, for calculating the terminal value, you have to calculate the future values, future value of
the benefits, whatever the benefits coming out of, what are the cash flows coming out of this
project, they are called as the benefits. So, we have to calculate the future value of those
benefits all those cash inflows, this compounded at 12 percent.

Here now for calculating the modified internal rate of return, we apply the concept of
compounding, not the concept of discounting. Discounting is only for calculating the present
value of the cost, there we apply the concept of discounting and further calculating the
terminal value, we apply that concept of compounding. So, we have to calculate the future
value compounded at 12 percent rate of interest for all the cash inflows, then you have to
apply the model of MIRR.

So, let us calculate this terminal value. So, for calculating the compounded value or the
terminal value TV, what you have to do is, you have to take the first inflow is how much,
20,000. If you look at the first inflow is 20,000. So, you have to take this 20,000 and you
have to now multiply by 1.12 earlier for discounting we divide and now you have to multiply
so, 20,000 is coming when? In the first year and this is going to be re-invested for how many
more years? 4 years.

So, you have to compound it for 4 years, plus next inflow available is 30,000. 30,000 again,
you have to compound at the rate of 1.12 but for a period of 3 years. Because this cash flow
we are going to re-invest back for a period of 3 years. Then we have to take here the next
inflow and that inflow is 40,000; 40,000 into 1.12 and we are going to compound it for a

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period of how many? 2 years. 40,000 into 1.12; 40,000 into if you take care this particular
part, 40,000 is into 1.12, 40,000 into 1.12 power 2, so you have to compound it only for 2
years.

And then is next one is plus 50,000. 50,000 is going to come to us in which year? This is
going to come to us after 0 year, it is coming to us at the end of the fourth year, so you are
investigate only for how many years? You are investigate only for 1 year. So, it means we are
going to compound it for 1 year and that is 1.12 and then it is plus the final value is the last
cash inflow, this is 30,000, and 30,000 is available at the end of the last year. No
compounding is required to be done in that case 30,000 will be equal to 30,000.

So, what is the total terminal value of this project? If you calculate the terminal value by
summing up all the compounded value of all the cash inflows, this comes up as rupees
209790; 209790 this is the value we call as the terminal value, which is based upon the
compounding of future cash flows. 209790 is found out by compounding the future cash
flows for a period of next 5 years at the rate of cost of capital and that cost of capital is 12
percent.

So, 209790 will be the terminal value and now we already have only one cost. So, present
value of the cost is 1 lakh rupees only. So, if you apply the model of this MIRR, so you will
be doing something like this 1 lakh into 1 plus R. And how many years are there? 1 plus R
you going to call it as MIRR, so we signified sometimes R star, MIRR is signified like R star
and for a period of 5 years, and that is going to be how much?

This is equal to the terminal value of all the cash flows that is a 209790. And then, if you out
of this, if you solve this equation, if you want to find out the value of the R star, which is the
modified internal rate of return, this comes up as 15.97 percent and this is in a way you call it
as my MIRR, modified internal rate of return 15.97 percent in this case.

So, it is very simple, it was not very complex because the cash outflow was only in the one
period and that is in the current period. Had there been multiple cash outflows, then what you
have to do is?

You have to calculate the present value of the cost by discounting the cash outflows at the
future subsequent number of years. For example, there is a cash outflow in the first year, fine
0 period is equal to 100 percent, third year you discount it add it up in the first one and then

442
the fifth year then discounted and then add it up in the say the first and the say third years
inflows, so, that we have to calculate the present value of the cost.

Since it was not required to be done, anything was not required to be done here. So, we have
to simply find it out that for calculating this, if you had to find out. So, it will be something
like present value of the cost is equal to terminal value divided by the 1 plus R, 1 plus MIRR
power 5.

So if you have solved that we have taken the one step forward and directly after solving it, we
have found out this equation which is 1 lakh into 1 plus R star, R star means MIRR power 5
is equal to 109790 that is when 1 lakh rupees means what this signifies. If you look at this,
what does it signify?

This signifies that if 1 lakh rupees IS compounded at the rate of 12 percent for a period of 5
years, the cash flows which are coming out for a period of 5 years, if they are compounded
for the next 5 years period of time then the total value available here will be 209790. The
terminal value of this project means the compounded value of all the future cash flows will be
209790.

And when you solve it out, then you find out something that the value of R star in this
equation is 15.97 percent which is in a way is called as the modified internal rate of return or
MIRR, which is the modified internal rate of return.

Now, next question is to calculate the PBP the payback period and if you look at the payback
period for example, simply if you want to calculate the non-discounted payback period, so it
means you have to do a very simple job, you have to sum it up, how many years we got in?
we are investing here 1 lakh rupees. In the first year we got 20,000, second year we got
30,000, fourth we got 40,000.

So, it means how much it is? 90,000 we have recovered at the end of the third year and
remaining 10,000 will be coming to us, so in the beginning of the fourth year or maybe by the
fourth year. So you can say payback period is if you want to write here, payback period is
slightly more than 3 years.

In this case simple if you want to look at with the naked eyes then it comes up as slightly
more than 3 years. And if you want to go for the discounted payback period, so far we have
already calculated the discounted values also, and if you want to look at the discounted value,

443
so you can sum up these values and if you calculate these values, so it means it comes up as
how much?

First year we got discounted value of 20,000, 17,860 then it is 23,910. So, this becomes
somewhere around more than 41,000, then it is 69,000 because it is 28,480 and then it is a
31,800. So, if you sum up these 4 cash flows it will be a roughly becoming say discounted
value only by say summing up the cash flows discounted values of the cash flows of the 4
years.

So, the discounted payback period is going to be simple non-discounted is more than slightly
more than 3 years and if you want to calculate the discounted PBP payback period, then you
can call it as slightly less than 4 years.

So, all the questions we have tried to answer here means whatever was asked here, we have
to try, we have tried to answer all the questions here and this is very simple proposal where
we could try to see that if you have got this information, which is very complex to get about
the cash inflows and outflows, if this information is available, we can apply any of the 6
discounted and not-discounted criteria which we applied in this case and we have say try to
answer all those questions.

So, when you try to answer these questions, first thing was asked to calculate NPV we
calculated NPV in this case was positive 19,060, benefit cost ratio is 1.19 which is more than
1. So, the decision says yes go for the project means finally if you have to take the decision,
every criteria says you go for the project. First says NPV is positive, go for the project,
benefit cost ratio is more than 1 and net benefit cost ratio is more than 0. So, yes, it says go
for the investment.

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(Refer Slide Time: 34:18)

IRR is given to us available from this project is 18.69 percent internal rate of return and our
cost of capital for example, if it is 12 percent, then internal rate of return here it is 18.69
percent. Again it also says go ahead we can make investment.

Modified internal rate of return if you calculate it is still more than the cost of capital because
here we have found out the modified internal rate of return is also more than the cost of
capital, cost of capital is 12 percent. Modified internal rate of return is 15.97. So, it means
again it says go ahead with the investment and PBP is normal which is 3 years and
discounted PBP is less than 4 years or maximum 4 years you can say.

So, it means by taking into account the all the results by applying all the 6 discounted and
non-discounted techniques, we have found out the answer that this project is worthwhile, this

445
investment can be made. And if you make this investment, finally, we are going to add
something to the value of the firm that is ultimate objective of any capital expenditure or
capital investment proposals to add values to the existing value of the firm or ultimately the
value maximization is the objective.

So, this is one problem we did here at this point. So, like this 2, 3, 4 more problems we will
do in next one or two classes, and then I will close the discussion on the capital budgeting
techniques or the evaluation of investment criteria, or maybe the process of evaluation of the
capital budgeting or the capital expenditure proposals, till then, thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 27
Capital Budgeting Part 11
Welcome all. So, now we are in the process of winding up the discussion on capital
budgeting, but as I discussed with you in the previous class that before we complete and wind
up the discussion on capital budgeting, I would like to do certain problems with regard to this
particular topic.

So, what we discussed as the say the different investment criteria, how to apply that criteria
maybe the discounted and not discounted for evaluating the different capital investment
proposals. We are in the process of doing certain problems.

(Refer Slide Time: 1:31)

In the previous class also I did one problem where we learned that how to apply all the 6
parts of the evaluation criteria means both discounted and non-discounted, where we learned
how to calculate NPV, then how to calculate IRR, how to calculate MIRR? How to calculate
the benefit cost ratio, how to calculate the payback period.

And then the, this payback period, we did it in the previous one and then the discounted
payback period, yes discounted payback period we learned about. So, since we had all the
discounted cash flows available with us while calculating NPV and IRR, so calculating
discounted PBP was also not a difficult job. So, we applied this, we did not apply the
accounting rate of return.

447
Because that criteria is not much in use because out of the non-discounted criteria, only
payback period is the one or discounted payback period is the one which we normally use and
accounting rate of return is one available in the literature, but used means very less because
of so many limitations as I discussed with you that it depends upon the PAT, not upon the
cash flows and it is taking into account the total investment coming from both the sources,
debt and equity, whereas PAT is only available to the equity shareholders not to the debt
suppliers.

So, because of those inherent limitations, we do not use much the accounting rate of return. It
was very much in use when the discounted criteria was not there. But now we use PBP so we
learned in the previous problem and then discounted criteria we use in that also we use
largely two methods, NPV and IRR.

If there also benefit cost ratio, because of some limitations attached to that we seldom use the
benefit cost ratio. So, in the discounted criteria we use the NPV and IRR. And in the non-
discounted criteria we largely depend upon the PBP. So, we learned all these 6 methods that
how to apply them in evaluating the capital investment proposals or the capital budgeting
proposals.

And now we will do certain more in this class, in this as well as in the next class, I will
devote two more classes means this class as well as the next class for doing some problems,
practical problems. And then after that, we will move to the next part.

(Refer Slide Time: 3:36)

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And the next part is the cash flow estimation, that whatever these cash flows we are showing
here, these cash flows because we find that this process is very easy, calculating NPV, IRR,
or maybe payback period. It seems to be very easy, but it becomes easy provided these
inflows and these outflows are available with us.

So, it is means, it is a very complex job. It is a cumbersome job. It has a very lengthier
background procedure to arrive at these figures. These are not a one day job, we have to
prepare the detailed project feasibility report and after that we have to calculate these cash
flows.

So, once the cash flows are available with us, yes we can evaluate the proposal with the help
of the capital budgeting criteria, but arriving at these cash flows is a very very complex job
and we will learn in the next part after completing discussion on capital budgeting, we will
learn about the cash flow estimation and then means the different methods involved there and
how to go for the cash flow estimation that we will be doing.

So, let us do some two, three more problems and then be clear about how to apply the capital
budgeting and different methods of the capital budgeting or the capital budgeting evaluation
criteria.

(Refer Slide Time: 4:40)

Here in this case now, for example, what is given to us? It is given to us that Raja
international wishes to evaluate a capital project whose expected cash flows are as follows.
The cash flows are given to us here for how many years? 5 years, current year is the 0 year

449
and then is the cash inflow means only current year is causing the cash outflows and then
after that, we are only having the cash inflows.

So, at the end or till the end of the 0 year current period, we have to shell out, 1 million
rupees, 10 lakh rupees for building of that project and after that in the first year, we will have
the cash inflow of 1 lakh rupee first year. Second year we will have the cash flow of the 2
lakh rupees, third year we will have the cash inflow of 3 lakh rupees, fourth year we will have
the cash inflow of the 6 lakh rupees , year 5 we will have the cash inflow of the 3 lakh rupees.

And these all cash inflows are assumed to have been earned at the end of the year and this is
also we say that till the end of the current period, 0 period we are incurring or we are shelling
out or investing 10 lakh rupees, 1 million rupees and that is going to give us the total annual
inflow which is also at the end of the year.

Now required, what we have to do here is, what is the NPV of the project? If the discount rate
is 14 percent for the entire period and b, second question is important, what is the NPV of the
project, if the discount rate is 12 percent for the year one and rises every year by 1 percent?

So, it means we have got now that differential discount rates which are rising, which are
changing over a period of time. So, in the first case, we have to evaluate this proposal that if
only one discount rate is available for discounting all the cash inflows. And in the second
case, we will have to use the differential discount rates starting with the 12 percent and rising
by 1 percent every year.

So, let us know how to evaluate this proposal and how to calculate the say NPV. In both the
cases, we have to find out the net present value, so how to find out that NPV net present
value we are going to do or we are going to learn something about that.

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(Refer Slide Time: 7:11)

So, now in this case, we will write here NPV of the project at discount rate of how many, 14
percent. So, we will have to now discount it and if we have to discount it, so, what we will do
it here?

Now, we will start with the cash outflow and this is the first year cash outflow is how many?
1 million rupees or 10 lakh rupees. First year cash inflow is how much? 1 lakh rupees
100,000. So, we are going to discount it and for discounting we will have to use the discount
rate which is 14 percent. So, this is 100,000 and 1.14 and there is no power as such because it
is the year 1.

So, we, without also writing we assume that this is discounted, because it is coming to us at
the end of the first year. So, we want to find out the present value of it. Second is how much?

451
200,000, so it is again 1.14 and power here it is 2 that is because at the end of the second
year, so you have to discount it for the future cash flows to be discounted for the 2 years
period of time.

Then we have got next thing is the 3 lakh rupees, 1.14 power 3. So, this is going to be
discounted here for 3 years period of time and then we will go ahead with this plus, next is
how much we will go to 6 and 3, only two cash flows are left. So, it is 6 lakhs divided by 1.14
and what is the year? Year is 4 and then it is plus last is 3, 3 lakhs and then divided by 1.14
power 5, so total number of years are how many? 5, so we are discounting these.

So, very simple problem we have only the cash outflow is in the current period that is in the
0 period and in the subsequent 5 years. At the end of every year, we are getting a cash inflow
1 lakh rupees, 2 lakh rupees, 3 lakh rupees, 6 lakh rupees and 3 lakh rupees. So, now we have
to calculate the net present value of it.

So, if you calculate the net present value of these cash inflows, this works out as if you solve
this, this comes up as minus 44837. This is the net present value. So, it means the project is
not worthwhile, we should not go ahead if your cost of capital is 14 percent and that should
be the minimum return available from the project.

And whatever the cash outflows are caused by the project, what are the cash inflows are
available from the project, if you discount that and compare the net present value, so this is
coming up as against the total expenditure of 10 lakh rupees. So, the discounted value is
going to be lesser by this amount. So, it means somewhere we are going to get how much?

We are going to get somewhere is that you can call it as 956173. This is the only maximum
the discounted value of the cash inflows, some as a summed value comes up. So, it means 10
lakh we are investing which is equal to 10 lakh in the 0 period and what we are going to get
back is discounted value.

Means in sum total if you say, without any kind of analysis, you would say how many lakhs
we are going to get back? We are going to get back 15 lakhs against the investment of 10
lakh rupees in the current period over the 5 years, we are going to get back 15 lakh rupees.

But when this 15 lakh rupees coming back over a period of 5 years discounted at the rate of
14 percent. So, we are finding out that by shelling out or by investing 10 lakh rupees, you are
getting somewhere 956173, this much amount is coming back as a discounted value. So, the

452
project is not worthwhile or at least you can say that at least the return from the project is not
14 percent, it is lesser than that.

So, we will have to compare it with the cost of capital. If the cost of capital is 14 percent, so
we want minimum return of the 14 percent. So, that our NPV is 0. We do not want to incur
any kind of the loss, we may not be interested in the profit or maybe the surplus or the
positive NPV. But the decision criteria wants that normally an NPV should be positive more
than 0 or more than 1.

But if it is not more than 0, at least it should be 0 so that whatever the investment we are
making the discounted cash inflows coming out of that project over a period of next 5 years,
that NPV should be 0. But in this case and it is coming up as a negative. So, the project is not
worthwhile. And we can conclude that at least 14 percent return is not available.

(Refer Slide Time: 12:45)

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Now, we go for calculating the NPV of the project at varying discount rates, we are given the
varying discount rates and these discount rates are how much? These discount rates are
minimum is 12 and after that, the discount rate is increasing over the say years by 1 percent at
the varying discount rates, so this is another problem.

We have discussed this conceptually also while discussing the theory, we have discussed this
also that if the varying discount rates are there, how to solve that problem? So, we are going
to solve that problem here, NPV of the project at varying discount rates and when you go for
say calculating the NPV of this project, so what you take here is?

You take care is that is minus 1 million rupees, 10 lakh rupees plus. So, the cash flow coming
back is how much is, it is? 1 lakh rupees and it has to be discounted at the rate of 1.12 and

454
this is for a period of 1 year. Then we have to go for here is 2 lakh rupees, 2 lakh rupees and
here we are going to discount it at a discount rate, what? Varying discount rate.

So, it means current year for only 1 year it is 12 percent and for the next year it is increasing
by 1 percent. So, it will become 13 percent. So, how we have to give the effect of it? we are
going to take it as 1.12 and 1.13. So, we are going to take it like this. So, we are going to take
these varying discount rates. So, when you are calculating the varying discount rates, we have
to take the product of the two discount rates.

So, we are going to write here 1.12 into 1.13, we are taking the product to two discount rates,
not one discount rate because it is increasing. Then is the next and next year the next cash
flow is how much? 300,000 rupees, so here we will have to now increase the discount rate
further and it will become now little more complex part and this will be 1.12 into 1.13 and
into increasing it by 1 more percent 1.14, this is 1.14 it will be, so we are increasing the
discount rate here and we are taking the product of not only 1 or 2 we are taking the 3.

So, 1.12, 1.13 and 1.14 and then what is the next cash flow now? Next cash flow is 3 lakh
rupees and then after that it is 6 and 3. So, it is 6 lakh rupees this has to be discounted further
by increasing a discount rate and if you take the discount rate here it will become the product
of 4 discount rates and this will be 1.12 into 1.13 into 1.14 into 1.15. So, this is the product of
the 4 discount rates 1.12, 1.13, 1.14 and 1.15 and then it is 6, then it is 3 lakh rupees.

3 lakh rupees means 1.12, then it is 1.13, then it is 1.14 and then it is 1.15, and then it is going
to be 1.16 these are the discount rate. So, we are taking the product of the 5, 1.12, 1.13, 1.14,
1.15 and 1.16. If you solve this, so some figures will come up here. In this case it will be 10
lakh is equal to 10 lakh, this is 10 lakh is equal to 10 lakh plus the first discounted value will
be how much? 89286, second value is 158028; and then is the 207931 and next value is
361620. And then it is going to be next value 155871.

So, how many? 1, 2, 3, 4, 5, so if you calculate the sum of it, the sum of it will become that is
minus 27264, this is the net present value and again this net present value when you are
discounting at the varying rate and taking the product of not only one discount rate of 1.12
but the product of the discount rates varying by 1 percent over the years.

So, in that case the final NPV comes out as 27264 and this NPV is also negative NPV. So,
what we will do? Project is rejected. In case of the previous one, we have seen the NPV is

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negative project is rejected, you cannot go ahead with this investment proposal. We cannot
take up this investment and we have to abandon this investment.

So, very simple in the first case we learned about how to apply the NPV criteria, when the
discount rate is stable only 14 percent. In the second case we learned about when there is a
varying discount rates then how to apply this discounting criteria and we varied the discount
rate, we started the discount rate cost of capital was 12 percent but we varied it and increased
it by 1 percent each and we went up to the 16 percent.

So, we took the product of 1.12, 1.13, 1.14, 1.15 and lastly the 1.16. So, these products were
taken, and when we took the total products and we calculated the total values, so we have
found out that the NPV of the project has again become negative, though the negative figure
has come down to 27000 from the 44000.

But still, it is negative. Because ultimately for selecting the project, we want that NPV should
be at least 0. So, in this case, if the NPV is a negative, this is not worthwhile. There is no
point going ahead with this kind of the proposal. So, we should abandon it and we should not
make any kind of the investment, capital investment in this project.

(Refer Slide Time: 19:59)

Now, the next thing is we will do one more problem here. And the next thing is that is, it is
going to be again interesting problem that problem number 3 if you look at here. What is the
internal rate of return of the following cash flow streams?

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And you look at if you look at these cash flows, they are non-conventional that in the first
case in the 0 year, we had 3000 rupees of the, or 300,000 rupees of the or the 3 crore rupees
of the say investment we are going to make.

Then at the end of the first year we are going to have an inflow of the 9000 and again in the
second year, we have to again make investment of the same amount, what we made in the 0
period that is of the 3000 rupees. So, in this case there are say how many? There are total 3
cash flows, we have 2 cash outflows and the 1 cash inflow.

So, if you look at this, we have to evaluate this proposal and for evaluating this proposal what
you have to find out is what is the internal rate of return? You have to find out the value of R
and as I told you that normally the say R that is the internal rate of return, the limitation of
internal rate of return is that when the cash flows are non-conventional, that you are making
the investment in the 0 period and only the cash inflows are coming over the subsequent
years, then it is fine. This is a conventional cash flow problem.

But in this case when the cash outflow is going in the current period and then cash inflow is
coming, then again cash outflow is going so it means it is a non-conventional cash flow. So,
question arises, can we apply the internal rate of return criteria here? Let us see whether we
can apply or not, we will calculate the say R, value of the R internal rate of return and then
try to find out whether it is worthwhile to use the IRR criterion or not. So, in this case how to
you do it?

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(Refer Slide Time: 22:03)

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We have to find out the value of R that is the internal rate of return or we can call it as IRR.
The question is that what you have to find out here is that what is the internal rate of return?
So, we are going to find out the internal rate of return from these cash flows. So, these cash
flows are what? 3000 rupees in the 0 period, so that is 3000 rupees no point of discounting it
then it is the 9000 is coming up at the end of the first year.

So, we have to discount it and we have to discount it with some figure and that is called as R
and since it is at the end of the first year, so no power means only 1 which we do not write
and then again the sign becomes negative and this is again 3000 rupees and here you have to
discount it and for discounting will be 1 plus R power 3. So, we are making the investment in
the third year. So, money will also be going out in the third year.

So, this will become minus 3000 equal to 3000, 9000 to be discounted for 1 year 1 plus R,
and you are making investment not now, you are making investment in the third year. When
you are making investment, so it means finally, we have to again discount it also and this
value should be 0 that is minus 3 cash inflow and outflow, where the value is 0, the net
present value is 0 that is the our selected internal rate of return.

So, if you solve this equation, if you try to find out this equation with the help of trial and
error method, so what will be this? Value of the R internal rate of return will be if you
calculate this, if you solve it and you apply the discounted criteria and try to find out the
value of the R with the help of trial and error method.

So, the value of R will be in the one case it will come as 1.61 and in the second case, it will
be minus 0.61. So, it means if you convert that into the percentage terms, this becomes 161
percent and this becomes minus 61 percent. So, we are getting the two discount rates, one is
the 161 and second one is going to give us the 61 percent.

So, it means, what happens here, we want to find out the one internal rate of return that is the
requirement ultimately. But in this case, we have found out the two internal rates of return,
one is positive for discounting the inflow and one is negative for discounting the outflow
taking place in the third year.

So, it means the rule of the internal rate of return breaks down here, because you are not
finding out which one to take. So, when you are going to calculate, here as the NPV will be
getting this kind of the 2 situation, this is NPV 0 here, NPV is 0 here also.

459
So, which one to select? You cannot select this. So, this limitation, which we discussed
sometime back in the one problem that it is a in case of the non-conventional cash flows, if
you want to apply the internal rate of return, it is not possible as this is a problem coming up.

So, it means in the one case it is coming up as 25 percent and in other case it is coming up as
400 percent. So, it means, if you want to apply this you cannot apply and the rule of this
internal rate of return is broken down here. So, when you are not able to find the one say
internal rate of return, so, in that case, what we do?

We do not apply the internal rate of return, this is not possible and this kind of the cash
inflow as well as outflows are not required for applying the internal rate of return criteria. So,
your answer should be, you should show this kind of the calculations, working out of this
kind of the calculations and then you should try to then find out that, since we are getting the
2 rates here, two internal rates of return, so it is not possible to apply the internal rate of
return criteria and the solution of this kind of the situations or this kind of the problems is that
we can apply here or we can calculate here the modified internal rate of return.

So, if you apply the modified rate of return, so you have to calculate the certain things like
you have to calculate the present value of the cost, PVC you have to calculate, then you have
to calculate the your terminal value and then you have to apply the model and that model
which you apply is that is a PVC is equal to TV divided by 1 plus MIRR. If you apply this
model, then you will be able to calculate the modified internal rate of return.

So, here we are going to calculate the present value of the cost we are going to get 3000
rupees and then again 3000 rupees and then this have to be discounted, we are going to
calculate the future value, compounded value of the cash inflows and then we are going to
apply this model.

So, if you apply this model you can calculate the value of here MIRR and MIRR is a solution
in case there are the non-conventional cash flows and if the cash flows are conventional, you
can calculate IRR.

But if the cash flows are non-conventional like this, you have outflow, inflow, outflow,
inflow, then the solution is modified internal rate of return and not the internal rate of return.
So, the answer is that in this kind of situation you cannot apply the simple internal rate of
return.

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(Refer Slide Time: 27:52)

Next problem we go for it is that XYZ limited is considering two mutually exclusive
investments.. That is project P and project Q, the expected cash flows of these projects are as
follows. We are given here again the period of 5 years and we are given the 2 projects now.

Now, we have the mutually exclusive projects, this problem is different from the previous 2,
3 problems which we did. There only we had one project and only the one cash inflow and
cash outflow only one issue was there, one project was there and we had to simply evaluate
that problem.

But in this case, now the things are different, here we are given the again 5 years period of
time, but we are given the two projects. Project P and the project Q and what these two
projects are? Mutually exclusive, if you can take one, you cannot take other, if you take the

461
second, you cannot take first. So, we have to decide which one is the best product or project
or the investment proposal and how should we go for taking the decision. So after looking at
these cash flows here.

Now, these are the two different situations in this case, the first how many, 3 years 0 period at
the end of the first year, at the end of second year and at the end of third year, there are the
negative cash flows. It means cash outflows are taking place only here 4 and 5 are giving us
the inflow whatever the total information is available.

In this case, we have got the project where the cash outflow is occurring only in the current
period, but over the subsequent 5 years, we are going to get the cash inflows. So, we have to
evaluate it and there are some questions given here which we have to answer these questions.

So, first question is construct the NPV profile of the two project. Second is what is the
internal rate of return for each project? We have to calculate the IRR for each project. C,
which project would you choose, if the cost of capital is 10 percent and 12 percent? So, we
have to evaluate these are the two COC’s cost of capitals and d is what is each projects MIRR
if the cost of capital is 12 percent?

So, almost we have to answer all the questions, what we discussed conceptually with regard
to this discounted criteria. Here largely we are going to talk about the discounted criteria,
where we are going to calculate the NPV also, we are going to calculate the IRR also and we
are going to calculate the MIRR also, only one thing that is the benefit cost ratio is not asked
and we are not going to calculate it. And second thing is we are not going to calculate
anything which is as per the non-discounted criteria.

So, to answer these four important questions, and to evaluate these two projects, which are
mutually exclusive, we have to again do the detailed analysis after solving all these questions
and trying to find out the answers for these questions based upon the process which we have
learned through the conceptual discussion on the capital budgeting proposals.

So, this particular problem, problem number 4, I will discuss with you at length, every
question we will learn how to answer the every particular question, but this problem, I will
discuss and answer and solve it in the next class. Till then, thank you very much.

462
 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 28
Capital Budgeting Part 12
Welcome all. So, in the process of solving some capital budgeting related problems, we did 1
or 2 problems or rather 3 problems in the previous two classes. And now we are going to do
one more problem which is quite comprehensive and we are going to answer many questions
here which are of quite a good amount of interest for all of us.

And first important thing here is that these two projects are mutually exclusive. Mutually
exclusive projects are those projects where you can take only one, if you take one, you cannot
take other, if you can take second, you cannot take one.

(Refer Slide Time: 1:05)

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So, you are given here the information about the cash outflow and cash inflow of the two
projects, project P and project Q. And these are the four questions which we have to answer
here. We have to make the NPV profile of the two projects then we have to calculate the IRR
of the two projects, then we have to answer the question which project would you choose, if
the cost of capital is 10 percent and 12 percent. And the last question is what is each projects
MIRR if the cost of capital is 12 percent.

So, we have to answer these four questions and after doing this problem, I think most of the
issues related to the capital budgeting as far as the practical problems are concerned will be
clear to you. So, the peculiar point if in this project, if you look at the project P, we have the
cash outflows for the first 3 years, including 0 period, the current period, that is the period of
building the project plus at the end of the first year also, we have the cash outflow, second
year we have the cash outflow, third year we have the cash outflow, fourth year we are going
to have the first inflow and fifth year also we are going to have the first inflow.

Though the capital outflows in the year second and third are not very substantial, but still it
is quite a good amount, which is, you can call it as, 50 percent of the cash outflow in the year
1 that is happening in the year 2 and year 3, almost you can say that is 25 percent of the cash
outflow which has occurred in the year 0 or in the current period, which we have invested
that is 1000 crores or 1000 lakhs or whatever it is, these figures are given to us.

So, cash outflows and then the cash inflows, but again, you would not call these cash
outflows and inflows means multiple cash outflows and multiple cash inflows as the non-
conventional cash flows, these are the conventional cash flows because non-conventional

464
means, when there is outflow, inflow, outflow, inflow then it is a conventional, then then it
creates a problem there you have to apply the concept of MIRR, not the concept of IRR.

But in this case, because these all are the outflows happening till the end of the third year,
only in the fourth year, we have got the first inflow, fifth year also we have got the inflow.
So, it means, this is a conventional problem and can easily be done. And here also you can
calculate the IRR, also not required to calculate the MIRR and NPV is very easy to calculate
in this case.

In this case the things are quite easy it is very conventional and simple situation. In this case,
you can say that, in the current period 0 period, there are the cash outflows, 1600 rupees and
in the subsequent 5 years there are the cash inflows that is 200, 400, 600, 800 and 100. So,
these cash inflows are there.

So, we have the 5 cash inflows, one cash outflow. So, the problem is quite simple here,
whereas in this case we have the 4 outflows and only two inflows. So, still the things are not
very complex and the main basic and the positive point here is that these cash flows are
conventional, not non-conventional.

So, simple NPV can be calculated and IRR can also be calculated. But the projects are
mutually exclusive, so you have to answer the questions in terms of that if you take the
project P you cannot take the project Q, if you take the project Q then we have to abandon the
project P.

So, that is the meaning of the mutually exclusive projects. Let us solve these problems and
then try to find out what is the NPV of these two different projects? So, if you want to
calculate the NPV of these two, so we will to prepare the NPV profile.

NPV profile you have to create of two projects and for calculating the NPV we are going to
take the different discount rates, this is the discount rate and these are in the percentage terms
we are going to take these discount rates in the percentage terms and the discount rates for the
project P and project Q and we are starting with the discount rate of 0.

And then we are going to take the next one 5 you can take any discount rates, but we have
assumed here that the discount rate is 0, the discount rate is 5, discount rate is 10, discount
rate is 15 and discount rate is 20. Because we have taken two knowingly that one we have
taken 10, then we have taken 20 also because it is asked in the question, we are asked in the

465
question that which project would you choose if the cost of capital is 10 percent and 12
percent?

And in this case, we will have to now answer this question depending upon the number of
issues involved. And in the second case is, what is each project’s MIRR if the cost of capital
is 12 percent? So, in this case, when you have to choose the projects out of this, out of these
two.

So, what we have to do here is that we will have to calculate the cost of capital, we have to
discount these projects and after discounting the cash inflows available from these projects.
We have to try to find out the answer for the question that how we can answer these questions
or how we can calculate the total cost out of it. So, it means we are going to find out these.

So, in this case, we are given the different options available here. So, what we are going to do
here is that we are going to evaluate the projects and in the one case, we are going to try to
find out which project would you choose if the cost of capital is 10 percent and in the second
case, this cost of capital is 12 percent.

One dimension we can add up here also that if for example, the cost of capital is 20 percent,
then which project we will be choosing? So, we will answer these questions while calculating
certain values and after calculating these values, we will have to find out the solution for
these questions.

So, in this case, when we have to calculate the NPV for these two projects project P and Q,
you know the process very easily and for example, if you want to calculate the NPV of the
two projects, and applying the discount rate and the discount rate is 0. So, for this case simple
NPV will come up, in this case is how much is outflow because the value of outflow and
inflow will be same because discount rate is 0.

So, 1 plus R when you do so, 1 plus 0 you will be doing so, it means we are assuming that
whatever the cash outflows are going to be there and whatever the cash inflows are going to
be there values are going to be same.

So, in this case, we have to do here is one thing that is , what is the cash outflow here in the
first 3 years including 0 current period, the cash flow is going to be 1000, then 1200 is 2200,
2800 and then it is 3050, the total amount is 3050 and out of this if you say subtract this
inflow, inflow is 2000 and 4000.

466
So, this becomes 6000. So, this inflow of the 2000 will be taken as 2000, 4000 will be taken
as 4000, so total becomes 6000. From the 6000, which is the present value of the inflows, if
you subtract the present value of the outflows, so, you are left with one something which is
called as NPV and NPV of this project comes up here as 2950. So, this comes up as 2950.

So, very simple because almost you can say we are not discounting it and we are discounting,
so, we are saying that even the discounted values will also be same. So, the discount rate we
have applied here is the 0 percent and the NPV of the project is coming up as 2950 and in the
second case the NPV of the project is coming up here as the 500. So, it means 2950 and 500
are the two NPVs which we have to calculate by discounting the cash inflow and outflow at 0
discount rate.

Similarly, if you follow the discounting process, what we discussed in the previous class and
if you calculate, so you will find out the NPV is here in this case at the 5 percent discount
rate, you will find in case of the project P, this will come up as 1876. In the second case, if
you go for the detailed calculation of the NPV because the cash flows are conventional, so
easily you can do it, this will come up as 208. In this case this will come up at 1075 and in
this case it will come up as minus 28.

And in this case, at the 15 discount rate if you want to find out this comes up as 471 and this
comes up as minus 222; 222 is the NPV and as the discount rate 20 if you want to find out
this is 11 and this is minus 382. This is 382. 11:16

So, this is the NPV profile of the two projects, project P and project Q, so easily now you can
answer different questions on the basis of it because if the discount rate is 0 again the project
P is better as compared to project Q, though it was looking like if you look at the cash flows,
so we are finding out that for the first 3 years, including 0 period, we are only incurring the
cash outflows, but when the cash inflows start coming in, and when we calculate the NPV, so
NPV of the project P is more as compared to project Q where the NPV is only 500.

In case of the discount rate 5 percent again, the NPV of the project P is higher as compared to
project Q. And when the discount rate increases to 10 percent again the same situation even
in case of the project Q, NPV becomes a negative and 15 and then the 20, NPV is further
more negative. So, it means your NPV from this project means every angle you look it at
from that project P seems to be the better option as against the project Q.

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So, it means if you take the NPV net present value as criteria and look at the cash inflow and
outflows available from the two projects and discounted them at the different rates, at every
rate the answer comes up as project P is better than the project Q. So, this is the first question
we have answered.

Now, we have to calculate the internal rate of return for the each project and for calculating
the internal rate of return for each project we have to calculate the R for the project Q. And
we have to calculate the R for the project P that is the internal rate of return for the P and for
the project Q.

So, let us calculate for these. So, we will calculate the internal rate of return for project P,
IRR, project P. So, we are going to calculate IRR for the project P. So, in this case what this
amount comes up as? We have to take now the outflows and we have to start with outflows.

So, what is outflow given here? It is starting with 1000 going up to the 1200, so like that. So,
in the first case, it is going to be how much? This is going to be something like minus 1000
because it is the first year's cash outflow, then it is again minus 1200 into, now, we have to
discount it, and we have to discount it means at rate, so rate is not known to us, we are going
to find out that rate, because it is the internal rate of return. So, you have to discount it.

So, what can you do is? You can write here the one option is 1 plus R and year is 1, so this
becomes 1 and this R is not known to us. So, this R we are going to find out, so this is the one
way. So, what can you do is? Means you can do this way also you can calculate it also or you
can apply the trial and error method also. So, if you apply the trial and error method because
ultimately you have to apply the trial and error method, so if you calculate with the help of
trial and error methods, so what we can do is?

We can make use of the present value interest factor and if you take the present value interest
factor so it is PVIF we have to take so 1200 is the cash outflow and at the end of the first
year, it is taking place. So, PVIF you have to take multiply it by (R,1) so we have to take up
this, rather than calculating it, we can pick up the value from the table directly.

In the next case, it is minus 600 and then we have to take here R into the year is which is
2(R,2). So, we have to calculate the value of the R for the year 2 we have to find out. This is a
PVIF. We will properly write it, let us write it like this that so that it is clear to you.

468
We can take here 1200 into PVIF, and it is the R year 1 then it is minus 600 into PVIF and
this is for how much R and it is for the year 2, we are going to calculate for the PVIF for this,
this is the amount of the year 2.

So, first is the minus 1000, second is the minus 1200 PVIF( R, 1), third is a 600 and then it is
into PVIF (R, 2) and then it is again minus 250 into PVIF (R, 3).And then we have to make it
as the plus this is 2000 into PVIF(R,4) and then it is plus what was the remaining?

The remaining is 4000 and 4000 into PVIF(R,4) if you take PVIF and then you have to say
take the (R, 5). So, this is a total project profile if you want to make it as if you put all the
values here. So, we are first taking up to this point we are taking only the cash outflows.

These are the cash outflows in the 0 period the cash flow of the 1000, in the first year the
cash flow is 1200, second year 600, third year 250, 250 and R is for the third year and then
we have to go for the 2000, how many years we are taking, 1, 2, 3, 4 , the cash outflows are
4, first is 1200, 600 and 250. And then we have started getting the cash inflows. And if you
take the cash inflows here, so this comes up as 2000 into PVIF( R, 4) years and 4000 into
PVIF(R,5).

And this amount has to be finally equal to how much? finally, everything should be equal to
0. So, if you want to calculate it here, now what you have to do is? You have to find out this
value of R. So, for calculating the value of R here, what you have to do is? The answer is the
trial and error method you have to apply the trial and error method.

So, that finally, sum total of this, total these minus outflows and the discounted value of the
inflows becomes equal to 0 that will be our internal rate of return and for calculating that with
the help of trial and error method, if you want to find out, you will find out here if you do it,
you will find out some rate and that rate will come up here as 20.13 percent.

If you solve it and use the trial and error method, you will find out the one rate that rate will
come up here as 20.13. If you discount all these cash inflows and outflows for 20.13, you will
find out that the total discounted value of the cash outflows and inflows will be 0 and in this
case, NPV is 0 here and that to add the rate of 20.13 percent, 1.

(Refer Slide Time: 18:28)

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470
Now, we have to do this for the second one also and we have to calculate the IRR for the
project Q and in this case, but we are starting with the this project, so only in the first year
there is a negative cash flow or the cash outflow that is 1600 over the next 5 years if you
look at we have the inflows only so again, very simple, simpler than the first one you can say.
So, you have to take here it as that we have to calculate the value of IRR.

So, we have to start with this 1600 and again you have to discount it, so 1600 is equal to
1600 and the first year the inflow is 200 into PVIF present value interest factor and for (R, 1)
this is for the year 1 you have to take. Second is the inflow is 400 and then it is PVIF into (R,
2) and then you have to take here as 600 and in this case you have to take the PVIF, PVIF and
then you have to take R, it is 3 for the third year , PVIF (R, 3) that is 600 PVIF (R, 3) and
next inflow how much, 800, 800 into PVIF into, in this case (R, 4) and then we are going to
get the next inflow and that is 100 and 100 into PVIF present value interest factor and then it
is (R, 5).

So, if you take these all outflows and inflows and you try to discount them so that NPV of the
project becomes 0. So, this value is becoming 1600 which is the outflow in the 0 period.
Other years we are getting how many, 1, 2, 3, 4 and 5 these are the inflows available. So,
PVIF (R, 1), PVIF (R, 2), PVIF( R, 3), PVIF (R, 4) and PVIF (R, 5) we are going to find out
and we are going to discount these inflows for some discount rate. And if you talk about the
discount rate, again the issue here is we do not know what is the discount rate?

So, again you have to find out the trial and error method and with the help of trial and error
method, the internal rate of return if you calculate from this particular problem, you will be
able to find out that at 9.34 percent, the NPV of these cash outflows and inflows, of this
project will be 0. So, from the previous project, we found out the internal rate of return is
20.13 percent. In this case, we have found out the internal rate of return is 9.34 percent.

So, in this case, we have to now answer the next question and the next question here is we
have answered the first 2 questions, construct the NPV profile for the two projects and then
what is the IRR for each project we have calculated. Third question is which project would
you choose if the cost of capital is 10 percent, 12 percent or we add here one more dimension
that is 20 percent.

So, we will try to find out the answer from which that is the NPV profile we have worked out
here. Now, for example if you take this 10 as the say discount factor cost of capital is 10

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percent. So, we have got these 2 NPV, first NPV is 1075 and the second NPV is minus 28.
So, obviously which project would you choose? The project P at the cost of capital or the
discount rate given to us here is the cost of capital is 10 percent. We are going to choose the
project P because NPV is far more as compared to the project Q when the NPV is negative.

And if you take for example, the cost of capital is 20 percent. Again, the answer is the project
P though the NPV has come down from say 1075 at 10 percent to only 11,000 crore, lakhs
whatever you want to consider it as to only 11, but if you look at the NPV of the project Q it
has become further more negative and that has risen up to 382, 382 rupees lakhs, crores
whatever it is.

So, it means in every case you can find out and at the cost of capital 12 percent you can
calculate yourself that you can find out again all cash outflows and inflows are given, if you
discount them in between somewhere it will be because I have discussed the two extremes 10
percent and 20 percent, at 10 percent, NPV is 1075 whereas, it has come down to 11 but if
you increase it to for example, to 12 so, it means NPV will come down. But certainly it will
be say far more than 11 or in this case it will be negative again because at 10 itself it is
negative.

So, at 12 also it will be negative and that will go up, but will not go up to means this level
where it has reached up to minus 382 at the say cost of capital of 20 percent. So, this is the
means 12 percent level you can calculate yourself and you can then find out the answer for
this particular question.

Now, next thing is, what is the next question? Next question is what is each project’s MIRR,
the modified internal rate of return. So, for this particular purpose, for calculating the MIRR
for this, we can easily try to find out the MIRR out of it and for calculating the MIRR,
modified internal rate of return, we can see that we know the formula and how to calculate it
that we have to first of all calculate the present value of these all say, what is we call it as the
inflows and outflows we have to calculate the present value of all the cash outflows. So, that
is the formula.

So, if you look at the formula, what is the formula here? We can say here that is for
calculating the MIRR, modified internal rate of return so what is the formula? Present value
of the cost is equal to terminal value of the cash inflows and divided by 1 plus MIRR and
power it is n here.

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So, it means, we have to calculate the present value of the cost, we have to calculate the
terminal value of all the inflows by compounding them against the given cost of capital and
then we have to find out the MIRR. So, for following or calculating MIRR, we will be
following the same process and if you follow the same process of what we do is?

(Refer Slide Time: 25:29)

We take here the project P, if you take the project P here, so we have to calculate the PVC
present value of the cost for first of all, so for calculating the present value of the cost, what
you have to do here is? You have to now, take 1000 and if you take the 1000 during 0 period,
so you would say here, that is the PVIF into 12 and the year is 0 because 1000 in the current
period is equal to 1000 we are taking it as 0.

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Second part is what? 1200 into PVIF present value interest factor into this amount will
become 12 percent and for the year 1 and then it will become plus. How much is the next
cash outflow? Cost means 600 into PVIF, so here it is again 12 into 2 means 12 for the 2
years and last cash outflow is how much? First one is 1,000, second is 1200, third is 600 for
PV for 12, 2 and then it is a 250 into PVIF and then it is 12 and it is for the years how many,
3. So, first 3 years including 0 period, we have the cash outflow. So, these are the 4 cash
outflows.

So, if you calculate the PVC this comes out as 2728, rupees 2728 is the present value of the
cost. Then we have to calculate the terminal value of the cash flows whatever the total cash
flows, we are going to have here, we have to calculate the terminal value of these cash flows.
And if you calculate the terminal value of these cash flows, so, what is here, first cash inflow
2000 and you have to compound it at the rate of 12 percent and for how many periods? 1
year.

And then second is the 4000. So, these are the 2, one is a 2000 compounded for 1 year’s
period of time at the rate of 12 percent and the second cash flow is coming at the end of the
last year, whose value is equal to 4000. So, if you calculate this, this works out as rupees
6240. So, now you can apply the same model which I discussed with you. What is the present
value of the cost? 2728, present value of the cost is 2728 and then what is a terminal value?
Terminal value is 6240 divided by one plus MIRR and power is n, so n is how many number
of years? Total it is 5.

What is the life of the project? Total number of years given to us is the 5. So, we have taken
this and if you solve this equation, it will become something like this 2728, if you take this
2728, so what you have to do is? In a way you can try to find out here it is that means you can
write it like this also 2728 and then it is 6240, 6240 into PVIF present value interest factor of
MIRR for 5 years and this we have to calculate or even if you calculate by cross
multiplication, so you can solve this also.

So, finally, this value if you want to take it up as this becomes how much? 1 plus MIRR
power 5 becomes if you take this, this value becomes 2.2874 and if you want to calculate the
value of MIRR out of it, this value becomes how much? 18 percent, if you want to solve it,
this value comes up as 18 percent. So, this is called as the modified internal rate of return,

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So, similarly you can calculate the modified internal rate of return for the second project also
and the second project if you try to find out here is then the MIRR for the second project will
be here in this case will come up as for the project Q. MIRR for the project P and for the
project Q, if you calculate MIRR for the project Q. So, MIRR is equal to if you calculate it
comes up as 10.41 percent means not I am solving it, you can solve it yourself.

Again you have to calculate the present value of the cost of the there and you have to
calculate the terminal value of the cash flows. So, in that case if you look at the present value
of the cost in this case, this is 1600. No need to calculate anything and if you calculate the
compounded value, terminal value or the compounded value of the cash inflows.

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(Refer Slide Time: 30:37)

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So, you can calculate present value of the cost in this case becomes how much? Rupees 1600,
here and if you calculate the terminal value will come out here as 2624. I am giving you the
final values, you have to calculate yourself and if you want to apply the formula here, so it
becomes 1600 into 1 plus MIRR power how many years are there? 5 and this becomes 2624
it is the terminal value.

This is a present value of the cost, this is a terminal value. And if you want to calculate out of
this if you solve it, so MIRR comes up here as that is 10.41 percent. So, we have calculated
all the things, we have calculated IRR also, we have calculated MIRR also and we have
already calculated the NPV also.

And NPV we have calculated not for only one level, for multiple rates 4, 5 rates, discount
rates, we have calculated or cost of capital we have calculated and if you want to now say
take a decision on the basis of all these criteria, if you talk about the NPV at every level
means 0 to 20 percent we have calculated at every level the NPV of the project P is more than
the project Q. So, if you want to take one out of the two, then the project P is better.

Looking at the internal rate of return, project P gives you 20.13 percent and the project Q
gives you 9.34 percent, so no comparison. Again the project P is better than the project Q.

(Refer Slide Time: 32:08)

Then you talk about the MIRR, if you calculate the MIRR, in one case the MIRR is coming
up as 18 percent. In the second case, the modified internal rate of return is coming up as
10.41 percent and again there is no point of comparison.

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So, it means at every step if you want to evaluate any mutually exclusive projects, if you
want to try to find out the solution of this kind of the answers, or the answer to this kind of
the questions, you have to go for the detailed analysis, you have to apply different discounted
criteria, NPV, IRR, MIRR if it is required.

And then on the basis of that you have to find out because ultimate objective of every firm is
that to maximize the value of the firm, and that is only possible where every project
contributes in terms of the positive NPV’s, highest NPV’s towards the total value of the
firm's, so that value maximization or maybe the wealth maximization objective of the firms
can be achieved.

So, after solving these 3, 4 problems, one more problem is given here, which is homework to
you can do. A problem number 5, other 3 problems are here, problem 5, problem 6, problems
7, these problems you can solve yourself. And if there is any question with regard to these
problems, you can discuss with me during the when the course, will start at the discussion
forum, you can raise these questions.

I do not see any problem here that you will not be able to solve these problems. You can
easily solve these problems and for any difficulty, any kind of the clarification you want to
see, you can refer to the books on the Financial Management and the best book I am
repeatedly telling you is that “Financial Management by Prasanna Chandra”, so you can refer
to that book I have taken these problems from that book only.

So, you can refer to that book, you can see these problems there. There are the, solved
problems also, unsolved problems also and then you can try to see that how to apply the
discounted and not discounted criteria for evaluating the capital investment proposals.

So, with this total discussion till now, what we had for the last number of classes, till now
what we could discuss that was the detailed exhaustive discussion on the capital budgeting
process. And we learned in this that if any capital expenditure proposal has to be evaluated,
how to evaluate it, what are the different ways, techniques, methods, different criteria is
available, and we discuss everything at length.

And for any doubt, any further clarification, any further discussion or any further reference
you can refer to the any good book on Financial Management and the book which I am
referring “Financial Management by Prasanna Chandra” would certainly solve all your
problems and resolve all your issues.

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So, with this I stop the discussion on the capital budgeting now. And now, next part of
discussion means in the next class onwards, we will start talking about the estimation of the
cash flows. So, whatever the cash flows we are used here in case of the capital budgeting, we
thought that they are readily available with us, but these cash flows are not readily available,
we have to work out these cash flows.

The process is very lengthier, there is a very long lengthier background process involved in
working out the cash flows. So, how to estimate the cash flows? What are the important
factors to be kept in mind? And all other issues relating to the estimation of the cash flows, I
will discuss with you in the next class. Thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 29
Estimation of Project Cash Flows Part 1
Welcome all. So, now we will move to the next part of this learning in the Financial
Management and the next part is that is the estimation of the project cash flows. In the capital
budgeting we saw that the cash flows were given to us and we learned about that how to evaluate
the any capital investment proposal based upon the cash flows which are available to us.

(Refer Slide Time: 0:57)

So, in that process we had that two kinds of the cash flows were there, one was the cash outflow
and second one was the cash inflow, these two cash flows are available with us and once these
two cash flows are available with us this we are showing in the minus terms and this we are
showing in the plus sign.

And then the purpose in the capital budgeting was that we had to compare that the present value
of the cash outflow has to be equal to the present value of the cash inflows that was the minimum
basic requirement and if any project meets that requirement, then we say that yes, there is a point
or there is some merit in looking into the project or considering the project. Otherwise, there is
no point considering the project or looking into the project.

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So, there the comparison was between the cash outflows and inflows and the entire process we
did and learned there was that we discounted the cash inflows especially because cash outflows
we considered they are in the initial period. So, they are equal to 100 percent but the cash inflows
coming in in the subsequent years, because of the time value of money, their value goes down.

So, you cannot consider the cash flow coming at the end of one year equal to the cash flow
which is available with us currently or maybe coming back to us after two years or at the end of
three years or at the end of the four years that is equal to the current cash flow or the cash or the
funds available with us or the cash available with us. So, it means there we apply the concept of
discounting.

So, we calculated the discounted value of the cash flows and then we applied the to kind of
criteria discounted criteria and the non-discounted criteria for evaluating the capital investment
proposals. Now, a million dollar question here arises is, from where these cash flows come, this
is a very important question.

They are not served to us on a platter means to the finance people or to the financial managers.
These cash flows are not served on the platter it is a very, very complex job. It is a very, very
tedious job and largely projects succeed because of the right estimation of the cash flows, or
many times project fail because of the wrong estimation or committing a blunder or error in
estimating the cash flows.

So, it is a very, very important job, it is a very, very important part, it is a very, very important
component of the overall Financial Management or evaluation of any capital investment
proposal. And you would agree with me that cash flows largely, when you talk about the cash
outflows, we talked about that in terms of investment, how much investment is required to be
made in any project.

That is a very important consideration and for arriving at this figure of investment, because in
the, if you go back in the initial discussions in the financial management or the financial decision
areas, we discussed that they are the two important decisions to be taken in the financial
management and we learn about that in detail while we study the overall this concept of the
financial management or the area of the financial management, two decisions are, one is the
investment decision and second is the financing decision.

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And investment decision we talked about is that for example, any project we want to take up
whether it is new, for the first time, it is a new firm, new business organization, maybe a startup
or maybe in any form of organization is created for the first time, even then, and even if it is a
project being created by or being undertaken by an existing firm, in both the cases the estimation
of the cash flows is important.

So, in this case, when you talk about the investment decision, we have to arrive at on some figure
of investment and this figure of investment is 1 lakh rupees here, we need 1 lakh rupees to
establish this project or move into this kind of the business. Now, from where this 1 lakh rupees
has come up, who has found out or how we have been able to arrive at? Means there should be
some basis for it and for estimation of the cash this investment will cause us the cash outflow.

This will cause us the cash outflow and to arrive at this figure of the 1 lakh rupees or 10 lakh
rupees or 1 crore rupee or 1 million rupees 1 hundred million rupees or 1 billion rupees that will
depend upon some estimation and we have to arrive at on these estimates on some basis. So,
when you talk about the investment in any business largely we have the two kinds of the
investment, one is the long term investment and second investment is called as the short term
investment or you call it as the current investment.

So, two kinds of investments are required to be made in any business and for these investments,
we have to work out, we have to arrive at on some basis and we have to find out these estimates
on some basis for taking the decisions. So, it means long term investment is, we are going to
make it somewhere in the fixed assets or the assets which have the long term value, which has a
high value and the very long life you can call it as, it has a medium to long term life.

So, we have to make the investment into these assets and then we have to make investment into
the current assets or the short term assets. So, they are called as the current assets or short term
assets and the investment in these assets is equally important to support the investment made in
the long term assets.

So, they are reciprocal to each other, means current assets support the fixed assets and fixed
assets need the current assets, so, it means sum total of this when you talk about is, this becomes
the total investment. So, to arrive at this figure of maybe whatever it is we call it as, it has to be
found out on some basis.

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And that basis means when you talk about the fixed assets, what are the fixed assets, land, you
need for establishing any manufacturing facility or any organization, any business undertaking
you need the land, then you need to create the buildings on that, then you need to go for the plant
and machinery, then you need to go for the furniture and then you need to go for the vehicles. So,
so many different kinds of the fixed assets are required.

So, maximum thing we can do is that if we are a new firm or we have the lesser amount of the
funds available with us, we cannot make investment into these assets, maybe land and building,
we can hire some existing building maybe if it is some building is there and it is lying unused or
if it is available for renting purpose or leasing purpose, this can be, if it is a new firm so that
immediately you can avoid making investment into land and constructing the building.

But you need to have the plant and machinery, you need to have furniture, you need to have
vehicles and so many other kinds of things. So, ultimately whatever the level of the fixed assets
we work for, we have to create and that will cause the investment and investment is ultimately a
synonymous to the cash outflows, this is one. Second part of the investment you require for the
current assets.

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(Refer Slide Time: 8:19)

Now, the what are the current assets? We need to have raw material, we need to have, to pay for
the wages of the employees because if the raw material is not there, what kind of the plant you
are going to have, workers are not there to run the plant then why you are going to have the plant
and then to have the raw material and then you have to have the say lighting and other kinds of
thing.

So, all these for running of the plant and for the successful implementation of your business plan
or the business objectives, you need to create, give shape to this organization, and this
organization has a structure, here you have to create the fixed assets, here you have to create the

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current assets and some total of this will require something which is called as the investment to
be made and when you are making investment, it is causing the cash outflow you have to
estimate this.

So, how much investment is required to be made in for giving a shape to a particular kind of the
business. So, how would you make estimate for that? So, we have to do different kinds of
analysis, there is one before undertaking any new project maybe by the new firm, new
organization or by the existing firms you prepare one report which is called as a DPFR, this is
called as DPFR - detailed project feasibility report.

And this detailed project feasibility report has many important components or many important
parts of it. First of all is the inception of idea, this is the first important thing we should have for
moving into the business, maybe by existing firm or by the new firms.

Once you have idea, then we will go for the market and demand analysis, this is the second
thing, then you have to go for that technical analysis, and then after that you have to go for the
next thing which is called as the financial analysis.

Next, next thing is that we have to go for is the financial analysis, we have to make the financial
analysis, this is called as the financial analysis, then we talk about the risk analysis and so on and
so forth like then we go for the net working techniques or other kinds of things are there. So, net
working techniques we have to use for other kinds of things, because we have to exercise that
control over the project also.

So, it means everything once your idea is there in the mind, then whether that idea is saleable in
the market, is acceptable to the people in the market. Means either you can convert that into the
product, you can manufacture a product or you can render a service, means you can create a
service, generate a service and you can start giving that service to the people.

So, it means idea will be something like that, other than this is not possible, largely we confine
our analysis and discussion upon the two things, either we are going to have the manufacturing
firm or we are going to have the service sector firm. So, for example, when this owner of the
OYO rooms, he moved into the business and then he thought of starting the hotel service.

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So it is a service sector idea, and he tried that idea, it worked very well and now it has become
one of the biggest groups serving the country. Similarly, when the owner of this Ola, IIT
Bombay graduate, if you think about how you got that an idea, he graduated from IIT Bombay
and then he was working in some companies he moved to US and then he had an idea about the
Uber because Uber was already operating in other countries including US.

So, he got an idea that why not to start this kind of the cab service in India also and he started
Ola. So, for example, during the demonetization days even before that, we have this Paytm. This
is again a service sector product and Paytm was invented and then the service started and then
Mr. Sharma, the owner of this Paytm, or the person who created this Paytm, he had an idea in the
mind that if I create an app which facilitates the receipt and payment of funds by the people so it
can work well.

So, it means once you have an idea in the mind, maybe for manufacturing your product or many
times I refer to you is about the question why is idea about manufacturing Nirma washing
powder or then I discuss with you is the Fruit Beer idea by the Anchor group.

So, these are the ideas, come to somebody's mind and the basis of ideas is that if we are in the
developing countries market then we draw some idea on the basis of the developed countries
markets, the products and services, which are very much prevalent there, very common there and
they have not even come up to this country or in this economy, we can have an idea that yes, this
service can be used by the people in India also. So, why not to start this service or move into this
kind of the business.

So, you have to, first of all have an idea, once that idea comes up in the mind and we become
serious to convert that into the business. Then after that the million dollar question is conducting
the market and demand analysis and conducting the market and demand analysis is a very, very
cumbersome job it is a very very complex procedure.

Who is going to buy my product? Because manufacturing or generating of any service is not
difficult these days. Maximum difficult part is the selling of that product or service in the market
and for that we need the market we need the demand.

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So, we have to go up to the people being the potential users of your product of the service, we
have to conduct the market and demand analysis and on the basis of that we will come to know
whether or people intend to buy any kind of the product or the service if it comes up or not.

So, it means market and demand analysis is the backbone of success or failure of any project. For
example, in case of the Nirma, Karsanbhai never did any market or demand analysis, he did it
not actively but passively because he first all had an idea. So, he started converting that into the
finished product and he started distributing amongst the people living in his vicinity, he started
distributing this to his relatives, and then he increased the scale.

So, when he got the response is very good. So, in a way you can call it as a market and demand
analysis, he manufactured at a very small scale a few kgs of the washing powder, he distributed
it amongst the people and people liked it. So, it means that is also a sort of market and demand
analysis, after conceiving this idea, converting into the washing powder, he did not even start
manufacturing at the mass scale or the larger scale.

No, he did not start that production, even if it is why some existing company even they are the
resources also Karsanbhai did not have the resources at that time, but even you have the
resources also, then, you cannot start manufacturing or selling at any large scale until, unless you
are sure about the acceptability of the product.

So, whether actively or passively we have to do the market and demand analysis and once the
results are quite positive, and we are able to find out that yes, initially in the first year this much
of demand we can expect, because we have to estimate the demand, we have to adjust that
demand against certain factors.

And finally, we have to arrive at a figure, whatever that market and demand analysis we do, may
be ourselves or be the help of somebody else, we can refer it to some consulting firms also we
can get it verified by them also, and then we can arrive at some conservative estimates that yes,
this much of the demand for our product or service could be there in the market.

The next thing is, once the market is responding or expected to respond and we are expecting
some positive results from our business. The next thing is we have to go for the technical
analysis that now if I have to give shape to this organization, this firm, how much investment I

487
have to make. And that investment when you talk about that investment has to be made into this,
your fixed assets and current assets.

So, it means on the basis of market and demand analysis, you are going to convert that idea into
the business, it means you are taking sort of a decision which is called as the investment
decision. Now, we have to know the quantum of investment and in a way you call it as
estimation of the cash outflow that in the initial period 0 period, whenever we want to give shape
to the project, whatever the investment is required, and we have to estimate for that figure.

So, it means, when you are estimating for that figure, it means you are estimating for the cash
outflows required at the stage of building the project. And this investment requirement to a larger
extent will depend upon the technical analysis, because technical analysis guides us that how
much land is required?

How much building is required, what is the size of the plant and machinery available in the
market and be required for that what other fixed assets are required, furniture is required,
vehicles are required, everything we have to make estimates of and then we have to then sum it
up.

So, you can say that yes, this is the level of the fixed assets I need to create and when you
convert those fixed assets into the financial terms, so, that gives us the requirement of
investment in the long term assets or into the fixed assets and on the basis of that fixed asset
estimate.

You then estimate about that to efficiently, properly run and make use of these fixed assets and
to go to the fullest capacity utilization in the business, how much working capital I require, how
much short term funds I require? I need the funds for material, I need the funds for paying the
wages. I need the funds for paying for these utility and water and then for the other ancillary
products.

So, total working capital we have to estimate, so total invest we have to estimate and that
estimating the total investment and then we arrive at some figure, which is called us investment
requirement and in a way you call it as a cash outflow. So, then we are saying here, that this cash
outflow, when we are talking about the cash outflow, we are going to make.

488
In this case you are saying that this investment of 1 lakh rupees, I am estimating here that initial
investment, total investment in the fixed assets and current assets required is 1 lakh rupees, it
means I have some basis on which I have arrived on this figure and I am in a way estimating
about the cash outflows.

Similarly, then, we will now look for, forward that once we take the investment decision, then
how much time will it require to build that project and finally give shape that project and how
much time it will take to start working or commissioning of the project, and after that production
coming out of that plant or that project and then going to market and giving us the cash back,
which is called as the estimation of the cash inflows and cash inflows will largely depend upon
something, which is called as the market and demand analysis.

It is called as market and demand analysis because larger the demand for your product in the
market, higher would be the sales and higher would be the cash flows coming back to the firm.
So, estimated because many times what happens when we go for conducting the market survey
people because they do not have to buy the product at that time. They do not have to shell out
any money at that time.

So, you are simply asking their opinion, and they say yes, if this kind of the product comes up, or
this kind of the service comes up, I will be the person will be buying or using that service, but in
the real sense when the product comes up in the market, then it it creates the real situation. Now,
whether people are positively responding for that, or they are dormant or they are negatively
responding for that.

That is why what happens that many times when the existing firms when they launch the new
products in the market, because for them resources are not the problem, for them the business
acumen is not the problem, for them the technical know-how is not the problem, they already are
into the business and they want to either add a new product into their existing say line of the
products or they want to go for the expansion or entering into the new markets.

So, what they do is, they have an idea in the mind they test it not by market and demand analysis,
but through other modes. For example, that product is already existing in the other countries
markets or within the same country, but in the other segments. Now, they have to take the

489
product either from the developed economy to the developing economy or from within the
country say India from the northern India to the southern India.

So, it means already the product is being manufactured, either by themselves or by somebody
else. So, if we also start manufacturing it, if it is not in India, we bring that product to India or
that service to India, we start say generating or manufacturing it.

So, what we do it, initially we manufacture it at the small scale and then we start distributing to
the people as a free sample and people when they start liking it responding to it, many times for
example, when you move to the market you might see that some small, means many companies,
means different, means the stores we visit these days or malls we visit these days many
companies have these small outlets may be, they have introduced new kind of the fruit juice and
they are offering you a glass of a juice without charging anything for that. What is that? That is
called as a market and demand survey.

Because once you use that product and you know the price, so you may find that there is a value
in the product. So, later on next time you start asking for that and you become the customer for
that. Sometime when we move again to the mall or some other place, some baby food is
available there. They have brought it up and they start distributing as a free sample when you
take it to your home you use it and then the baby responds very well we become the customer.

So, sometimes we are sure about the success of the product, investment is not a problem and
marketing is also not a problem because the firm is already existing in the market in that case
what we do? We manufacture the product, remaining sure on the basis of the other sources and
then we start distributing it as a free sample and then when the response starts coming up we start
selling it in the market.

So, this is a one way of looking the things and sometimes it may be possible that we are very
sure about this success of the product but it may not respond like that as the Fruit Beer project of
anchor, it failed. So, initially they also thought about that Fruit Beer is a very common product
being used in the other countries by the people so why not it will be saleable in India?

So, they did not go to the people with the product but they conducted the market and demand
analysis, technical analysis, financial analysis they gave the shape to the project and finally,

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when they started distributing it even free of cost, product failed, people rejected the product
because we are not to buy the fruit beer for the price of the normal beer in the market and the
purpose of using beer in India is different as compared to the fruit beer and the intoxicated beer,
alcoholic beer.

So, market demand analysis either you do it theoretically or you do it practically both ways is
important. And that tells us how much cash inflow is going to be there with us, because then the
demand is going to increase then over the years, the cash inflow is going to increase. So, it
means what is happening here, the estimation of the total investment is a cash outflow and total
inflow is by way of manufacturing and selling the product in the market and getting the funds
back.

So, we are talking about the cash flow. I am not talking about the profitability, there is a
difference between the profit and there is a difference between the cash flow, cash flow is the
wider term as compared to the profitability, profitability you arrive at from the sales you subtract
everything, there you subtract the manufacturing cost, you subtract the distribution cost, you
subtract the technical costs in the form of depreciation, you subtract the financial cost in the form
of interest.

And finally, even you subtract the taxes also to be paid to the government. And finally, we arrive
at maximum profit before tax and profit after tax that is something different. When you calculate
the cash flow, we use the profit and when we start from the profit and then we backtrack into the
profit, we add back the financial expenses like profit and then interest cost and then we add the
non cash expenses also, and then we subtract the interest cost again.

So, then we arrive at it. It means profit is the one part of the cash flow and cash flow is a wider
term which includes profit, it includes all non cash expenses and then we come to know that at
the end of the first year, how much cash will be flowing in to us or back to us, second year, third
year fourth year. So, that way the cash inflow analysis has to be done.

And cash outflow normally we assume that in the conventional projects, in the conventional
capital expenditure ideas or the projects the cash flow occurs in the beginning of the period and
that is in the 0 period in the current year in the capital budgeting problems also you have seen
that largely we are assuming that most of the projects are conventional in nature and whatever

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that cash outflow has to take place, that will be either in the 0 period or in the beginning 1, 2 or 3
years.

Because we keep on building the project. For example, let us say very large project,
petrochemical project or maybe the refinery of the petroleum products. So, building a refinery
may take 2 years a period of time. Similarly, building a cement plant may take the 2 year’s time.

So, during that 2 year’s time or 3 year’s time or 1 year’s time, we are not getting any inflow
means only outflow is going out and we are giving shape to the project, we are building. For
example, hydro project, it takes years to build that project and at that time only the cash outflows
are there.

So, whether that is a 0 year or that is about 1, 2, 3, 4 years, we in the conventional projects, we
estimate that first cash outflows will be there and after that cash inflows will start coming up. So,
we bifurcate the period into two, one is the cash outflow period that is the investment period and
then is the cash inflow period when the funds start coming back to us.

So, the cash outflow and inflow analysis. In the capital budgeting it was looking very simple that
we are served on the platter the cash flows, and we have to simply discount them and make an
analysis by way of calculating NPV or IRR, but that is not the case.

You have to estimate the cash flows and that is a very very complex job, success or failure of any
project or any investment proposal largely depends upon the true and correct estimation of the
cash flows, both phase, outflows and cash inflows, both cash flows are important for the survival
and growth of the firm.

So, when you talk about this, now, we can show this entire thing, entire structure, something like
this, the cash flow component when you talk about the cash flow. Before that I will discuss some
theoretical concepts with you, some important concepts with you that role of financial manager
now let us see, we will discuss this afterwards. But let us go for that. When you talk about the
cash flows, what do we mean by that? So, you can show the cash flow process, means when you
talk about the cash flow components or the cash flow process.

(Refer Slide Time: 28:53)

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So, we can say it is the cash flow components. So, we can calculate these cash flow components,
we can try to find out what are the cash flow components. So, these cash flow components are
like you can have a line like this. So, you might have the different number of years here, we start
with the 0 year, then we have the 1, 2, 3, 4, 5, 6, 7, 8, 9 and 10 we have the 10 number of years
which is the foreseeable period of the project.

This is the foreseeable period of the project. And what we are doing here is that when we are
calculating these cash flows, we assume here that these cash flows will come to us at the end of
the year., not at the beginning of the year whether it is cash outflow or the cash inflow at the end
of any year how much cash flow has taken place.

So, in the first case you call it here that this is the cash outflow in this year and we call it as
150,000 and you can call it as the initial investment also or you in a way call it as the cash
outflow, this is the cash outflow. So, at the end of the year, in the period 0, we have to shell
150,000 rupees or make investment of 150,000 rupees this is my cash outflow and then in the
subsequent 10 years, we will have the cash inflow.

So, you have to now calculate something, in the first year for example, we get back is 10,000
then we get back is at the end of second year 15,000, then we get back here is 30,000, then we
get back here is 50,000, then we get back here is again 50,000, then we get back here is 40,000,
then we get back here is 30,000, then we get back here is 20,000 and then we get back here is
again 20,000.

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And lastly, we get back here is the 10,000 these are the cash inflows available to us and these
cash inflows, when you talk about, we have to calculate on some basis and for calculating these,
what we have to do is we have to be very careful and this will depend upon the idea and the total
investment requirement and largely will be based upon something which is called as technical
analysis.

This all will depend upon all these figures for the 10 years will depend largely upon the market
and demand analysis. And whatever this we have calculated, here is this, you call it as the
operating cash inflows. So, we have the certain figures in mind and these figures are in terms of
this is a cash outflow, this is operating cash inflow, which we have calculated.

And one more thing here we have to take into account here is that is called as the last thing
which will be here is in the last year that will be something called as the some amount is coming
to us here is that will be called as a 50,000 and this amount will be for what? This will be for the
terminal cash flows, this is called as terminal cash flow, and this amount you can say is
something like 50,000.

So, the total structure of the cash flows can be shown like this. So, now number 1 is, it is at the
end of the year these cash flows coming to us and we are saying that foreseeable life of our
project we give shape to that project is how many? 10 years. The total cash outflow will be in the
current period that is in the 0 period, till the end of the 0 period, you will be required to invest or
shell 150,000 rupees and this amount will be called as the total cash outflow.

So, this project is called as the conventional project, after that when we start working on that,
then the project will become operational when we commission the project, we will start
manufacturing the product, selling it in the market and revenue will start coming back to us. So,
operating cash flows at the end of the first year we are getting 10,000, 15,000, 30,000 and this
way we are getting at the end of the 10th year the last is the very nominal amount and that is
10,000 rupees and after 10 years the project will be liquidated.

And at that the time you will get back something which is called as the terminal value means at
that time also when you terminate the project you get some salvage value for the fixed assets and
that too on the depreciable basis that whatever the fixed assets we have created, now project is

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closed down, we sell them out in the market as a salvage value or maybe as a the leftover value
or the leftover assets so some amount will be realized at that time also.

So, you have to take these into consideration, three important things are to be taken into
consideration, one is the cash outflow, then the operating cash inflows over the operational
period of the project and then third is the terminal value of the project. So, these three important
cash flows are to be taken into account while estimating the cash flows for the projects or capital
investment proposals whether it is by the existing firms or by the new firms.

So, this is the idea about that how we can estimate the cash flows and how we can proceed
further bit. That must be say that this is the total investment requirement whether it is with us or
not, are we ready to make this investment or not. And if we say yes, that these inflows will be
available, so, summed up value of these will be calculated plus this value will be calculated and
then you will calculate these cash flows.

And then we have seen in the capital budgeting, discount them and including for the terminal
value, and then we will compare them with the present value of cash outflows, and then we will
finally take the decision whether to go for this investment or not. So, it means, in this whole case,
the cash flow analysis, particularly this component and this component, and even this component
is very, very important and a very complex job.

So, this is just initial discussion on the cash flow estimation, further more typical things and
more interesting things with regard to the cash flow estimation, I will discuss with you in the
next class and further more in the subsequent classes. Till then, thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 30
Estimation of Project Cash Flow Part 2
Welcome all. So, in the process of learning about the cash flow estimation, what is the role of
financial managers in the business organizations? Maybe it is a new firm or whether it is a
existing firm finance people have to be there if even a person want to start a start-up, want to
start a new firm.

He must have some minimum idea of the finest or the financial management or if he does not
know the finance himself he may be a technical guy, he can have somebody with him who
knows finance and who can help him in performing the financial functions because it is very
important.

(Refer Slide Time: 1:12)

So, what normally the financial managers are expected to do in estimating the cash flows,
four important things. One is to coordinate the efforts of various departments and obtain the
desired information. So, what happens, as I told you that market and demand analysis,
technical analysis even financial analysis we have to do.

So, marketing part or maybe the market and demand analysis, the marketing people will be
doing or maybe if you are going to buy the ready-made information from the market some
consultants or somebody even then we must be able to understand what kind of the
information is there. So, somebody must be there taking care of the marketing functions.

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And in the existing firms when they introduce a new product or a new service they already
have the marketing department and marketing department is responsible for conducting the
marketing and demand analysis. So, they cause the cost, means they are the one important
department which need to be provided the funds.

Then the production department, then it is a purchase department, then is the distribution
department, store department, so finance department’s job is to ask the different departments
that if we want to introduce a new product or the new service how much investment is
required to be made? So, they are technical people they will make assessment of their funds
requirement and finally tell to the finance department that total requirement will be this.

So, finance guy has to coordinate amongst the different departments if it is a existing firm. If
it is a new firm, even then the entrepreneur or the person who want to go for a start-up has to
perform these functions either by himself or by hiring the people or by making a team of the
people as a part of the initial promoters of that particular idea, who has technical background,
somebody maybe a B. Tech, then he has to bring in the team maybe some finance guy, MBA
finance or some marketing guy also so if it becomes a team of four, five people.

For example, when Infosys was created, so it was a team of the 7 people, it could have been
created by the 1 person also, but creation of 1 firm by 1 person and creation of the firm or a
new business by the 7 people makes a difference. So, we have to perform and knowingly or
unknowingly, whether actively or passively we have to form the different functions and for
that we need different people.

And finance guy’s job is to take the estimates of investment in terms of the cash outflow as
well as in terms of the cash inflow from the different departments. So, the coordination is
important, and they do it.

To ensure that the forecasts are based on the set of the consistent economic assumptions,
whatever the forecast we make in terms of manufacturing the product, selling the product in
the market, buying of the raw material in the market, how this all has been done? who has
done it? what is his background about the market, about the purchase, about the raw material?
He has to make sure that whatever the funds they are demanding for whether they are based
upon the consistent existing assumptions in the market or not. So, again important function.

Then one more function is to keep the exercise focused on the relevant variables. So, it means
he has to say proper focus on all the relevant variables which have been taken into

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consideration. So, it means complete focus on the relevant variables he has to have because
when you are talking about the market and demand analysis, what variables they have
considered?

Whether the income of the people is considered, whether the particular age group is taken
into account for which the product is being manufactured or we are talking about the
geographical terrain of the country or maybe some total of the different factors or variables,
means he should be having some background idea that, how much funds are required to be
invested in for a one particular activity how much they have invested, so very important
component.

And last is to minimize the biases inherent in the cash flow forecasting. Normally what
happens that when we talk about the cash outflow different departments intention are biased
towards asking for the higher amount of the funds, larger amount of the funds, more amount
of the funds.

Whereas the marketing people are they are little conservative in their estimates, they should
be conservative in their estimates. So, it means whether these biases have influenced the
forecast or estimate some of the cash outflow and cash inflow this is his job. So, to coordinate
the efforts of the various departments one.

To ensure that forecasts are based upon set of consistent economic assumptions and proper
focus has been there on the relevant variables or not of the different people involved in
estimating about the cash outflow and inflow about the project. And last is that biases are
minimum in estimating the cash flows. He has to make sure that people are more optimistic
means not optimistic but their estimates are optimum and we will use the term optimum
neither more, nor high nor low.

So, we will look for some estimates, some forecasts which are optimum. So, whether these
are optimum estimates or not and undo biases have not affected the people that is a very
important consideration here. So, it means finance guy has to be a very very active person, he
should have the proper background, what to do and how to take the things forward and
whatever the estimates are being done here whether they are acceptable or not?

Now, we talked about the elements of the cash flow.

(Refer Slide Time: 7:00)

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In the previous class we discussed one structure and that structure is here. So, I discussed this
structure and I talked about the three things, one is a cash outflow, operating cash inflow and
then we talked about the terminal value.

(Refer Slide Time: 7:07)

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And these are the three important things we have to consider them as important elements of
the cash flow stream that is initial investment required to be made to build the project,
operating cash inflows coming over a period of time and the third important thing is the
terminal value of the project.

How much is the relationship between the quantum of the cash outflows and cash inflows and
the relationship between these two important or three important values that is these are the
three important elements of the cash flow stream.

First of all cash goes out, then cash start coming in and once the life of the project is over
then we terminate the project and at that time we get something, a salvage value of the fixed
assets and the working capital. Working capital is recoverable in the full amount. There is no
salvage value that is recoverable at the book value of the project.

So, in the terminal value we have to be very careful, what we are going to recover in the form
of the terminal value. We are going to get the salvage value back for the fixed assets. Because
the plant, building, machinery other than land, plant, building and machinery we have
purchased. we use that, we provided the depreciation over the 10 years period of time.

But still that structure is there and if you sell that structure as a (())(8:35) trash even then it is
going to get something back for us and that is called as a salvage value of that plant
machinery and other fixed assets. Plus the working capital which we have invested the funds
in the working capital in the inventory, inventory if you sell in the market that is going to
give you the full value.

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Because we record the inventory at the cost of the market price or price whichever is lower,
then you talk about your credit sales. If some credit sales are made in the market whatever the
book value of the credit sales is there we are going to recover them full, any cash is available
with us.

So, working capital we should count for at the time of calculating the terminal value into its
fullest extent as equal to the book value in case of the fixed assets, we should take the salvage
value. That is the total book value, purchase value minus the depreciation over the number of
years.

And, now finally, what the value is left up we are going to get this amount from the market
that is called as the salvage value. So, these three important considerations are to be borne in
mind. Because these are the three important elements of the cash flow streams.

Now, next important thing here for us is the time horizon of the projects, means for how
many years we are going to estimate the cash flows. What is the foreseeable life of the
project? For how many years, because when we are talking about the cash flow estimation
there has to be some period for which the cash flows can be estimated.

We know that cash outflow we are going to incur only in the current period or maybe the
current period till the beginning or the till the end of the first year or till the end of the second
year that we know that how much investment is required to be made. And how much time it
is going to take to build the project

But once it is commissioned and the production starts coming back to us and we will start
selling it in the market then the cash start flowing in back to the firm and that is called as a
operating cash inflows.

So, operating cash inflows are going to be available back to the promoters or to the owners of
the project for how many future numbers of years? So, here are the four important
considerations either of the four considerations can be considered as, first here it is called as
the physical life of the plant.

When you create a structure, when you create a plant, it has the minimum physical life or the
maximum physical life after that you have to dismantle that plant and either you have to
replace that investment with the new investment means bring the new plant at the place of the

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old plant or maybe terminate the project because now it has phased out. The production or the
services coming out of it they have phased out.

So, it means physical life can be the one important consideration that once you have created
the structure how long that structure is going to or that what is the life of the plant building
machinery. After that if the product is there in the market and still we can manufacture and
sell, again you have to make the fresh investment and replace the existing old structure with
the new assets, with the new fixed assets or you have to dismantle it forever.

Because now the new things have come up in the market 10 years down the line and now this
is not required. So, the maximum life of this project was 10 years, we used it for 10 years
now it has to be closed down.

Second could be the basis of the working out the time horizon can be technological life of the
plant. Physically plant is okay, it is still working, but that technology has changed, but the
technology has changed.

Now, I can give you a good example here, for example, when in 1991 steel sector was opened
for the private sector participation, till 1991 when it was a closed economy 90 percent of the
market was with the SAIL - Steel Authority of India Limited and some part of the market was
being served by the TISCO Tata Iron & Steel Company.

So, because SAIL was the public sector company, why? Because they were working in a
sector which was reserved only for the public sector. When the sector became open for the
private sector participation and the private sector firms came up in big way in the steel sector
or for the manufacturing of the steel.

We had firms like Jindal Steels, Jindal’s created the Asia's first high-tech steel plant at
Vijayanagar in Karnataka and Jindal Vijayanagar steel plant which was known later on as the
JVSL was the Asia’s first high-tech steel plant. Then we had Lloyd steel. We had SR steel in
the western part of the country.

So, at that time now the situation became very peculiar for the sale. Because sale was
operating in the market on the basis of the old plant machinery and old technology. And
when the new private-sector companies came up in the market they came up with the new
technology.

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So, now a firm manufacturing a product with the older technology has to compete with the
firm's manufacturing the product with the new technology. So, you can understand that the
product coming up with the new technology will be better in quality lesser in price. Whereas
you cannot sell the same product which is manufactured based upon the old technology may
be inferior in the quality and may be expensive in terms of the price.

So, immediately after that SAIL was required to phase out the old technology and replace the
old technology with the new technology. So it means the life of the plants of the SAIL was
ended up at that time. When the new technology came up in the market and the private sector
units manufacturing the steel came up with the new technology it necessitated the investment,
new investment for SAIL also. So, it means you could say the time horizon for this kind of
the projects is up to the technological life of anything.

For example, we talk about the IT systems software's. We buy one software today and we
very quickly we have to recover the amount which we have invested to buy that software.
Because we know that within 2, 3 years new software will come in the market. Similarly, in
case with the hardware also, one computer is today after 2, 3 years a new computer with the
new features, with the new storage capacity, with the new high capacity processors are
coming up in the market.

So, it means one particular product has a life which is a technological life. So, if that is going
to be the shorter than the physical life of the plant then certainly it will become the time
horizon for estimating the cash flows.

Then, it could be other way around, next thing could be the product market life of the plant.
Physical life is fine, product is physically doing well, technologically it is doing well but the
product market life means the product coming out of the plant now has phased out.

There is no market for the product now or the market is squeezing or going down day-by-day
and now there is no future of that kind of the production. So, automatically you have to find
out while establishing one particular project that if we start manufacturing this product today
how long it can stay in the market and what can be the product life cycle because every
product has its life cycle.

And that product life cycle, you can show it like this it is something like this. So, it is the
initial inception stage, it is a growth stage, it is a saturation stage and it is a decline stage,

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after some period of time this product start declining and this is a phase out. This product
phases out of the market.

For example, I tell you one product is polythene bags, long back maybe 20-30 years back
when this product came in the market this was considered as a welcome product. Even you
would be wondering at that time government was supporting the manufacturing of the
polythene bags, unemployed youth were being given liberal finances through district industry
centres.

And they were being encouraged to establish the manufacturing of the polythene bags units.
And because the plant capacity was very high so sometime it was not possible that whatever
the production monthly or six monthly or annual productions coming out of the plant is that is
not sometimes saleable in the market by the owner of the unit.

So, even government gave the facility that whatever you can manufacture and sell in the
market you sell that and if any unsold amount is left we will purchase that from you all. Now,
you look at, at that time 20 years back 25 years back we used to welcome this product and
this product was a preferred product polythene bags.

But today this product, nobody likes it, government is discouraging it. It has totally phased
out, but still now the manufacturing is going on, sale is also going on. But now what is
happening, now this product is on the last stage of its cycle and it is on the phasing out
stage.

So, likewise whatever you will talk about any product whether it is a consumer product or the
consumer durable, now, earlier we had the refrigerators which were not frost free these days
we have the frost free refrigerators. Talk about the air conditioners, air conditioners these
days now, there was a time of normal AC’s, but these days we have the inverter AC’s
because of the lower power consumption we have found out the inverter AC’s, so new
technology has come up in the market.

So, it can be the one basis, the product market life because physically the plant is existing, is
having a good life also, technologically also that it is good but the product coming out of it
there is no demand for that product. So, automatically you would see that what is the time
horizon? can be one important consideration maybe the product market life.

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And fourth can be investment planning horizon of the firm, investment planning horizon
normally there are some kind of the products which we can plan it like the short-term
investment, medium-term investment, or the long-term investment.

For example, we are going to have some say hydropower plant. We want to create
hydropower project. We know that it is going to have a long life term, it is going to be there
sustained exist for the long term, or on the long-term basis. Similarly, if you talk about the
steel plant certainly it will be for the long term.

Say petroleum refinery, certainly is a long term project. So, there you can see that cash flows
can be estimated for the first initial 10 years, then for the next 10 years, then for the next 10
years that way you can plan the time horizon. There can be some products like some
consumer products we are manufacturing, it can be a medium-term project and can very
small.

For example you talked about ice cream manufacturing. So, if we are going to create it as a
seasonal product. The life of that project is going to be how much? 6 months maximum,
active life of that particular project is 6 months. So, that way also we can decide the time
horizon.

So, on the basis of the either of these 4 or some of these 4 , may be putting together 1 or 2 or
3 whichever is giving to you as the minimum time horizon whichever out of these four is
going to give you the minimum time horizon that will become the basis of forecasting the
cash flows. Minimum time horizon, physical life can be there, technological life can be there,
but the product can be there in the market sustainable only for the 2 years.

So, setting aside the other factors that will become the basis or the time horizon for
forecasting the cash flows. We are going to create a petroleum refinery means very long time
horizon. So, you can even forecast the cash flows for the next 20 years also.

So, whatever is we are going to work out time horizon has to be that minimum period of time
which either of these factors are helping us to work out and for that period of time we will be
estimating the cash flows.

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(Refer Slide Time: 21:23)

Now, in this case we will be talking about the basic principles of the cash flow estimation,
and these are the four principles of the cash flow estimation, separation principle, incremental
principle, post-tax principle and consistency principle.

(Refer Slide Time: 21:56)

First one is a separation principle, when you talk about the separation principle. We have the
two sides of this project investment coin two sides. One side is called as the financing side
and another side is called as that investment. And two are the different things, different
components, you cannot say that financing is same as investment and investment is same as
financing.

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In the balance sheet also if you for example when you create the balance sheet on the one side
you have the liabilities and capital. And this side you have the assets at the end of the day
both are same if you want to tally the balance sheet you can tally the balance sheet, easily you
can say.

So, it means this is one, this side is one, they are depending upon each other, they are
complementary to each other but these are the two sides of the coin and while talking about
the cash flow estimation also we have to consider them as the two different things. And the
principle of the separation has to be applied here.

So, when you talk about this principle of separation you can take the help of this kind of the
structure here. For example, what we are going to do here is we are going to create this
project. This is the project we are going to build up and we have two sides of this project, one
is the financing side and other is the investment side. Or you can say it is a balance sheet of
the project, financing side and the investment side.

Now, if you talk about the cash flows, when you are talking about the cash flows here we
have to take into consideration the time and second thing we have to take into consideration
is the cash flow. Here it is also time and then we have to take here the cash flow. These are
the two important considerations in case of the financing side also, in case of the investment
side also.

So, we will talk about here is financing, Because once we have taken the decision of going
for the investment. Certainly we are now going for the second decision of financing the
project. Because investment decision is the first decision in the decision areas of finance first
is comes up the investment decision and once that investment is okayed. Then we go for
arranging for the funds how that investment will be financed? that decision is called as the
financing decision, that decision is called as the financing decision.

So, in this case time we are talking about here is the 0. In the 0 period for example we are
going to talk about here is that the investment requirement of this project is plus 1000. We
require this 1000 rupees as per the investment requirement of this project we have calculated
here that if you want to give shape for this project you have to arrange a sum of rupees 1000
maybe it is 1000, lakh, crore or whatever it is, 1000 is the requirement.

So, it means on some basis at the time of estimating the investment we have identified that
some investment will be required and that sum of the investment is 1000 rupees and how that

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will come, that may depend upon that the type of the different source is available. It may be
equity finance, it may be debt finance, or it can be sum of both debt and equity finance.

So, normally when you talk about the project financing we consider that both the source is
important for us. The equity is also important, debt is also important, so we assume that funds
for any investment proposal will come from both the sources by way of equity also and by
way of the debt also.

So, whatever it is from different sources we arrange 1000 rupees as the finance and this 1000
rupees in the 0 time itself is converted into the investment. So, this is called as the investment
because this is investment side so this is the plus 1000 cash coming in to us. And we are
investing it into the business so it is minus 1000 because project and the owner are the two
different entities.

So, the owner is arranging for the funds for meeting the investment requirement. So, either
firm own resources, first he will generate the cash and that cash in the form of financing will
come in the firm and then that cash will be used for giving shape to the project for buying of
the fixed assets and then keeping some money for the current requirements in the form of the
working capital.

And the time period of the project is only 1 year we are assuming time period of the project is
only 1 year, so in the 0 period we are constructing the project and then we are now
commissioning it and at the end of 1 year project is going to be terminated. Only 1 year’s life,
operation life of the project is only 1 year. And what is the cost of capital? We are assuming
here as the cost of capital is 15 percent.

So, after 1 year in the first year what will happen because the life of the project is only 1
year? So, what will happen here, in this case now we are here at the year 1. In this we will use
it and at the end of the first year what will happen? We will have to now return this money
so here is also a year 1, from this investment when this investment is made into the business
we had a cash outflow of the 1000 rupees. And at the end of the first year that is the last year
also of the business operations we got a total cash flow of the 1200 rupees.

And since the cost of capital which we borrowed here to generate 1000 rupees is 15 percent,
so we are going to pay the interest of 150 rupees, 15 percent on this 150 rupees. So, now the
cash which is going to be paid here is going to be minus 1150, so we are assuming here is

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cost of capital is 15 percent and here when you talk about is the rate of return is RoR. Rate of
return is equal to how much? 20 percent.

So, this way you have to apply the separation principle, that whatever is the time that is
important for us and during that period of time what is the construction period of the project,
during which period the investment will be required, first you will arrange the funds so in the
balance sheet it is a liability side. If it is own investment it is capital, if it is a borrowed fund
it is liability and if it is a sum of the both then both are there.

So, separation means you keep the two things separate, first funds will come in then the funds
will go out in the form of investment. So, 1000 is arranged coming in and then that is going
out in the form of investment. So, plus sign became a minus sign when financing became
investment.

After 1 year when we have to terminate the project we evaluated the whole thing that what
we got, we will look it at first the investment side that by investing 1000 rupees we got the
total year and cash flow of the 1200 rupees out of that we will pay back 1150 and the
remaining amount will be available with us.

So, if you make a comparison of the investment and the financing side our cost of capital is
15 percent, our rate of return is 20 percent. So, we can say that on the basis of cash flow
analysis and applying the separation principle we can say that the cost of capital is lesser than
the rate of return available from the project. It means we can think about going ahead with
this kind of investment and we are going to make a profitable investment or maybe a
investment where the NPV will be positive.

Because ultimately the analysis depends upon or the acceptance or rejection decision will
depend upon the cash flows of the project. So, cash outflow will be compared with the
present value of the cash inflows and then we try to find out what is our cost of capital, what
is the rate of return available from the project and then we will be making a comparison of
the two and we see what is the NPV available.

So, separation principal raises a point of question here that you keep the financing side
separate, you keep the investment side separate and then you say that for financing of your
total capital structure of the firm how much funds are required at what cost of capital these
funds have been generated?

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And while investing into the business how much return is available and then you make a
comparison of the cost of the funds with a rate of return available and take yes or no decision.
So, clear-cut separation between financing and the investment.

(Refer Slide Time: 31:34)

Second principle is a incremental principle, then is the post-tax principal and then is the
consistency principle. Incremental principle, I will just begin the discussion on it but detail
discussion I will have in the next class. Incremental principle is more important in case of a
firm which is already existing.

This is not in case of their firm which is not existing at all. If it is a start-up kind of a thing
this principle will not apply. Incremental principle is the one, only when you are going to
start a new project and the firm is already existing in the market.

A product a new product or a service to be launched by a firm which is existing in the market
for example Reliance Industries are already there in the market and they moved into a new
area of the business also that is the telecom services. And they came out with the new product
or new service called as Jio mobile services under the name Jio. So, they came up. They
introduced this service.

So, incremental principle says that we are existing firm and when we go for a new project,
adding up a new product or a new service, how much value this new project is going to add
into the existing value of the firm. Whether it is going to increase the value or is it going to
erode the value, value erosion is going to be there or value addition is going to be there but
that too on the incremental basis.

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And when you talk about the incremental basis here, why we are talking about the
incremental basis? because when you are going to add the value it is going to affect the
existing performance of the existing projects also, some effects are positive which are called
as a synergetic effects and some effects will be negative, loss of the sale of the existing
product or maybe a pressure on the existing plant and machinery or extra overheads to be
paid to sustain the new product or the new service.

So, both negative and positive effects will be there but when you talk about here, this
principle if the firm is existing and they want to introduce a new product or service in the
market then we will have to evaluate the cash flows in terms of incremental principle,
because new funds will go out, funds will also come in and that inflow and outflow of the
cash will have incidental effect upon the existing projects of the firm also.

So, how this entire process has to be taken into account that plus the other important two
principles post-tax principle and consistency principle I will discuss with you in the next
class. Till then, thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 31
Estimation of Project Cash Flows Part III
Welcome all, so we are in the process of learning about the estimation of the cash flows for
the new investment proposals or for the new projects and in the previous class we initiated
the discussion on this particular topic that is a cash flow estimation and we discussed the
some basics or the fundamentals parts of the fundamental requirements of this cash flow
estimation.

And we discussed some basic principles of cash flow estimation process, as we have seen in
the previous class also that there are the four important principles of the cash flow estimation
which are very important.

(Refer Slide Time: 1:06)

First one is the separation principle, second one is the incremental principle, third one is the
post-tax principle and fourth one is the consistency principle. So, separation principle I have
discussed with you at length, where I have talked to you that we have to treat it in two,
different ways the inflows and the outflows of the cash like balance sheet, in the balance
sheet also we have the one side which talks about the sources of the funds and on the other
side we talk about the applications of the funds or in the simpler language, we call it as the
liability and the capital side of the balance sheet and the asset side of the balance sheet.

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So, on the one side, the funds flow in the business and from the other side, it goes out so, we
convert that cash or that investment into the assets. So, we have to separate it. On the one side
we have to show it as the inflow, on the other side we have to show it as outflow. And finally,
on the termination of the project, what is the terminal cash flow available is, we have to
calculate that, so that was a separation principle I have discussed that length there.

Now, I will take you to the next two, three other principles because they are very important.
Cash flow estimation is not a easy task, it takes time to understand and to be clear about the
basic fundamentals and for that reason, we have to bear in mind that all these things are
equally important, all these principles are equally important to understand before we move
into the process of estimating the cash flows practically or physically.

So, after separation principle, the next important principle is the incremental principle. So,
when you talk about the incremental principle, we have to very careful while estimating the
cash flows and incremental principle plays a very important role.

(Refer Slide Time: 3:00)

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So, what this principle says, under incremental principle we have to ascertain a project’s
incremental cash flows you have to look at what happens to the cash flows of the firm with
the project and without the project. So, again let us again understand it to ascertain a project’s
incremental cash flows, you have to look at what happens to the cash flows of the firm with
the project and without the project.

So, when we take up a project, what will be the addition or say deletion, maybe reduction in
the cash flows or if we do not take the project, if we carry on the process without this project,
how the cash flows of the firm will be there? Normally we expect that there is no reduction in
the cash flows, otherwise why to take up a new investment proposal.

So, we expect that there will be increase in the cash flows, but that increase is considered as
an incremental increase or the incremental cash flows because existing amount, we are
earning some amount of the cash flows. For example, the firm is having, say four different
products they are manufacturing, and the total cash flows after adjusting for all kind of the
cash outflows and everything. Finally, the free cash flow available to the shareholders is
somewhere like 100 crores.

So, if we take up a new project, new investment proposal and we go for adding up the one or
two new products in the existing product line, so whether our cash flows are going to increase
or our cash flows are going to remain stable or any other kind of change is there normally we
expect there is going to be a increase.

So, that increase will be considered as, for example the cash flows become now from 100 to
120 crores, so, that 20 crores will be the incremental cash flow. So, we have to look it at that,

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if we take up the project, what will happen and if we do not take up the project, what we will
so, you can simply show it like this, that the cash flows of the project.

Incremental cash flow of the project you can calculate is like this, that is the project cash
flow, or the firm cash flow you can call it as, the project cash flow for the year T, so you will
calculate it, cash flow for the firm with the project for the year T minus cash flow for the firm
without the project for the year T.

So, it means cash flow for the firm with the project for the one particular year T and cash
flow for the firm without the project for the one particular year which is called as year T for
in any particular project and that difference will be called as the project cash flow for the year
T or for that particular given year.

So it means we are adding up this new project or this new investment proposal and we are
going to find out that with the project, how much is going to be the incremental, means the
total cash flow that is the existing cash flow plus the cash flow coming from the new project
and if we do not take it up, that is a minus cash flow for the firm without the project for the
year T for the same year, if you take up the project how much cash flow will be there, if you
do not take up the project how much cash flow will be there, so that difference will be called
as the cash flow for the new project for the given period or that particular year which we call
as T.

So, we have to look it at always, not in the totality we have to look at the cash flow, we have
to look at the cash flow on the incremental basis and for calculating that incremental cash
flow, we have to try to find out that whether the cash flow is going to increase as compared to
the cash flow without the project or cash flow is going to remain the stable or maybe there is
going to be any negative impact upon the existing cash flows. That is a very very important
thing to be taken into consideration and borne in mind. While following this principle of
incremental cash flow, we have to follow certain important guidelines. And these important
guidelines are here four, five guidelines are here.

And first guideline is consider all incidental effects. Now, in this case it is a very important
part because when we take up the project, we have to see what is going to be the incidental
effect, it may be possible that the new product we are going to add up is going to create the
problem for the existing products of the firm.

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Or it may be possible that we are going to add up the new product increase the sales of the
new product, but because of that, the existing resources of the firm’s which are being used for
the existing four products, they start feeling the pressure because of the introduction of the
new product fifth product and it may impact the performance of the existing four products
negatively, the sales or the performance of the existing four products may come down. So, we
have to be very careful in that part.

And, what is going to be the incidental effect in terms of sales of the existing products
because of the sales of or adding up of the new product. Second thing is what is going to be
the incidental effect upon the expenses especially the overheads, because when you talk about
the direct expenses, all direct expenses are directly related to all the different products.

Talk about the material cost, talk about the labor cost, talk about the direct overheads cost
that is directly attributable, because if you manufacture one category of the product, product
number 3 or product number 4, or maybe this new product number 5, you will incur only raw
material, if you go for the manufacturing, if you do not go for the manufacturing of any of the
products, you will not incur any raw material cost.

Same is the case with the direct labor, same is the case with the direct overheads, those
expenses which are directly identifiable with the introduction or manufacturing of any
product or not manufacturing of any product, they are called as the direct expenses. But those
expenses which are indirectly affected means there is a common pool of expenses and you
cannot directly identify that how many expenses are happening or taking place because of
manufacturing of the product X, Y, Z, A, B or C, so that creates the problem.

So, in this case in the overheads also especially in case of the indirect overheads, for
example, if the indirect overheads are not going to increase, like administrative cost, like
your, say your advertising cost, like your selling and distribution costs, like your other
general expenses, if they are not going to increase by the introduction of the new product.

So, it means we can ignore the incidental costs also that okay, we are introducing the new
product directly they are going to be direct expenses which will be included into the cost
sheet of the new product. But as far as the indirect overheads are concerned, they are more or
less going to remain same within the given existing administrative cost, establishment cost,
general expenses, selling and even distribution expenses. We are not going to incur
something extra for this.

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So, you can think about, but if some extra expenses are going to be incurred for the
introduction or for the inclusion of the fifth product, then we have to take those into
consideration, how those extra indirect expenses are going to impact upon the cash flow we
have to be very very means be careful about that.

One more important effect here is that is the product cannibalization effect, product
cannibalization effect is that you can simply define it as erosion of the sales of the existing
products because of the introduction of the new products, because it may be possible that our
attention is diverted from the existing four or divided now amongst the five.

So, if our resources are same, but if we are adding one or two new products into the existing
line of the products, it may happen that we are not able to take care of our distribution
channels of the existing four products as we were taking care of them in the past.

So, we may lose some of the sales, or sometime what happens we are going to introduce a
new product which is somewhat similar or a substitute to the existing products. So, it may be
possible, though you are coming up with a new product in the market, but it can serve the
need of the either of the existing products also. So, the sales of the existing products maybe,
getting affected negatively.

So, the cannibalization effect have to be taken very seriously, whether the sales of the
existing products are going to be affected negatively or not. If they are going to be affected
negatively, then we have to go for one important thing is that try to find it out, quantify it that
how much sales are going to be for the new product and how much sales we are going to lose
for the existing products.

And if there is something kind of the loss of the sales of the existing products because of the
introduction of the new product if that is happening then you have to factor those losses of
the sales or the loss of the revenue or the loss of the cash flows and that is called in the
technical term, here we call it as the negative incremental effect.

So, when you take into account the negative incremental effect means, we show that in our
cash flow statement, like the loss of the contribution from the existing products, and if you
show it, it is treated like a cost, it is treated like like a cash outflow or the loss of the revenue.

So, what will happen that if you treat it as a negative incremental effect the loss of the sales
of the existing products, because of the new product in that case, what will happen, when we

517
evaluate the whole cash flow available, the new product may result into the negative cash
flows or the lesser cash flows, or it may not look like a profitable product.

So, we can think about it that if there is some negative effect going to be there or
cannibalization effect is going to be there, then you have to evaluate it very carefully, can we
avoid the introduction of the new product? because the net increase is not going to be too
much, we are going to add up the fifth product, but it is affecting the sales of the existing four
products.

So, it means, because of the erosion of the sales of the existing products, we are going to
introduce it but the net result of the new product is going to be negative or sometime not very
much positive. So, can we avoid it? But then you have to consider the important
consideration that okay we can avoid it, but if our competitors introduced the product, which
we are now proposing to introduce, then what will happen? Anyway we are going to lose the
sales.

Now, we are going to lose the sales in favor of our own product. But in that case, we will be
losing the sales in favor of the product introduced by our competitors. So, in that situation,
what happens? That it sometime becomes inevitable that is better for us to introduce the
product. For example, you talk about a firm is manufacturing different kinds of refrigerators.

So, we have the four refrigerators, different kind of the refrigerators we are currently
manufacturing and when you introduce the more advanced or more energy efficient or with
the more features the fifth new refrigerator in the market, it may be possible that the sales of
the either of the four existing refrigerators may come down because people will shift from the
existing products, maybe from the product four to the product five.

Or the refrigerator number four to the refrigerator number five, because refrigerator number
five is more advanced in the technology, in the features and the price difference is not that
much, but you have to be careful here, if we avoid the introduction of that fifth refrigerator,
but it may be possible that our competitors introduced that product.

So, sometime what will happen, that our customers for the refrigerator number four will be
shifting towards our competitors, because they have come out with the new product almost
for the same price or little increase in the price, but with the more advanced features, so in
that case we have to look the whole thing in totality, that if there is a complete entry barrier.

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That the product is protected by the technology, patenting or maybe any kind of the
trademarking or any kind of the business agreements. If there are some strict entry barriers
are there and there is no possibility, there is no likelihood that our competitors will introduce
a new product, which may become the competitive product for the firm in question, then the
firm in question can avoid the introduction of the product number five, because it will lose
the sales of the existing products.

But if there is no entry barrier, product is very simple, so, much of the competition is there in
the market, then in that case, it is always better to introduce the new product and count upon
the cash flows and ignore even the loss of the cash flows occurring because of the lesser
number of sales of the refrigerator number four that can be ignored.

Because any way we are going to lose the sales, because if you do not introduce the new
product, somebody else will do it, then we will not lose the sales in our favor or within the
firm, but somebody else will gain so it means in that case that negative incremental effect can
be avoided. And we can say that what is the now cash flow from that adjusting four products
plus the incremental cash flow from the fifth product.

So, that can be taken like that but if there is no possibility that no competitor can come, then
either we have to count it as a negative incremental cash flow rather than counting it as a
positive because positive you are counting from the product number five, but the product
number four sales’ loss should be counted as that is called as a loss of existing contribution.

So, that should be taken into account as a negative incremental effect and then the positive
from the new product and then the net effect should be worked out. So, working out the
cannibalization effect is very very important consideration in following the incremental
principle.

Then we talk about the next important requirement here is of the ignore sunk cost. So, if you
talk about the sunk cost. Yes, sunk costs should be ignored anyway, because they do not
make any sense to keep on thinking about the sunk cost. Now, what is a sunk cost? When we
want to introduce a new product in the market.

So, sometimes huge preliminary expenses have to be incurred, they may be on conducting the
market survey or maybe trying to find out that what new product can be manufactured and at
the same time, for the new product once we have identified the product and everything. Then

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how the will be manufactured, what will be the attributes, what will be the input
requirements, so you have to incur huge R & D expenses.

So, for incurring the huge R & D expenses if you now you start counting upon that once we
have now finally manufactured the product and the product is now about to go to the market
or finally, the product goes to the market at that time, if you start counting upon the cost right
from the beginning day one, when we started thinking about the product or the introduction
of the product, so what will happen? The cost of introducing the project, product will become
very huge.

Now, for example, if we want to identify a new drug, the drug manufacturing companies or
the pharmaceutical companies they estimate in the market that if you want to come out with a
new drug, new drug, it is not a new processor manufacturing that drug with the new process,
but the new product itself means identifying the new molecule.

If you want to identify the new molecule, we are existing, the firm is existing pharmaceutical
company, they are a manufacturing different type of the drugs, different type of the
medicines, but they want to introduce now the new drug for curing one particular kind of the
ailment.

So, there is one estimate that identification or identifying a new molecule, new drug in the
market or for the market or for curing any kind of the different kind of the ailments, it
requires minimum 10,000 crores of Indian rupees 10,000 crores of investment and minimum
10 years period of time.

So, it means if we want to come out with a new drug and we are going to invest or we are
ready to invest 10,000 crores, so larger part of that 10,000 crores should be considered as a
sunk cost. Because if you tomorrow price the product like that our total investment is 10,000
crores and we have to recover now that the whole amount from the market plus the existing
manufacturing expenses also, then what will happen the price of the drug will be so
exorbitant, so high that it may be beyond the reach of the people.

So, what you have to do is that till the date of identification of that molecule, whatever the
cost has been incurred, that costs should be considered as a sunk cost and for calculating the
present cash flows, we have to only take into account the present manufacturing cost, selling
and distribution cost, after sale service cost, administrative cost all these costs for giving
shape to that product or that particular final product to be taken to the market that cost should

520
be taken into account and then the revenue available from that total product after selling that
in the market.

If you start recovering the entire 10,000 crore from that particular drug that it may be very
difficult that the cash flows of this or the net present value of that particular new product will
never become positive. So, we have to consider initial costs, preliminary cost or R & D costs
which we have incurred and sometime it may be very huge.

So, that cost has to be considered as a sunk cost. And we have to focus upon the current cost,
which is a manufacturing and selling and distribution cost of the product and compare that
with the revenue for evaluating the product to be taken to the market or not to be taken to the
market or especially for calculating the cash flow from the new product.

Then third one important thing here is that include opportunity cost, opportunity cost is
something like that, for example, we have the different resources available, so while investing
those resources, for example, now the firm is already there in the market, they are already
manufacturing four products. They want to introduce the fifth new product in the market.

So, that fifth new product will take invest cost, first of all you have to shell out money, you
have to invest that, that will be called as a cash outflow, after that the cash inflow will start
coming in. So, we have to be careful that while thinking about investing their surplus funds
available with us for coming out with a new product in the market, we should be open
mindedly think about if we invest this surplus amount available with us in this product, how
much return is available?

And if we invested somewhere else or we do not make use of these resources ourselves, we
give it to somebody maybe if we have the investment, we may invest that in the market or we
have the surplus capacity, we have the surplus buildings, we can rent them out or we can sell
them off.

So, what is the opportunity cost of introducing the new product that also has to be taken into
account because one resource or the set of resources have the multiple uses, and you have to
select that use which is going to give you the best outcome, best cash flows. So, you have the
number of options available, for example, adjusting a resources, if they are in the form of the
plant capacity or in the form of some buildings or maybe other physical facility that can be
rented out.

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So, can be rented out can be sell it off or sometime it can be possible that if we manufacture
product number five, or if we can strengthen the sales of existing four products, either of the
two choices are there. So, you have to now consider it in totality that out of the given possible
alternatives, what is the best possible use and if I invest this surplus resources into the new
product, how much cash flow is available? And if I use into the existing production, and
manufacturing and selling in the market, how much cash flow will be available.

So, means a clear cut, open minded opportunity costs analysis has to be done and what is the
best outcome? We have to go for that. So, this is another part of the incremental principle
which is very very important consideration. And the next one is a question the allocation of
the overhead cost?

What are the overheads? As I told you, the overheads are those expenses which you can call
it as the indirect expenses, direct expenses are directly attributable, if you manufacture the
product, you are going to incur the raw material cost, you are going to incur the direct labor
costs, you are going to incur the direct overheads cost, but sometimes indirect overhead costs
is there.

So, you have to follow the principle here that if by introducing the new product, if there is
going to be any increase in the fixed cost or the indirect cost, then only that increased part
should be taken into account.

For example, the plant capacity there, if you are going to add up a new plant, then certainly
you should take into account the depreciation of that new plant. But for example, we have the
surplus capacity in the existing plant and we are going to make use of that and by making use
of that we are going to introduce the fifth product.

So, there is no point in adding up those additional indirect overheads into that or subtracting
it from the cash inflows or calling it as a cash outflow. So, that depends upon that if there is
going to be additional overheads, allocate them to the new product cash flows or subtract
them from the new products cash inflows.

But if there is no change going to be there, then for the moment, you can ignore it also,
because it is immaterial for us whether you introduce the product, you do not introduce the
product, you are going to incur the same amount or the fixed cost or the indirect cost. So, in
that case, why to consider it as a cash outflow because cash outflow is not taking place. And

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the one last important thing, we are going to talk about here is that is the estimate working
capital properly.

Sometime what we do is, we consider a major mistake while working out the cash flows and
we sometimes commit a mistake and that mistake is called as not estimating the working
capital requirements properly or wrongly or wrongfully estimating the working capital
requirements, because it should be clear when you adding up the fixed capacity or you are
going to introduce a new product, it requires the cash outflow on the two important accounts.

One is on the fixed expenses, another is upon the short-term expenses which is called as the
working capital. So, if you talk about the working capital part, in the working capital part,
you have to be very careful that when you talk about, thinking about or working out the
working capital.

Because working capital is estimated in terms of total investment requirement in the fixed
asset as a percentage of the fixed assets, we can work out the working capital requirements or
sometimes as the percentage of the sales coming out of the new product, we can work out the
working capital requirements.

Or if you do not want to follow these two approaches, then there is the operating cycle
approach. So, that operating cycle means investing cash to meet the working capital
requirements and then converting it again back into cash.

So, it means you need the working capital for buying of raw material, for paying of the wages
salaries, then electricity expenses, water expenses, because your plant machinery and
building, the capacity which are created for manufacturing the new product or adding the new
product will be useful only if we have the raw material to use those machines, if we have the
people to work on those machines, if we have the power to use those machines. If we have
the proper water to fulfill the requirement of the existing manufacturing facility.

So, all those things are there, then only the fixed cost is going to be of any sense or going to
make any sense, otherwise, it is not going to make any sense. So, what happens many times
we are very serious or very seriously we work out the fixed capital requirement, but we
sometime oversight or miscalculate the working capital requirements.

So, we have to very carefully work out the working capital requirement and in that case, we
have to go for the net working capital requirement for working it out. We have to calculate

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the net working capital requirement, what is the networking capital requirement? That is the
current assets minus current liabilities.

So, what is the current assets required? Current assets are required in terms of inventory, in
terms of supporting the credit sales, in terms of keeping the cash in hand and cash at Bank.
So, this total is called as the current assets and then to fulfill this requirement of current
assets, parts of the funds will be available in the form of the current liabilities.

Current Liabilities means suppliers credit is there or maybe the wages we have not to worry
for at least thirty days or this power expenses or the water expense we have not to worry for
the thirty days. So, this virtual credit is available to us. So, it means what is the total current
assets requirement in the firm after introducing the new product and , how much funds will
be available from the current liabilities and the difference will be called as the net working
capital.

So, that net working capital has to be worked out very carefully, we should not commit any
kind of mistakes. Another important thing here is that, in case of the fixed assets, whatever
the investment we make in the fixed assets that keeps on depreciating over a period of time.
For example, the life of the project is five years, from the 0 year, 0 is the current year, and
then the next 1, 2, 3, 4, 5 years are there, the cash inflows are expected.

So, for example, we are going to use that plant machinery buildings for the five years all the
fixed assets for the five years and the depreciation on the plant and machinery is going to be
20 percent, so it means that value of plant and machinery is going to be 0 at the end of the
fifth year, but still for example, whatever that skeleton or maybe that structure is left out that
can be sold in the market.

So, we can say, though the technical value will become 0, but that structure of the plant and
machinery will fetch some value. So, that is called as a salvage values, so while calculating
the terminal cash flows, we calculate the salvage value of the fixed assets plant, machinery or
sometimes the buildings also.

But in case of the working capital, working capital is recoverable in the full amount, working
capital does not decrease, it remains the same amount because that investment which we are
making, for example it is 20 percent of sales. So, 20 percent of sales you are investing where,
in the inventory, in the credit sales, in the cash, maybe in the cash in hand then cash at bank,

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so we are investing there. So, at the point of or at the time of termination of the project, you
can recover that full amount.

So, it is not to be treated like fixed assets, where only salvage value will be available as a
terminal value, but in case of the working capital, full amount will be recovered. So, when
you convert the current assets into cash, then the full amount has to be taken into
consideration as a terminal value of the working capital unlike the terminal value of the fixed
assets. So, be careful that while calculating the working capital requirement, always look for
the networking capital requirement that will be required to be invested in cash.

Second thing is while calculating the terminal value, you have to assume here that at the time
of the termination of the project full working capital will be recoverable and that cash inflow
has to be counted or considered at the time of the fifth year or at the year of the termination of
the project. So, there is a basic difference, major difference in the terminal value of the fixed
assets and the terminal value of the working capital or the current assets.

So, these are some important considerations to be borne in mind while talking about the
incremental principle which is a very very important principle and we should be carefully
considering all these points while working out the cash flows.

(Refer Slide Time: 33:32)

After that, two more principles are also there, post-tax principle and then the consistency
principle, these two principles are equally important very relevant, very important while
estimating the cash flows. But these two principles, remaining two principles, I will discuss
with you in the next class. Till then, thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 32
Estimation of Project Cash Flows Part 4
Welcome all. So, in the process of learning about the basic principles of estimation of cash
flows. I will be now taking you through the two more principles. That is the post-tax principle
and the consistency principle. In the previous classes we learned about the separation
principle and the incremental principle.

Incremental principle we discussed at length, because it is very, very, critical, very, very
important to learn about the incremental cash flow, because when we calculate the cash
flows, we calculate the incremental cash flows, so all important incidental effects of the
incremental cash flow have to be taken into account. So, we discussed at length that
particular principle in the previous class.

And now, these two remaining principles, post-tax principle and the consistency principle I
will discuss with you in this present class. And after that I will do certain problems,
practically we will learn that how to estimate the cash flows practically that if some projects
are given, some information about the inflow and outflow is given to us and some
information about the taxes, depreciation, interest and all these working capital, fixed asset
investment when all this different problems are, given to us.

Practically how to calculate or estimate the cash flows that we will be learning or will be
doing in the subsequent classes after this class. So, let us learn about the two remaining
principles post-tax principle and the consistency principle.

Post-tax principle here says that whatever the cash flows, we work out, they should be
worked out as post-tax cash flows, sometime we commit the mistake that we on the one side
keep the cash flows which are cash outflows because in the 0 period or maybe sometime in
the subsequent years also whatever the cash outflows are going to occur or take place, we do
that, we correctly work out those cash outflows.

But while calculating the cash inflows we sometime undermine or ignore the importance of
the tax factor. So, mind it, whatever the cash flows are going to be available to us, they
should be calculated post-tax, I would say that not even post-tax, after taking into account all
any kind of the cash outflows cost even after the commissioning of the project, if any cash

526
outflow is going to take place, then from the total cash inflows all cash outflows should be
subtracted. After that, whatever the cash flow is left with us is called as the free cash flow.

So, we should calculate the free cash flow and for calculating the free cash flow, it will be
very much imperative that you calculate the post-tax cash flows. Though tax is payable only
when we have the profits, cash flow otherwise will also be there, whether we have the profit
or the loss, we have the cash flows, we do not have the profits.

Profit means tax will be payable only in case the project starts giving the profits, cash flows
will be there even without the profits. But if there is a profit in case of a project giving the
profits or the profit making projects, we should calculate the cash flows after taking into
account or giving the effect to the tax or subtracting the tax part from the total cash inflows
coming to us.

So, the post-tax principle cautions us. Ultimately what we are going to do? we are going to
calculate the net present value from the project. So, on the one side you are going to keep the
discounted value of the cash outflows, discounted means if in the subsequent years also the
cash outflow is going to occur, if it is in the 0 period only then there is no discounting
required for the outflows. But when the inflows are occurring in the subsequent years, then
they have to be discounted.

Now, when you have to discount it, so which cash flows you are going to discount, you are
going to discount the pre-tax cash flows or post-tax cash flows? Because we can commit a
major mistake, if it is a pre-tax cash flow project can be taken as a very profitable
preposition.

But if you subtract the tax part and tax is very very high in the developing economies in India
also, early rate was 30 percent these days it is reduced to 22 percent but I think it is a
temporary phenomena, and again it will go back to 30 percent. So, if the firm is profit making
the project is profit making then for calculating the cash flows, we have to give the effect to
the tax. So, cash flow should be the post-tax cash flows not the pre-tax cash flows.

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(Refer Slide Time: 5:18)

So, it is clearly written here that cash flows should be measured on a post-tax basis. And
second important point is that on which cash flow we should calculate the tax? The marginal
tax rate of the firm is the relevant rate for estimating the tax liability of the firm, marginal
means the number one is the marginal revenue. Marginal revenue is that for example, we are
already having the four products and those products are earning 400 crores and this product is
going to add up 100 crores, so the total revenue of the firm is going to be how much rupees
500 crores.

So, you have to calculate the tax on this particular part and this is called as the marginal
revenue. Marginal revenue means that revenue will come back to the firm only if the project
is taken up otherwise the existing revenue of the firm is the 400 crores.

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So, you have to take it up number one, the tax on the marginal revenue. And second
important consideration here is what is a tax rate? Tax rate is also the one which is applicable
to this particular project, it may be possible that different activities are causing different kinds
of the tax rates.

So, here we have the products, four products which we are manufacturing here existing tax
rate of the firm is 30 percent. But this may be because of some special announcements by the
government or some special category product or some special category of the item, the tax
rate maybe not 30 percent but the 20 percent here.

So, what is the tax applicable on the marginal revenue generated by the new project should be
taken into account and that should be calculated on the marginal revenue at the marginal tax
rate. So, it is clearly written here that marginal tax rate of the firm, is the relevant rate for
estimating the tax liability of the firm.

So, not to apply the flat tax rate, if the tax rate is flat for example, we are manufacturing the
new product also which is in the same category of the existing products and the tax rate is 30
percent and fine then 30 percent is okay. But if it is requiring the lesser tax to be paid to the
government or the rate of the tax is different, then sometimes we have to apply the marginal
rate of the tax on the marginal revenue which is coming out from the new project and not as
the flat rate of the 30 percent or whatever the tax we are paying on the existing products or
the existing revenue of the firm.

Here some important considerations are to be borne in mind while talking about the post-tax
principle, what are these considerations?

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(Refer Slide Time: 8:01)

These considerations are given here in this table and this is regarding treatment of the losses,
sometimes what happens that when a firm starts a new product or manufacturing a new
product or the new project. So, it might have different kind of situations or the five different
situations may emerge.

So the losses coming out, maybe from the firm as a whole or from the only the new project,
we have to treat it in a different way because sometimes what happen, that when there is any
loss to the firm as a whole or maybe because of the introduction of the new project or taking
up of the new project or introduction of the new product, the loss may be there, so the loss
coming out from the new product or the new project maybe set off against the profits of the
firm.

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So, how that all has to be dealt with here, it is very clear, when you look at this particular
slide and this talks about the treatment of losses, how we have to treat the losses. Now, for
example if we are not clear about it, how can we calculate the true or the correct cash flow?
We will not be able to do that. So, it is very important to always first understand treatment of
losses.

So that, after this when we start practically calculating or estimating the cash flows in case of
the practical problems, you remain very clear that how I have treated the losses and how we
are normally going to take care of it? So, now, the first scenario can be, there are the two
things, one is the project and second is a firm. Firm is already existing, ABC limited is a
company, it is already existing in the market, they are manufacturing three products already
and the fourth one is going to be introduced or it is already introduced.

So, now, the firm ABC limited manufactures four products. So, four products and the four
different projects are there. For one product, one investment, facility has to be created. For
the second you have to create the independent second facility, third independent facility,
fourth independent facility and if you go for the fifth one, then the fifth independent facility.

And each facility is treated as an independent project. So, scenario one can be project incurs
loss, and it is quite natural that in the initial years of the commissioning of a new project, it
incurs losses, it is quite unlikely that from the year one onwards, the project starts giving the
profits it may be sometimes difficult. First year there is a loss, second year there is a loss,
third year it may be possible that the project reaches at or derives at the breakeven point and
fourth year onwards we start earning the profits.

So, first year scenario is project incurs a loss, and firm incurs a loss, both incur the losses it
means no tax saving question is there, because we are incurring a losses, we are not going to
pay any tax. So, from any loss which is incurring here in this project cannot be a set off
against the profit coming from the other products of the firm because all the projects are
incurring the loss and the firm as a whole is in the loss.

So, what is there that the tax savings which can be availed from this project, by setting off the
loss coming out of this project against the profits of the firm, so it can be deferred, because
both are in the losses, firm is also in the losses, project is also in the losses and the firm as a
whole is incurring the loss.

531
So, the benefit of setting up of the losses against the profit of the firm will be done, when the
firm will start earning the profits, currently since they both are incurring losses, so the action
you have to take is that you defer the tax savings.

Later on when the firm starts earning the profits, we can take the benefit of the tax, losses of
the project against the profits of the firm as a whole. Second scenario can be that project
incurs losses and firms makes the profit. Existing firm ABC limited is earning the profits, but
the new project is initially for the initially 1, 2 or 3 years is incurring the losses, what action
you have to take? Take tax savings in the year of loss because what will happen that the profit
of the firm.

When you have to treat it, for example, the firm is there and without the project, if there is no
introduction of the fourth product or not taking up the fourth project, firm’s profit is how
much? Rupees 100 crores, we have taken firm is earning 100 crores profit and, and this is
from the three A, B and C, three products we are manufacturing currently. So, total product
profile or the portfolio of the firm is three products A, B and C. And after manufacturing and
selling these products, the firm is earning a profit of 100 crores.

But when you add up here the D, that gives you the loss of the 20 crores. So, it means this is a
loss, this is a profit. So, how can you do it? Total profit of the firm will be calculated. So, this
is coming up as the 100 and this is minus 20, so the net profit of the firm will come down to
80 crores. So, what will happen?

The tax liability of the firm will come down. So, what is written here? If you look at here,
incurs losses makes profit, take tax savings in the year of loss from the losses which are
happening in this project can be set off, the benefit can be taken off the tax savings, the
benefit of tax savings can be taken against the profits coming out from the firm. Then three,
project makes profits and firm makes the losses.

So defer taxes until the firm makes a profit, because only one project when we are seeing
here, the three products here A, B and C are incurring losses firm as a whole, without the
fourth one, the firm is incurring the loss, only the fourth one is giving you the profit or is
earning the profits. So, what will happen while you are calculating the total? Now you
reverse the situation, so what will happen here that 100 crore is the loss now, it is not a profit,
rupees 100 crores is the loss and this project is giving you the profit of the 20, so what will
happen here?

532
Minus 100 plus 20, so your net loss will come down to 80, so it means taking the tax savings
or the benefit of tax savings, this question does not arise and because net result of the firm's
operations from all the four projects res is the loss and the loss is 80 crores rupees.

So, it means there is no question of taking the benefit of the tax savings in case the project
makes profits and the firm makes losses. So, what is written here, regarding the tax savings,
the action to be taken here is defer taxes until the firm makes the profit, we have not to pay
any tax because net result is you are not going to pay any tax, this is 20, this is 100.

So, it means, what is the net result of the firm? It is a loss of 80 crore rupees. So, there is no
tax liability and partly because of the profit coming out of the project D, the existing losses of
the 100 crores coming out of the three existing projects have come down by the amount of
the profit coming out of the product D or the project D or the project number 4.

So, net result for the firm is a loss, there is no profit. So, there is no question of paying any
kind of the tax on the total losses of the, or net losses of the firm, fourth scenario can be
project makes profit, firm makes profit, then what action is required? Consider taxes in the
year of the profit, because there is no loss to be taken the benefit of, it cannot be set off. With
a loss from the project cannot be set off against the profits of the firm because both are giving
you the profits, new project is also giving you the profit, firm is also giving you the profit.

So, both are profit making, so what will happen? The situation here will be something like
this, that for example, you are incurring the 100 crore profit and then 20 crores addition, so
total profit of the firm will become how much? Rupees 20 crores, and in this case, you have
to pay at the rate of for example, 30 percent you have to pay the tax, so that will be paid on
the entire profit of the firm.

So, you have to look at these four situations and the fifth situation is like stand alone, the firm
is new. It is not existing, already existing in the market. For the first time the firm has been
formed, it has come into existence and this is the first project of the firm, which we are
writing here is as the stand-alone and that incurs losses, what action is required here? Defer
tax savings until the project makes profits. So, what we do in that case, we do follow different
kind of situations.

(Refer Slide Time: 17:25)

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For example, you right here as the year 1, this is 0, then 1, 2, 3, 4, 5, 6, 7 this is the 7 years
foreseeable life of a new project, in this case what is going to be there? Cash outflow, we are
going to make investment in the 0 period, and here we are going to have the loss of 20 crores,
then we are going to have a loss of 30 crores, then we are going to have a loss of again 20,
crores, and this year we have the profit of 20 crores, then we have the profit of 30 crores then
we have the profit of 40 crores, then we have the profit of again 40 crores.

So, what is there it is a loss here and it is again a loss here and here we have started earning
the profits. So, whatever the losses are coming up in the first 2 years, total loss of how much
that is of the 50 crore rupees 20 plus 30, 50 crore rupees of the loss can be can be set off
against the profit coming up in the future years, and when the profit starts coming up to the
firm or the firm start earning the profit from the third year onwards, then this the benefit of

534
tax savings on account of the losses incurred in the initial years of the firm can be taken or
can be treated.

So, it means this is permissible, this benefit can be taken, this is allowed. So, it means
whatever the loss has been incurred in the initial years that can be done away or the tax
savings on this particular part can be taken, from the profit coming out in the subsequent
years. But till the firm start earning the profit, there is no question of paying any kind of the
tax because firm is not earning the profit rather the firm is incurring a loss and on the loss
mean every any kind of the taxes.

So, this is how in the 5 different situations when the firm is into existence, and the new
project is added first 4 situations talk about that, and when if the firm as a whole is new, and
this is going to be the first project of the firm, then how to take care of the losses and profits
that I have already discussed with you.

More it will be clear to you, when we will do the practical problems and we will estimate the
cash flows in the different situations, then the things will be more clear to you. But currently
you have to deal with the taxes this way.

And finally, that total tax liability of the firm has to be calculated by taking the benefit of any
kind of the loss coming out of the project against profits of the firm maybe or maybe setting
off the loss against the profits of the firm as a whole.

Next thing is now I am going to discuss with you is the consistency principle. Consistency
principle talks about here is that we should be consistent in terms of calculating the cash
flows and discounting of the cash flows as there is a difference in the discount rate.

If you change the methodology of calculating the cash flows, then certainly the methodology
of calculating the discount rate or applying the discount rate should also be changed. So,
consistency demands that how you are calculating the cash flows same way you apply the
discount rate.

Another important requirement under consistency principle is with regard to the inflation
because when you calculate the cash flows, when we grow over a period of time in the 0 year
we are making investment that is a cash outflow. But for the next 5, 7 or 10 years, which is a
foreseeable life of the project, projects start giving the profits or the cash flow start coming
up.

535
So, what will happen? Our selling price is not consistent or is not going to remain the
constant, selling price of our product is something different today, but over a period of time
we are going to increase the selling price and at the same time, the cost of inputs is also going
to increase.

So, it means why there is increase in the cost of inputs as well as the selling price of the firm
because of the inflation, so how to treat that inflation factor? Because when you are
estimating the cash flows, mind it practically we are not getting the cash flows. This is only
the projection, estimation means only the projection of the cash flows over the foreseeable
life of the project.

So, when you are going for the projections always keep into consideration the inflation factor
and consistency in the inflation is also equally important that how are you including the
inflation while calculating the cash flows, that we have to be very careful and carefully or
consistently, we should give the effect to the cash flows, whether it is a cash outflow or the
cash inflow.

It may be possible that in the subsequent years, it is not only the cash inflow, even the cash
outflow is also required. So, there the inflation is going to play the role, so we have to factor
the inflation principle, but consistently. So, in this case, when you talk about the consistency
in calculating the cash flows or working out the cash flows, we have to look at it from the
different angles.

But first look at what is the meaning of the consistency principle? Cash flows and discount
rates applied to these cash flows must be consistent with respect to the investor group and
inflation.

So, first important thing we talk about is the investor group from where the funds have come
while building of this project. There are the two sources, one source is the internal sources of
funds, second is external sources of funds. When you talk about the internal sources of the
funds, this is called as equity capital and then we go for borrowing some funds which is
called as debt.

So it means, this is the internal source of funds, this is the external source of funds and once
you are going to have the funds from these two sources, then what is there? We have to apply
the discount rate also which is applicable on the both. Consistency demands because if you

536
look at here, that investor group we have identified here that as an investor groups, the
consistency principle suggests the falling match ups.

One is cash flow, from where the cash is coming in, what is a source of cash which we are
going to invest in the business and which you call it as a cash outflow. First is cash flow is
coming from all the investors. It is written here cash flow to all investors but first, how do
you return the cash flow to all investors? First we have to receive the cash to be invested in
the business from all the investors and what are the sources of having the cash or the
investment in the business?

Two sources, one is the equity which comes from the promoters or from the shareholders or
from the owners of the business, second is the borrowing which comes in the form of the debt
from the market. So, when the borrowing has come means cash outflow, which invested in
the business called as a cash outflow in the 0 period has come from the 2 sources debt and
equity, same way the cash flow going back to the different interest groups or different
investor groups should be treated like that.

So, it means cash flow when you are calculating the will be the sum total of cash flow going
to the equity shareholders back as a result of making investment into the business plus the
cash flow you are returning back to the source of debt.

So, when you are taking it together the cash flow returned back for lending money or
investing money in the business, so it means you are calculating cash flow which has now
distributable to both the stakeholders or investors, internal owners as well as the lenders, then
the discount rate has to be the weighted average cost of capital WACC.

And normally in this discussion also here for this particular subject, whereas in the practical
life also, we apply the weighted average cost of capital as a discount rate for discounting of
the cash inflows. For this discussion also and otherwise also, we do not segregate it, but there
can be another way, another situation also.

Another situation can be that, for example, the cash flow we are working out only for the
equity shareholders, that we have already paid off the interest cost of the borrowing, we have
already paid the principal component of the borrowing and after that whatever the cash flow
left with us is that is called as a free cash flow and that is only available to the equity
shareholders if that way you are calculating the cash flow, then what you are going to do,

537
only the discount rate has to be the cost of equity and not the weighted average cost of
capital, so remain consistent.

What is the source of cash inflow or this is attributable to or distributable to both the
stakeholders or both the investors then weighted average cost capital has to be used, but if
only to the equity shareholders the cash flow has to be calculated, then the discount rate has
to be used as the cost of equity, which can be calculated with the help of CAPM - Capital
Asset Pricing Model.

So, detailed discussion upon the cost of capital I will have separately because it is
independent topic cost of capital. There we will talk about the weighted average cost of
capital also and the cost of equity also.

So, this is with regard to the cash flows and the discount rates. Now, let us understand how to
calculate the cash flows for the different interest groups. When we are talking about the cash
flows for all the investors how to calculate it?

(Refer Slide Time: 27:45)

We will calculate cash flow for all the investors. Cash flow for all investors, how would you
calculate it? You will calculate it like this PBIT - Profit Before Interest in Tax into 1 minus
tax rate i.e. PBIT(1-t). This is the profit after tax available with us plus depreciation and non-
cash charges, minus all kind of capital expenditure, minus changes or increase in the working
capital requirements

538
So, increase in the changes, or change in the working capital, any kind of changes in the
working capital, we have to write here, changes in working capital. So, it means whatever
now the cash flow comes up is we are starting with a profit before interest and tax.

This is that total cash flow left with us, profit before interest and tax which is coming up here,
and then 1 minus tax rate if you subtract the tax part from this profit before interest and tax,
so that will be left with us is, what will be that part that will be called as PAT - Profit After
Tax.

So, into that profit after tax for calculating now the cash flow available to all the investors
will be that is the profit after tax it means in a case, PAT that PBIT into 1 minus tax rate will
become now the profit after tax plus in that depreciation plus any other non-cash charge
which we have already subtracted before calculating this PBIT, that will be added back.

Because that is a non-cash charge, we have only considered as at an expense, but it is a non-
cash expense that will be added back because that will be the source of cash flow and any
kind of the capital expenditure, now we are going to incur in the current year that has to be
done from this cash flow only.

So, that will be subtracted including the investment we are going to make here in for the
working capital requirement. So, these two have to be subtracted, and these two have to be
added. So, profit after tax plus depreciation plus non-cash charges minus any kind of the cap
exp, we are going to do in the current year and minus any kind of investment we are going to
do on account of the working capital changes or any increase in the working capital.

So, from the total cash flow, you have to subtract the capital expenditure and the revenue
expenditure on account of working capital. Remaining cash flow will be called as the cash
flow for all investors.

This is the case, if you are calculating the cash flow for all investors and on this cash flow the
discount rate to be applied will be the WACC - Weighted Average Cost of Capital, so where
you will calculate the cost of debt which is given to us which is a borrowing rate plus you
have to calculate the cost of equity with the help of CAPM - Capital Asset Pricing Model.

Then you have to take the weightage, depending upon the contribution from these two
sources, you have to calculate the weighted average cost of capital and that will become the

539
discount rate in case of the cash flow to all the investors. And in case of the cash flow only to
the equity shareholders.

So, it will be little complex, cash flow to equity shareholders, how to calculate it? Again now
we have to start with Profit After Tax – PAT plus same thing depreciation and non-cash
charges, NCC, I am writing, Non-Cash Charges you have to add back here and then you have
to subtract here something, minus the preference dividend minus, if there is any kind of the
Cap exp,

Capital Expenditure has to be subtracted, minus changes in working capital, any kind of
changes in the working capital are there minus repayment of debt, if you are going to pay the
debt also, plus fresh proceeds from the debt, if any debt is raised, proceeds from that part of
the debt is repaid and new debt is borrowed.

So, proceeds from debt has to be added back because that will become the source of cash
inflow, and then is minus redemption of the preference shares or the preference capital and
plus proceeds from any fresh issue of the preference shares or the preference capital. So, this
will become the cash flow only to the equity shareholders.

So, it means all the claims belonging to the outsiders, lenders are also outsiders and
preference shareholders are also for this purpose are considered as outsiders though, though
the preference capital is called as a capital, share capital, but since it is only for a limited
period of time, and after that it has to be redeemed. So, it is also treated as same as the debt
borrowed from the some particular source.

So, same way it has to be treated, so here, you have to now calculate that cash flow only to
the equity shareholders in this process. And for calculating this the process is little bit
different here. So, when you calculate this cash flow for all the shareholders and cash flow
for the equity shareholders, calculating the cash flow for all the shareholders is different and
calculating the cash flow for the equity shareholders is different.

So, it means, once you follow the second method, second approach for calculating the cash
flow for the equity shareholders only then the claims of all outsiders have to be settled first
and then whatever is left now as a cash inflow final figure, which is called as a Free Cash
Flow - FCF that will be only admissible to, payable to the equity shareholders.

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Whereas in the first case, we are only talking about the capital expenditure and the working
capital increase as the cash outflow remaining, whatever the cash flow we are working out is,
that is payable or that belongs to all the investors both internal and external and from this
cash flow we will settle the claims of the debt suppliers, preference shareholders.

So, if you are following the first approach first method, then the “Weighted Average Cost of
Capital” will be used as a discount rate whereas, in the second case only the costs of equity,
but for our discussion and in the general discussion while calculating the cash flows, we
follow the first approach always and cash flows are always calculated, which are known as
the cash flow for all the investors for all the important fund suppliers both internal and the
external. This is the one part of the consistency principle.

(Refer Slide Time: 36:11)

And the second important component of the consistency principle is that when you calculate
this here, now we have to provide for the inflation part also. So, the consistency principle
suggests here, that the following match up should be observed. So, it means cash flow is
nominal cash flow and nominal discount rate and real cash flow means the, real discount rate.

So, when you talk about the nominal cash flow, in this nominal cash flow what we do is, we
include the inflation also we provide the allowance because when your selling price will
increase over a period of time not because of any other factor just because of the inflation
your cash inflow will also increase.

So, when you will calculate the, or you will discount those cash flows, that discount rates
should also be the nominal discount rate means it should be the inflated discount rate or the

541
present discount rate expected to be present in the market at that time, not the discount rate
which you are say taking the nominal discount rate minus inflation or the effect of the
inflation that has not to be done.

So, because when we predict, when we estimate the cash flows, we do not only estimate it at
the same level for example, we are saying that every year we are going to get back the 100
crores over the next 5 or 7 years it may be possible in the first year we are going to get back
100 crores, next year 120 then is 130. So, that is not because we are selling additional number
of units, total production and sales will remain the same, but because selling price will
change because of the inflation factor.

So, our cash flow will also increase. So, it means when you are calculating the cash flows by
taking the inflation factor into account, your discount rate has to be consistent like that and
discount rate also has to be anticipated or maybe estimated, which is expected to be there in
the market at that point of time.

So, consistency in case of the inflation remains that nominal cash flow, inclusive of inflation,
discount rates should also be nominal inclusive of inflation, but when the real cash flow
means you are subtracting now the the effect of inflation, then the discount rate also has to be
real in the discount rate also, you have to say take the nominal discount rate expected to be
existing at that time minus the effect of inflation and then that will become the real discount
rate.

But normally, we do not follow the real cash flow or the real discount rates, for our
estimation and analysis, we always follow and for this analysis, here also, we always follow
the process of nominal cash flows and the nominal discount rates. So, these are the four
important principles, which are very important before you start working out the cash flows or
estimating the cash flows, you should be very clear in your mind that what is the separation
principle, what is the incremental principle, what is the post-tax principle, and what is the
consistency principle.

If these 4 principles are clearly established in your mind, then estimating the cash flows for
the firm, any kind of future investment proposal or future investment project will not be
difficult for us. So here, I will stop with this discussion, theoretical discussion or the
fundamental discussion, which is important to be borne in mind, before we start knowing

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about or learning about how we practically estimated estimate the cash flows, it was very
important, I could do it.

And you also follow any good book, for example, which I am falling here is "The Financial
Management" by "Prasanna Chandra" you can follow that book, and you can see in that book
in very detailed manner, detailed form all these principles are discussed.

So, first you understand the fundamental theoretical portion and later on you start
understanding how the cash flows have been estimated here by me for the different practical
problems, which I will be doing from the next class onwards. Till then, I will stop here, and I
will see you in the next class. Thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 33
Estimation of Project Cash Flows Part 5
Welcome all. So, after talking about the different conceptual parts and the fundamental
concepts about the estimation of the cash flows. Now, we will learn about that practically in
the different situations while evaluating the definite investment proposals, how to estimate
the cash flows in the real life situations tomorrow when we have to estimate the cash flows
practically in the field for taking up the new investment proposals or the new projects.

How we will be calculating and how the cash outflow will be calculated, how the cash inflow
will be calculated. And finally, arriving at the final cash flow or you call it as the net cash
flow, which will be applicable, available to all the stakeholders internal as well as external,
how to calculate that? So, if you want to see here, how it has been calculated. So, we will
take a situation, we will take a hypothetical information or the hypothetical situation it is
given here in this slide.

(Refer Slide Time: 1:30)

And if you read this, first you read this slide carefully that what is the requirement of this
particular project, which has been identified or is being considered by some existing firm. So,
we assume that there is a company called as ABC limited that is already existing in the
market and they want to start a new project or they want to take up the new investment
proposal.

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And when they have prepare the DPFR detailed project feasibility report which includes all
kinds of analysis your idea first of all, then is a market and demand analysis, technical
analysis, financial analysis and then the other kind of the analysis.

So, the DPFR of the project says the information gathered there, that information is with
regard to the all cash outflows and the cash inflows and out of this considering all those cash
outflows and cash inflows, we have to work out the net cash flow available to all the
stakeholders.

So, in this case, first I will discuss the problem with you and then in this case, the first
problem. we have already solved it here and the solution is available in the form of the PPT,
it is given here so, that easily you can understand.

But for the subsequent remaining problems or the different type of the problems, I will work
it out with this pen and we will calculate, the problem will be given in the PPT and then the
solution we will work it out here and we will learn how to take into consideration the
different items and calculate the net cash flow to be available to the different investors which
are going to provide the funds or who are going to provide the funds for the new investment
opportunity or the new investment proposal.

So, let us first of all read it but it is given in this slide. The information given in this slide
says, ABC Limited is considering a new project about which the following information is
given.

And what the information is given? The All the important items are given here. It is with
regard to the cash outflows, cash inflows, different kind of expenses and we have to factor for
all these different inflow and outflow related information.

First points says the investment outlay on the project will be 100 million rupees, this consists
of 80 millions on plant and machinery and 20 millions on the net working capital, not on the
working capital net working capital that is current assets minus current liabilities.

So, it means, this hundred million which is required to be invested in this project proposal, 80
will be required for the fixed assets and 20 millions will be required for meeting the working
capital requirements that to the net working capital requirements The entire outlay will be
incurred in the beginning of the project years or in the beginning of the project or the first

545
year of the project. Not first year, we will call it as a current period of the project which we
call it as the 0 period.

Second point says, the project will be financed with 45 millions of equity capital, 5 of the
preference capital and 50 millions of the debt capital. It means the funds are going to come
from both internal as well as external sources.

Equity capital is the internal source, preference capital is also internal source, but we
sometime for the treatment of these funds we consider it at par with that debt, because these
funds come for a limited period of time. And they are not exactly as same as the funds
coming from the equity shares, they more resemble with that debt rather than the equity.

But equity is also there in the form of equity capital, preference capital is also there, and the
borrowings are also there, that about 50 percent of investment will come in the form of debt
as borrowings. Preference capital will carry a dividend rate of 15 percent and debt capital will
carry an interest rate of 15 percent. Both will carry the cost of capital will be here for the
preference also 15 and the debt also will be the 15. And for the equity capital, you have to
calculate yourself by applying the concept of CAPM capital asset pricing model, which we
will discuss later on.

The life of the project is expected to be 5 years, point number 3 says. At the end of 5 years,
fixed assets will fetch a net salvage value of 30 millions, project will be terminated after 5
years it has only foreseeable life of 5 years after that we will terminate, dismantle the project.

And when you dismantle it, plant and machinery, fixed assets there you are making the
investment of 80 million rupees will fetch as a salvage value 30 million rupees and the net
working capital will be liquidated at its book value. I told you earlier also in the discussion or
during the discussion part also, their working capital is realizable in full, when you convert
the current assets into cash, it comes back in the full.

So, it is convertible into the cash in the full amount. So, it means it will be realizable in the
full amount how much we are investing? 20 million and that 20 million will be recoverable.
So, 30 million will come back from the fixed assets as a salvage value and 20 millions will
come back as the working capital recovery.

Point number 4 says, project is expected to increase the revenue of the firm by 120 millions
per year. The increase in the cost on account of the project is expected to be rupees 80 million

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per year. This includes all items of cost other than depreciation, interest and tax. The effective
tax rate will be 30 percent.

And the last point says, plant and machinery will be depreciated at the rate of 25 percent per
year as per the WDV method written down value method. Hence, first year the depreciation
charge will be 20 million that is the say 25 percent of 80 is 20 millions, then on the reduced
balance of how much? 60 the depreciation amount will be again 25 percent which will work
out as 15 million, then 11.25 million, then 8.44 million, 6.33 million.

On the basis of all these details given to us with regard to the cash outflows and cash inflows,
we have to now calculate the, estimate the cash flows. This is only information given, this
information might have been drawn from the DPFR of ABC limited, who is going to start the
new investment means who have got the new investment opportunity, they want to convert
that into the say a business opportunity, they want to start establish a new project.

And the information available in the detailed the project feasibility report DPFR says that if
you want to go for this project, this much cash outflow will be required or cash to be invested
will be required and the cash inflow available is also estimated here by selling the output of
the project or the product in the market.

And finally, by say, incurring the other expenses and then working out the total cash outflow,
working out the total cash inflow, we have to finally find out what will be the net cash flow
available from this project.

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(Refer Slide Time: 10:01)

So, now after doing this, this all net cash flow here, last column if you look at here, the net
cash flow here has been worked out. So, if you look at all these items very simple, very clear,
and this particular problem we have taken is, is very clear because it is the first problem.

So, no complexities are involved here and whatever the cash flows have been worked out
here, very simple and straight. First, we have assumed here is that the cash outflow is going
to occur in the current period that is in the 0 period and in the subsequent years from the year
1 to 5, no cash outflow is expected to be there, only cash inflow will be there

Yes, cash outflow will be on account of the different other expenses, but as far as that capital
cash flow is concerned, the capital investment will only be in the 0 period in the current
period, out of the total 100 millions required to be invested 80 will be invested in the fixed

548
assets which is given here. 80 fixed asset it is given in the problem itself and net working
capital requirement is how much, 20 percent or the 20 million rupees these are the values
given to you in the million rupees.

So, in the 0 period what we are showing here? We are showing only the cash outflow, not the
cash inflow, no cash inflow is there. So, fixed asset is 80 and the working capital is 20. This
is the total investment requirement of the project. Then from the first year onwards now, we
will go to the third item.

So, this is the outflow source, means the avenue of investment on account of the fixed asset
and the current assets and from here onwards now, the cash inflow will start and first source
of the cash inflow is as I told you earlier also from the sales of the output of the project.

Whatever the product we are manufacturing, whatever the services we are generating out of
this project, we are selling that in the market and the inflow will be generated. Column
number C says here, that first source of the inflow is the revenue. So, we have calculated
revenue which means the sales revenue that by selling that product or services in the market,
the sales revenue will be coming up as 120 millions every year.

It is assumed to be same 120 millions every year, we have not considered as the inflation
factor or anything, we are assuming that every year the revenue level will be same 120
million in the first year, second year, third year, fourth year and fifth years. So, this is a first
source of inflow, then out of this, we will have to consider now the important causes of the
cash outflow.

These causes are cost, for manufacturing, for manufacturing the sales, worth rupee 120
millions you have to incur the cost, apart from this particular amount of the 80 and 20
invested in the fixed asset and current assets you have to now shell out funds for incurring or
for converting the raw material into the finished product or generating any service.

So, which will give us the revenue of 120, so the cost for manufacturing that product or
service will be at 80, 80, 80, 80 same in all the 5 years. Revenue will also be constant, cost
will also be constant, we have not considered different kind of the conditions or situations,
we are resuming the life is going to be very simple in this project over the next 5 years
foreseeable period.

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So, it means this is the cost and then we consider the another head of the cost after the cost of
production that is a direct cost on account of material, labor and the other direct overheads.
Now, we have the indirect cost also and the indirect cost, first this is called as depreciation.

It is given to us in the problem also if you look at the problem, it is given to us that the rate of
depreciation will be 25 percent and that will be charged as per the WDV method written
down value method. So, we have calculated the depreciation here, which here will be called
as the cost because total cost of the product when you will work out, the depreciation will
also be the part of that cost.

So, it means from the revenue, this is a revenue minus this minus this, you have to subtract
that, you will be left with something which is called as the profit before tax. This is called as
the profit before tax of the 20 million rupees because we got 120, we paid cost of production
80, we paid indirect costs as depreciation. Actually, we do not pay the depreciation but we
have to included it in the cost sheet.

So, we counted for the depreciation as a indirect cost which is 100. So, total cost of
production is how much this plus this is 100, so 120 minus 100 is now your profit before tax.
We have not considered the tax here, profit before tax is 20, and now it is already given to us
in the problem tax rate is 30 percent.

So, if you calculate the tax here on this profit before tax 20, 30 percent the tax comes out as
6,. So, it means, what is the profit after tax? Profit after tax given here is 14, we are left with
the 14 million rupees which is the PAT profit after tax. And in this case now, we have to now
go for winding of the project because everything, these all things, all are same in this year. If
you talk about this, this and this all the 5 years up to this particular part all the items are same.

First we are considering the revenue of 120 millions remaining same, then we are considering
the cost of 18 millions remaining the same. Then we are applying the depreciation at the rate
of 25 percent at the WDV method and then we are calculating the tax part. So, we calculated
the profit before tax, then we subtracted the tax which is calculated at the rate of 30 percent
of the profit before tax.

And finally, we are left with something which is called as PAT profit after tax. While
estimating the cash flows, the calculation or the profit after tax is the first requirement, first
you calculate the PAT, though it is available in the profit and loss account also.

550
But we pick up the figures from the profit and loss account, they are complementary to each
other, means for preparing the profit and loss account you need all these information and for
preparing the cash flow statement you need this information. So, it means all this is available
from the DPFR. So, we have taken this and we have calculated that PAT profit after tax.

After this, now, once the profit after tax is there, then we have to now go to the year number
5 and in the year number 5 now, we have to think about that all the 5 years we are going to
find out profit after tax is 14 million, year 1: 17.5 in the year 2; 20.12 in the year 3; 22.09
year 4 and 23.57 millions in the year 5.

Complete all the 5 years cash flows are worked out here and first source of the net cash flow
is the PAT profit after tax, we have seen in the formula also, we have seen here cash flow for
all the investors. Since we are following this approach, cash flow for all the investors, so,
what we are calculating? First requirement given here is PBIT into 1 minus tax rate. So,
actually it becomes the PAT and we have calculated the PAT.

Now, for calculating the cash flow, we will take into account the other items. Depreciation
and non-cash charges have to be added back into the PAT because depreciation is the non-
cash expense. We subtract that first from the profit and loss account. But since that is only a
book entry, and it is a recovery of the capital investment, which has already been made that
capital investment of the 80 millions, which has been made for acquiring the fixed asset, now
it is a process of recovery of that.

So, we call the depreciation as a expense, indirect expense, but since this expense is not paid
to any outsider, so, it is only a book entry and that amount the profit and loss account is
debited with, we will show there as an indirect expense and that amount is not paid to any
outsider. It is retained back, so it becomes a source of net cash flow.

So, in the PAT, we will be adding back now the depreciation plus any other non-cash
charges. For example, say in the other case you can call it as the deferred revenue expenses
are also there. Deferred revenue expenses also, we have incurred the expenses sometime in
the past, now, we will capitalize those expenses and over a period of time through the process
of amortization, we will recover those expenses.

So, these all are called as the non-cash expenses, which will be added back into PAT will
become the source of this cash flow. Depreciation is subtracted for calculating profit, but for
calculating the cash flow it will be added back into the PAT and if there is any kind of the

551
capital expenditure or the expenditure on account of working capital that has to be subtracted
from the cash flow available.

Since this project which we have worked out here, we are going to now terminate after 5
years. So, it means no capital expenditure is required. Capital expenditure was required only
in the year 0 or in the current period of the 80 million rupees, and then the revenue
expenditure that is the working capital.

So, now is a time of recovery of that expenses, because the project has only 5 years’ time.
And after this calculating the profit after tax, first source of cash inflow or the net cash flow,
we have calculated up to 5 years and at the end of the fifth year, we will be now say
dismantling the project, terminating the project.

So, now, we will have to see that, once you close the project, you dismantle it, then how
much now the total cash flow will be available in the year 5, net salvage value of the fixed
asset is already given to us that 30 millions will be available from that structure, which will
be now say saleable in the market. And the working capital will be recoverable in full
amount. So, how much of working capital we have invested here? This amount of the 20
millions and that will come back to us.

So, always mind it, you have to recover the full amount of working capital, because there is
no loss of working capital in any form, whatever the funds are invested in the working capital
for supporting of your inventory, credit sales or cash or prepaid expenses, they are realizable
in the full amount.

So, at the end of the fifth year, when you will close down this manufacturing process or this
facility, you will get back first source of cash flow will be PAT, 23.57, second will be 30 as a
salvage value and the next one will be 20 as the recovery of the working capital.

So, now, you go for this initial outlay was how much? 100 millions which is here the sum
total of this 100 millions and operating cash flows are how much? Operating cash flows are
now, operating cash flows we have calculated PAT plus this depreciation amount what is the
depreciation amount? 20, so 20 plus 14 is 34.

Similarly, say 15 and 17.5 is how much? 32.5, similarly, this operating cash flow is 31.37.
This amount is 30.53 and this amount is operating cash flow works out here as that is 29.90,
because the depreciation has come down very small amount, 6.33 and here we have got the

552
profit after tax 23.57. So, it means the operating cash flow will be 29.90 here at the end of the
fifth year.

Terminal cash flows will be how much? This plus this, these two, this amount plus this will
become the 50. So, this will be available with us, 50 will be available with us. So, it means
finally, if you calculate this amount, this will come up here as this amount we have to add
here and this will work out as how much that is 50. So, total amount which will be coming
back to us at the end of the fifth year will be how much? This amount will be, you can call it
as say net cash flow, we have calculated here as the net cash flow and the net cash flow here
is that is 100.

But cash outflow was 100 which was invested in the 0 period and at the end of the first year
we have got back some amount, that is called as 34, then 32.5, then 31.37, then it is 30.53 and
here since the terminal value is also available on account of the salvage value of fixed assets
and working capital, so, the net cash flow coming at the end of the fifth year will be more.

And finally, book value of investment was how much? Book value of investment was 100 in
the initial 0 period in the current period and at the beginning of the first year it was 80. It was
80 because 80 invested on account of the fixed assets.

So, it is equal to 80 but depreciating it at the rate of 25 percent. So, we have depreciated it
and depreciation out we worked out here. So, it means it has depreciated over a period of
time. So, this investment has been going down and when you have subtracted it because
depreciation was 20. So, it means, how much is that amount?

We were left with this amount is 80. So, it means this is in the beginning of the year and
minus this depreciation. So, remaining was the amount of the investment which was made in
the beginning of the year then minus depreciation. So, depreciation was here that is 15 is a
depreciation it has come down to 65, then it has come down to 53.75 and finally, it has come
down to 45.31 and last year we have to provide the depreciation.

So, we are calculating the book value of investment, book value of the investment is not
calculated for the fifth year because in the fifth year the project has been closed down, it has
been terminated.

So, this is the entire process, it explains the entire process here, how to calculate the cash
flows, but this problem we have considered here is we have taken that cash outflows in the

553
beginning here only in the current period during which the project is being going to be
constructed.

And then over the next 5 years, the life of the project is limited for a period of 5 years and
within a period of 5 years, we are going to have this much of the cash outflow, this much of
the cash inflow, net cash flow is going to be this much because in the last year, when you will
dismantle the project, so, it means you will get the terminal cash flows also along with the
operating cash flow.

So, it means now when you calculate this, the amount net cash flow, it has two components.
First component is operating cash flow, if you calculate the operating cash, this will come out
here as 29.90. But in this when you add up the terminal cash flows also this becomes a net
cash flow and net cash flow has become 79.90. So, 29.90 is the operating cash flow plus 50
you are adding up here. So, sum total you can call it test net cash flow becomes here at the
end of the fifth year is 79.90.

So, for evaluating this we have calculated the cash flows and now, you remember back in the
capital budgeting process, what we did? These cash flows were given to us this, this all these
were given to us. We assumed that all these cash flows are available, but we have to calculate
this way they are not available, they are not served to us in platter, we have to calculate by
preparing the detailed project feasibility report.

So, cash outflow is there. Now, the cash inflows are there. Now, they will be discounted for
evaluating the project whether to take up the project or not to take up the project. For go for
this investment opportunity or not to go for this investment opportunity, what we have to do
is? We have to now discount these at the given cost of capital. And since the funds in this
project have come from all the sources, we have the equity capital also, we have the
preference capital also, we have the borrowings also.

So, which rate of discount will be applicable? Cost of capital, weighted average cost of
capital will be applied here for discounting these cash inflows. So, you will be now,
discounting these, this, this, this, this and this, they will be discounted for the 5 years, we will
discount them at the weighted average cost of capital and compare against these cash
outflows.

So, discounted value of these 5 cash inflows, and the 100 will be 100 because it is in the
current period. So, this will be calculated and then the present value of the cash outflow or

554
the present value of the cash inflow will be considered for subtracting the present value of the
cash outflow.

So, the present value of the cash inflow minus present value of the cash outflow which is 100
in the present period, we will try to find out what is the net present value of the project?

And if the NPV is positive, then certainly we will go for the taking of this investment
opportunity, otherwise, we will abandon it because it is not worthwhile, but I think if you
look at all these cash flows, so, this will I think, come out to be a positive proposition and net
present value will be positive here, and that is what we want from every investment
opportunity. So this is the one important consideration.

Second important consideration which I want to share with you here is that look, we have
while assuming the cash outflows we have taken very simple and straightforward figures. For
example, here it is taken here as the 80 and 20 we assumed. That cash outflows are only in
the 0 period, in the present period, in the current period after that in the next 5 years, no cash
outflow is there.

But in the practical situation, it may be different that cash outflow is not only in the 0 or in
the current period, it may be in the subsequent years also. So, then you have to calculate the
present value of the cash outflows also like the present value of the cash inflows, this is one
important thing.

Second important thing here is, consideration here is that, for example, we are considering
here as the revenue if you look at this revenue figures, these are 120 for all the 5 years. In the
real life, this may be quite unlikely because inflation plays the role. Here production
remaining the same, number of units remaining the same, but your selling price increases
because the price of input will increase the cost, when the cost will also not be 80, cost will
also change and when the cost will increase certainly we have to recover that increased cost
plus the profits for us. So, this revenue will also increase.

So, this revenue will not be a straight forward figure of 120 and cost us as 80, this will also be
the fluctuating figures and sometimes what happens? We do not sell even the same number
of units in the market, sometimes we are selling for example, 100 units, but next year demand
came down. So, we are selling only 90 units. Next year the demand again went up. So, we are
selling 120 units. So, when even the selling price remaining same per unit, because we are
selling the different number of units, so, your total sales figure or the revenue will change.

555
So, we have to adjust for all those changes. And finally, we have to work out the cash flows,
both cash outflows and inflows, which are expected to be the practical figures, the expected
figures, you can call it as the reliable figures. So, since it was the first problem, so we took
the very simple straight forward figures, no Hanky Panky we have adjusted here or we have
created the situation that it becomes a complex problem in the beginning itself.

In the beginning being a first problem, we have kept it simple and straight and very easy
problem, but in the subsequent problems which I will be discussing with you in the
subsequent classes, they will be factoring for the different typical situations also both in with
regard to the estimation of the cash outflows, both with regard to the estimation of the cash
inflows as well as the other important components we will be adding some wrinkles.

So, that you understand that practically if the cash outflow and inflows are different or some
changes take place, then in that situation how to calculate the net cash flow. But this is just
the beginning and just to share with you or to means let you know or make you aware of that
after knowing the fundamentals of the estimation of the cash flows from the different
investment opportunities or different project proposals, practically how to estimate the cash
flows? and especially the Net Cash Flow.

Once this net cash flow is available both cash outflow and cash inflow now, the next process
is very simple, you discount these inflows by applying the cost of capital as a discount rate
and the cost of this present value of these outflows will remain the same as 100 million
rupees and then calculate the NPV and on the basis of that, you take the decision whether to
accept the proposal or you reject the proposal or company accepts the proposal ABC limited
accepts the proposal or rejects the proposal.

So, working out these cash flows is a complex job in this problem, it was easy, but in the
subsequent problems, we will add some new information and some information which is
practically expected to be there in the life. Till then I will stop here and next 2, 3 classes we
will discuss more problems and discuss some another important component of the estimation
of the cash flows for the new investment opportunities or the new capital investment projects.
Till then, thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 34
Estimation of Project Cash Flows Part 6
Welcome all. So, in the process of learning about the estimation of the cash flows, in the
previous class we did one problem, which was just initial beginning of learning about the
estimation of the cash flows practically, where we assumed that everything is constant that
your cost is also the cash outflows means the cost of the projects in terms of the cash outflow,
they are also constant and the cash inflows are also constant and then we try to work out the
other related expenses like non-cash expenses, depreciation and taxes, and then we arrived at
the net cash flow.

So, similarly, we will move forward now with one more problem. So, the problem which we
did yesterday that was solved here it was done and this the problem was also given in the
form of the PPT and then the solution was also given in the form of the PPT.

(Refer Slide Time: 1:26)

But now, today I have another problem with me, which is given here in the PPT. So, you can
understand, you can read the problem first well, you can understand it well, and then I will
now solve it practically on the sheet here. So, that we can learn it that how different type of

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the information given here in this problem the second problem, how we have to work out or
the estimate the cash flows based upon the information given in the second problem.

So, this will be done here as the previous one was done and it was only explained by me that
how it has been done and how the cash flows have been estimated or worked out. But in this
case, in the second problem, only the problem will be given to you. And its solution. I will
work out here and I will show that how the cash flows are practically estimated in case of
different kinds of the projects.

And here the problems which we are going to take care of are like that the cash inflows over
the number of years are not going to be stable. They are not going to be constant. The cost
may be same that is going to remain in the beginning of the year, but as far as your cash
inflows are concerned, they are changing over the period of time sometimes they are
increasing, sometimes they are decreasing.

And that happens practically also that cash flows never remain stable, because of numbers of
factors. Sometimes we sell more, sometimes we sell less. So, accordingly your revenue is
going to increase or decrease and that practical aspect we are going to address in this
particular problem the problem number 2.

So, let us first of all understand the problem given here in the PPT, let us first understand the
problem well, and then we will move forward for calculating or estimating the cash flows
based upon the information given in this problem.

So, the problem here given here is that India Pharma limited is engaged in the manufacturing
of pharmaceuticals. It is a pharmaceutical manufacturing company and the company is
engaged in the manufacturing of different pharmaceutical products, different drugs, they are
manufacturing.

The company was established in 2008 and has registered a steady growth in the sales since
then. It was registered in 2008. And it has grown over a period of time since then it is
working well and it is growing. Presently the company manufactures 16 products and has an
annual turnover of 2200 million rupees.

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The company is considering the manufacturing of a new antibiotic preparation or a new
antibiotic drug which is named here for the sake of simplicity, it is named K-cin, this drug
they want to manufacture for which the following information has been gathered. So, as I told
you in the previous class also that manufacturing drugs is a very expensive business.

Especially in case of say identifying a new molecule, especially the new drug, completely a
new drug including the molecule as I told you that it requires a minimum 10 years period of
time and 10,000 crores of Indian rupees. So, huge investment is required to be done when we
have to identify the molecules.

But if you have to go for say manufacturing the drug out of already manufacture, already
identified molecule in that case also the cost is very high and in itself means introducing a
new drug in the market in itself is a full-fledged project, because investment requirements are
very high.

And once the project comes into the picture, it takes the shape and the drugs start
manufacturing, then the outcome is going to be excellent is going to be good. Because it may
be possible that the drug is already tested in the market and the demand and the market for
the new product for the new drug is well assured in advance.

So, in this case, we are going to find out now, that they want to introduce a new drug which is
called as K-cin and they want to start manufacturing it, they want to introduce it and the
different information the data which has been gathered in the detailed project feasibility
report for this product is given here as under.

Number 1, K-cin is expected to have a product lifecycle of 5 years, product, after 5 years it
will phase out, means it will exist in the market for 5 years. And thereafter, it could be
withdrawn from the market, maybe some improved version of this drug may come in the
market or maybe it becomes ineffective or some alternative say remedies also available in the
market. So, this drug is only going to be there in the market for 5 years.

The sales from these preparations are expected to be as follows. Years are given to us, 1 to 5
years 1, 2, 3, 4, 5 and sales in million rupees are also given to us. First year the sales are

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going to be the revenue is going to be 100 million rupees, then 150 million rupees, then 200
million rupees, then 150 million rupees and 100 million rupees.

Number 2, now, after this estimation of the sales and revenue, now, we talk about the cost
part and the point number two the capital equipment required for manufacturing K-cin is
worth rupees 100 million.

And it will be depreciated at a rate of 25 percent as per the WDV method. As per the WDV
method it will be depreciating at the rate of the 25 percent but WDV is basically for the tax
purpose, we all know it that they are the different methods of charging depreciation. So, but
in the practice they are only two, state line method or you call it as a fixed installment method
and the written down value method.

But in India for the tax purpose compulsorily the WDV method has to be followed by the
corporates, by the companies. And for the other purposes companies follow the straight line
method or the fixed installment method. So, it is given clearly here that depreciation will be
charged at the rate of 25 percent. And since we are going to prepare this balance sheet for the
tax purpose, so this method followed for charging the depreciation will be written down value
method.

The expected net salvage value after 5 years is going to be 20 million rupees means, they are
making investment of 100 million rupees and after 5 years using that plant and machinery all
the occupants we will be left with the salvage value of the one fifth of the investment which
we are making now that is 20 million rupees.

Number 3 the working capital requirement for the project is expected to be 20 percent of the
sales. Now, as I told you in the previous class that working capital is a very-very important
component and it should be carefully analyzed, it should be carefully worked out and as I told
you, there are the three methods of estimating the working capital requirement, it may be
worked out as a percentage of the fixed investment or the investment we are going to make in
the fixed assets or it may be worked out as a percentage of the sales.

And third method is that on the basis of the operating cycle approach or sometimes we call it
as the cash cycle approach, say investing cash for the working capital and again converting

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the cash into the cash. So, means after following that complete cycle. So, that will be the third
approach. Practically firms follow the operating cycle approach for the estimation of the
working capital requirements.

But in some projects for the simplicity, it may be estimated on the basis of or as a percentage
of the estimated or projected sales. So, in this case, the assumption taken here is that it will be
estimated as a percentage of the sales. So, the working capital requirement here it is 20
percent of the and at the end of the 5 years working capital is expected to be liquidated at par.

Means as we know we discussed in the previous class also that fixed assets give us back only
the salvage value that is only the leftover value because technical value goes down to 0,
because we depreciate it and we assume it that over the given number of years of 5 years, 10
years, the technical value the useful value of that asset will become 0. And only we will be
left with some structural value, the value of that plant which is only the value of that structure
and that will be expected to be of a certain amount which is called as a salvage value.

So, for the fixed assets be calculate the salvage value, but for the current assets, for the
working capital, we expect that the whatever the investment is made in the working capital or
fulfilling the working capital requirements or current assets requirements, current assets never
depreciate and they are eligible at the end of that life of the project in the full amount.

So, it is a same thing given here also, that at the end of 5 years working capital is expected to
be liquidated at par. Bearing an estimated loss of 5 million rupees on account of bad debts,
there must be some bad debts maybe, because different components of the working capital
are what?

Number one, first component is inventory for buying up the raw material and say, supporting
the finished goods in the store, we need to make some investment. So, that investment in the
inventory is the first component of the working capital.

Second component is the credit sales sundry debtors. So, sundry debtors when we sell on the
credit, we sell today, or in the current period and we expect to realize those sales in the time
to come. So, that is called as the sundry debtors and sundry debtors are expected to be
realized over a period of time, but it may be possible as it is given here that all the sundry

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debtors has been not realizable, and there will be the expected bad debt of 5 million rupees.
So, that loss will be there.

So, it means whatever the investment we are making in the working capital, how much
investment we are making in the working capital that is the 20 percent of sales. So, at the last
year, at the end of the life of the project in the fifth year, out of the 20 percent of the sales,
which we have invested in the working capital 5 million rupees will not be reliable, they will
turn into the bad debts, the bad debt loss will be tax deductible. The bad debt loss will be tax
deductible, so, it means the final loss will not be much it will be something that total loss of 5
millions minus the tax payable on that value of the 5 million rupees. So, it means the actual
loss will be total loss minus the percentage of the tax.

Point number 4 given here is the accountant of the firm has provided the following cost
estimates for the K-cin. The accountant of the firm has provided the following cost estimates
for the K-cin, raw material cost is 30 percent of sales, variable cost is 20 percent of sales,
fixed annual operating and maintenance cost is 5 million rupees.

And overhead allocation, excluding depreciation, maintenance and interest are 10 percent of
the sales. Overhead allocations are the 10 percent of the sales. While the project is charged an
overhead allocation, it is not likely to have any effect on the overhead expense as such.

Point number 5, the manufacturing of the K-cin would also require some of the common
facilities of the firm. The use of these facilities would call for reduction in the production of
other pharmaceutical preparations of the firm. This would entail a reduction of the 15 million
rupees of the contribution margin. The use of these facilities would call for reduction in the
production of other pharmaceutical preparation of the firm. This would entail a reduction of
rupees 15 millions of the contribution margin.

So, I discussed with you our concept of the opportunity cost in the previous class. So,
opportunity cost means that when we introduced a new product, we will have to carefully
account for because of the introduction of the new product is there any possibility of
reduction of the sales of the existing products.

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We discussed the concept of that cannibalization, product cannibalization effect and in that
product cannibalization effect, we have discussed this thing that it should be very carefully
estimated that because of the introduction of the new product are the sales of the existing
products going to be get affected and negatively or going to get eroded or reduced.

In this case it is going to happen that when we are going to introduce a new, say antibiotic K-
cin, then certainly it is going to affect the sales of the existing products and that loss of the
sales could be amounting to rupees 15 million rupees. So, we have to adjust this as a
opportunity cost.

Point number 6 is the tax rate applicable to the firm is 40 percent. So, it means in this case,
when we have to estimate the cash flows, we have to keep all these factors in mind. The total
information given here we have to keep in mind and we will have to be careful here that since
cash inflows that is a basically as a source of the cash inflows as a means the revenue is the
source and the cash flow is coming from the revenue, they are not constant, they are
fluctuating, they are changing over a period of time, they are increasing, then decreasing over
a period of time.

So, it means we have to be very careful with estimating the cash flows, that is the opportunity
cost also, there is some overhead cost also, we have to see whether it will be allocated to the
new product or not allocated. So, overall it is a interesting problem. And if you are able to
estimate the cash flows out of this information given then I think to a larger extent, you are
clear with the concept of the estimation of the product cash flows because it is a very tedious
task practically it is a very tedious task.

Capital budgeting process will be complete only or will be possibly completed if we have the
right estimation of the cash flows. If the cash flows are not rightly estimated, then there is
going to be a problem and without proper estimation of the cash flows, both cash outflow and
cash inflow problems are going to be there. So, on the basis of this information, we have to
learn how to estimate the cash flows.

So, for now, this purpose we will be doing it practically we will be learning that how to
estimate the cash flows and how to work it out both the cash outflows and the cash inflows.

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And finally, at the end of this entire exercise, how much net cash flow is going to be available
with us, that we are going to work out here.

So, let us calculate it and learn how to work out the cash flows for the different problems.
This problem is quite comprehensive because it takes into account number of things, number
of factors. And those factors which I theoretically, conceptually discussed with you.
Practically now we are going to deal with this all the factors or all the assumptions. So, now
we will prepare the say estimation of cash flows.

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(Refer Slide Time: 18:08)

So, we write here estimation of cash flow for this product which is called as K-cin. So, this is
a new antibiotic which we want to introduce, company is already manufacturing the 16
products and this product is going to be the new in the row. So, we are going to learn about
that how to manufacture this product and what cash flows are going to be there.

So, in this case, the estimation of the cash flows for this product are going to be a very
interesting phenomena for all of us. So, what we are going to do here is? We are going to
write here is the particulars, you write here as the particulars and then we will put here the
years and this amount is going to be in the rupees millions. So, this is the particulars, this is
years and then we are going to estimate this entire process.

So, particulars we will be taking up here and years are given to us are 0, 1, 2, 3, 4 and it is 5
and it is given to us in the case that the product only has the 5 years lifecycle after 5 years it
will be phased out, it will be going out of the market. So, it means you have to estimate the
cash flows only for the 5 years. So, we will start with the factoring for the all the information
given to us and taking this into account for estimating the cash flows.

So, first is the, let us estimated that in the 0 years, what kind of the cash flows will be there?
In the 0 period, in the current period only cash outflows will be there. And in the case it was
given that the investment on the equipment is that is the major cause of the cash outflow. So,

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investment in the capital equipment is going to be the first thing and that we will write here
capital equipment, capital equipment.

So, how much is going to be required for the capital equipment? 100 million rupees, all the
cash flows we are going to take in the million rupees. So, it is the 100 million rupees, this is
the one. Here in this case there is no other cash outflow is going to be there. Next thing
required to be done here is the level of net working capital. So, level of net working capital,
we have to work out here. So, in this year we require, in the beginning we required the net
working capital of this one, 20 million rupees that is a requirement for the net working
capital.

And over the years, from the first year to 5 years, the working capital requirement will be,
means it is estimated as a percentage of the sales. And you are looking at the percentage of
the sales this was estimated as 20 percent of the expected sales, the net working capital was
expected to be 20 percent of the sales.

So, here, one important point to be borne in mind is we should be very clear about this point
because it is very interesting and very-very useful point here, we should be very clear about
that point. That look that it is given to us is that the working capital will be the 20 percent of
the sales. And here the point of say importance is that these cash flows when we are going to
show here, maybe whatever the cash inflow now because for first year there is a inflow,
outflow is only in the current period.

But first year is the inflow, second year is the inflow, third year is the inflow, forth year is the
inflow, fifth period is the inflow, but all these inflows are going to be estimated at the end of
the year. We assume it that the cash flows are not going to be, we are showing here the cash
flow at the means against the year 1, they are going to be there with us at the end of the year,
not in the beginning of the year.

So, when you are going to estimate the working capital requirement, whatever the capital,
working capital I will be showing here against the year 1, that will be presumed to be useful
for or that will be calculated for the year 2. And working capital shown here will be that is a
figure basically relevant for the year 3, and the working capital shown against the year 3 will

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be relevant for the year 4 and similarly, the working capital figures shown here will be
relevant for the year 5.

Because the any figure of the working capital which is shown at the end of the previous year
will be treated to be the same amount in the beginning of that next year. So, the closing
balance of the previous year in this way, we can say in the language of accounting we can
say, the closing balance of the previous year will be known as the opening balance of the next
year.

So, it means, if we show the working capital requirement as a percentage 20 percent of the
sales. If we show the requirement of the second year, in the second year only it means we are
requiring that at the end of the year. So, we do not require that at the end of the year, we
require at the beginning of the year. So, we have to estimate at the end of the previous year,
so that it is available at the beginning of the next year.

So, the closing balance of the capital will be the opening balance of the working capital
required in the year in question. So, be careful about that, that all these cash flows which we
show here, they are presumed to be means be available with the firm at the end of the year,
not as the beginning of the year.

So, similarly, when we are going to estimate the working capital which is the 20 percent of
the sales, we are showing at the end of the first year it means it is relevant for the second year
because it will be available in the beginning of the second year. So, now, we have seen in the
0 period we have seen that only cash outflows are there and no cash inflows are going to be
there in the 0 period.

Now, we talk about the revenues, third important requirement here is the revenues or maybe
the sales. So, if you look at the information given here to us is the revenues are already given
to us for the 5 years. So, we are given here the revenue that is for the first year, the revenue is
going to be 100, second year 150, third year 200 million, fourth year 150 and then the next
year the last year that is going to be again 100 million rupees.

So, we are going to put all the revenues here. So, what is going to be the revenue in the first
year? The first year revenue is going to be 100 million rupees, this is the first source of

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inflow and in the first year we are going to have inflows. Now, let us complete it for the first
year only, and then we will move to the second year.

So, in this case, point number 4 here, so it means you can understand that whatever the
working capital requirement here we are showing is that working capital requirement is say
available only means we are showing in the 0 period. So, at the end of the 0 period, the
working capital available will be 20 millions. So, that will be used in the first year.

And you can understand here it is automatically 20 percent of the sales of the first year, it is
the 20 percent of the revenue of the first year. So, it means I am showing it not against year 1,
I am showing it against year 0 because it is the end of the year 0 and that will be anything
which is at the end of the year 0 will be certainly available in the beginning of the year 1.

So we will be showing 1 year before, not on the same year because otherwise it will be
available at the end of the year. And we do not need that working capital at the end of the
year but at the beginning of the year. So, this is a one important thing we are going to be
careful about. So, let us put it together all the revenues because we will be able to adjust
everything.

So, the revenue for the year 1 will be how much? 100 million rupees, year 2 will be how
much? 150, year 3 will be how much? 200, year 4 will be how much? 150 and last year it is
going to be again 100 million rupees, revenue. And accordingly we are going to estimate for
the sales. Now, here we have shown here the 20 percent of the revenue of the first year, but
we have shown it at the end of the 0 period or in the current period.

Now, we are going to show what is the revenue in the second year? The sales in the second
year, 150 million rupees and as 20 percent of that will be how much? That is going to be 30
million rupees, so we are going to show it 1 year before means at the end of the first year will
be available in the beginning of the second year. Here how much we require is that is 20
percent.

So, the working capital is going to be how much? 40, in this case the working capital is going
to be again 30 and in this case also the working capital is going to be how much? 20, it is the
20 percent again of the revenue of the year 5. And in the last year, the working capital will

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not be required rather it will be say liquidated means the firm will be liquidated, the project
will be liquidated. So, working capital will be retrieved back it will be available, it will be
realized back.

So, no investment is required means that investment of the 20 million rupees which we are
showing has been made at the end of the year 4 will be available for the year 5 and since the
project is going to be terminated in the year 5. So, it means no further working capital is
required in the year 5, otherwise it will be relevant for the year 6 and project does not have
the life of the year 6. So, this is the total information about the capital equipment, level of net
working capital and the revenues.

Now, we take the next part is now we talk about the cost part. So, cost of raw material, we
write here as the raw material cost, raw material cost. So, what is the raw material costs here?
It is given to us and if you look at the raw material cost, it is already given in the form of the
percentage, it is given to us as 30 percent of the sales.

So, how much it is nothing to be here. So, 30 percent of sales is going to be how much? 30
million, in this case 30 percent is how much it is going to be? 30 percent it is of the so same
amount we are going to take here is a 45 million rupees, here it is going to be 60 million
rupees, here it is going to be 45 million rupees, and here it is going to be 30 million rupees.
So, this is the cost of raw material.

Next head of the cost is what? Labor cost, so, how much is going to the labor cost or the cost
of the labor is going to be how much? It is given to us is that it will be 20 percent of the sales.
So, if you talk about it, 20 percent of sales is how much? Nothing here, 20 percent of sales is
again how much? 20, here it is 30, here it is say 20 percent of sales is going to be how much?
It is again 40. So, it is 20, 30, 40 and is going to be 30 again, and it is going to be again 20.

And after that, we are given here is the, next information is about the overhead allocation,
fixed annual operating and the maintenance cost, which is fixed for all the 5 years. So, you
can call it here as the operating and maintenance cost. How much it is going to be it is going
to be? It is going to be 5 millions fixed, all the 5 years it is not going to change, 5 millions
fixed. So, you can put a 0 here.

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So, it is the 5 million rupees is the operating and the maintenance cost which is given to us, it
is the fixed cost to be taken as you can call it as 5 million rupees. One important thing, now
the next important thing here is the loss of contribution, it is given to us in the information
about this project.

Loss of contribution means there is a going to be cannibalization effect and what is a loss of
contribution? It is clearly written, given in the information in the case that because of the
introduction of this K-cin new product, the sales of the existing products will be negatively
hit and there will be expected loss of the revenue to the tune of 15 million rupees. So, that is
considered as the opportunity cost and that will be new drug will be causing a contribution
loss of the 15 million rupees every year from the sales of the existing products.

So, we have to treat it as a cost similarly as a cost, so that from the total revenue which is
coming or being generated by this product, you have to subtract this that is called as a
contribution and that is how much? 15 million, so this is the loss of contribution 15 million
rupees. This is the 15 million rupees. So, this is treated as same as the cost, you call it as the
negative revenue effect.

And it is going to cost certainly is going to cost as a negative revenue effect because the
revenue of the existing products is going to go down by this amount 15 million rupees. So, it
means it has to be taken or treated like a cost. Now, after this we have to take into account
some other important components like depreciation, bad debt losses, and then we have to
arrive at the profit after tax and then we have to look at some other kind of the components
here, say termination part and then we have to go for the say recovery, we will start recovery.

So, we will add for the other expenses means after this loss of contribution, we have the
depreciation as a non-cash expense and then we have the say bad debt losses are given to us,
because that is also expected that in the last year out of the total working capital that is 20
percent of sales, which is invested in the business as a 20 percent of the revenue, 5 million of
that will not be recoverable. So, we have to factor for that. And similarly, the other factors we
have to take into account, so the net cash flow will be worked out.

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So, in this class I have worked out till the say up to the important components that we have
taken into account the cash outflow which will be occurring in the current period, on account
of the two heads, one head is that is the capital equipment and second is about the net
working capital. Then we estimated the revenue and then we estimated some components of
the cost, like the material cost, labor cost, operating and maintenance cost and the loss of
contribution.

Other components of the cost like your depreciation, similarly the loss of the working capital
because of the bad debts and some other important relevant aspects, I will be taking care of.
So, we will continue with this problem in the next class also and hopefully in the next class
we will be able to complete it and work out the net cash flows. So, till then I stop here and
remaining part of the problem I will solve and I will discuss with you in the next class. Thank
you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 35
Estimation of Project Cash Flows Part 07
Welcome all. So, in the previous class we started working on the cash flow estimation for a
special product being introduced by the company which is called as the India Pharma
Limited, but because of the shortage of the time, we could not complete the entire solution or
entire problem we could not solve. So, I left it half done, but we will resume it from there,
where we have already left it and we have missed the part of the things we have already done
and where we have left it, we will start from there onwards.

So, in the previous class what we did was that we estimated the cash outflows in the current
period that is going to be 120 million rupees, 100 on account of equipment and 20 on account
or working capital. And after that in the number of subsequent years 1 to 5, we have
estimated the revenues, we have estimated the cost part and we have estimated the loss
contribution.

Because introduction of the new product K-cin will cause a loss of contribution to the
existing product or the sales of the existing products and consequently the loss of contribution
coming from the existing products because company as a whole is manufacturing 16 products
before introducing K-cin.

So, we have adjusted for the loss of contribution, because it is the opportunity cost so, it has
to be treated like a cost and we have to means factor it against the revenue being generated by
the new product.

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(Refer Slide Time: 2:01)

Now, we take the next head of the cost here, though it is a non-cash cost, but it is a cost. So,
that is the depreciation. This is going to be the depreciation, the next head of the cost is the
depreciation, how much depreciation is there?

The depreciation written here is that they are going to charge the depreciation on the written
down value method on the fixed equipment and the rate of depreciation is 25 percent.

So, rate of depreciation is 25 percent, it means equipment cost is how much? 100, so in the
first year how much depreciation will be there? At the end of the first year the depreciation
will be 25 percent and that will work out is how much? 25. Next year this will be 18.8
percent, then the next year it will be 14.1, then it will be 10.5 and then it will be 7.9.

Next, last year's depreciation will be 7.9. We will have to charge for this depreciation provide
for this depreciation. Next is the loss and loss is also treated like a cost. If you recall how we
prepare the profit and loss account, so in the profit and loss account we show all the cost and
the losses.

Because profit and loss account is basically a nominal account and rule of the recording the
transactions in the nominal account is debit for all expenses and losses and credit for all
incomes and gains.

So, all expenses and losses, all expenses we are debiting here, it is basically a part of the or a
replica of the profit and loss account, because ultimately whatever the inflows in the form of
the revenues, we are gathering, they have to be adjusted against the cost.

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And finally, we will have to calculate the profit before tax, profit after tax because working
out the net cash flow requires the working out of the profit first and then we will add back
certain non-cash expenses into the profit after tax. So, we will work out the cash, net cash
flow available from the project.

So, in this case we are going to take this non-cash expense depreciation and then we are
going to take the loss and this loss is on account of what? Bad debt loss, loss on account of
the bad debt, so we are going to take this. So, this loss is how much? We are going to take
care of the bad debt loss.

So, this loss we have to be treated like a part of the cost. And if you take this as a bad debt
loss in this case, it is clearly given to us that the total investment made in the working capital
that it 20 percent of the sales at the time of the termination of the project, this total amount
will be realizable back and as a principal also, the working capital is realized back bearing
any kind of the bad debts if are there.

Because one important component of the working capital is the sundry debtors, so sundry
debtors arise and appear in the balance sheet just because of the credit sales and 100 percent
of the credit sales may not be recoverable. So, part of the credit sales which are not
recoverable they are called us bad debts. So, in this case, we are clearly given here that there
will be the bad debt loss, but not in the all the years that too only in the last year.

So, we will have to factor for that and that is how much that is further, this loss is for the 5
million rupees but since it is a loss, it has to be taken into account. So, next thing is now we
have to take into account is the PBT, profit before tax this is called as PBT, profit before tax
because here we have got the revenue.

This revenue is already calculated by us and here all other are your cost figures including loss
and opportunity cost. So, these are the cost figures if you look at this, so you can easily find
out what is a profit before tax? In this case you will find out it is 5 means sum total of the all
cost items you have to do, all expenses you have to do and then that total we have to subtract
from the total revenue we are generating.

So, what is the total cost? 30 plus 20, 50, 55 this is going to be 70 and this is going to be 95.
So, 95 is the total of the cost opportunity cost and the depreciation that is a non-cash expense.
So, against the revenue coming up, the inflow coming up of the 100 million rupees the cost
expected to take place is the 95 million rupees.

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So, it means the resultant profit before tax will be how much? 5 million rupees, so we have
calculated that PBT is the 5 million rupees. In this case, it is going to be more now, profit
before tax is going to be more and this is calculated as 36.2. In the next case, it is going to be
how much? 65.9.

In the next case, it is going to be 44.5. And in the last case is going to be 17.1, it is simply the
subtraction of the total cost including the non-cash cost and the bad debt loss is from the total
revenue and whatever the resultant figure is that figure is called as the profit before tax. So,
we have already calculated now, profit before tax 65.9 was this cost. So, we have calculated
the total cost that is the cost revenue and now the profit before the tax. Now, in this case, we
have to work for the tax figures. How much is the tax? The tax rate was given to us 40
percent and you have to calculate the tax rate is a 40 percent.

How much is the 40 percent of 5 that is going to be 2. So, this is 2, in this case it is going to
be how much? 14.5. And in this case it is going to be 26.4. In this case it is going to be how
much? 17.8. And in this case, it is going to be 6.8. So, this is going to be the tax part.

So, now after taking it into account, the tax part will have to calculate now the PAT that is a
called as a profit after tax the column number 12 is the PAT, profit after tax. So, after this we
will move to the next sheet. So, this is a profit after tax PAT. So, how much is the PAT given
here? For calculating the PAT, we have to now subtract it, from the profit before tax you
have to subtract the tax.

So, the PAT is profit after tax in this case is how much? It is 3. In this case it is going to be
how much? 21.7. In this case it is going to be 65.9 minus 26.4 is going to be how much, 39.5,
in this case it is going to be 26.7, in this case it is going to be 10.3. So, we have calculated the
PAT.

This is the first source of the say cash inflow or the total net cash flow. And if you take this
amount, so it means the profit after tax which we have calculated is 3 then in the second case
21.7, in the third case 39.5 then it is 26.7 and 10.3.

Now, we will have to move towards because whatever is possible in the next 5 years, we
have already calculated. We built up the project in the current year and in the next 5 years we
estimated the total outflow on account of the working capital changes only because fixed cost
is not going to change.

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Then we estimated the whole revenue available, the cost to be adjusted against that revenue
and the profit after tax going to be available over the next 5 years period of time, we have
already calculated and as we know for calculating the net cash flow, we have to first workout
the profit after tax, we have calculated this part.

So, now, after calculating the profit after tax, we are moving towards now the termination of
the project because we are now left with the information which will be more relevant for the
year 5. So, we will be moving towards that. So, let us move to the next sheet here.

(Refer Slide Time: 10:53)

And in this case, when you move to the next sheet again, I am putting here the particulars and
then we will be taking the years. So years are 0, 1, 2, 3, 4 and 5 years, so after calculating the

576
PAT, the next item is the column number 13. And it is the net salvage value of capital
equipments. So, how much is going to be the net salvage value of the capital equipments?

This is going to be available which is clearly given to us is the net salvage value, because it is
not available in this, this and this year only the last year, the year of the termination and the
salvage value was given to us in the case was 20 million rupees will be available as the net
salvage value of the capital equipment. This is the information available.

And column number 14 says that the recovery of working capital, because working capital is
fully realizable. So, recovery of the working capital will be something like how much is the
working capital we have invested till now is the working capital was 20 million rupees which
was at the end of the fourth year and which was irrelevant for the year 5. But out of that 5
have become bad debts, they have already taken care of that 5, loss of the bad debt is here 5
we have taken care off.

So, it means now the recovery of this will be how much? 15 million rupees, not in this, but in
this case it will be coming back to us as the 15 million rupees the recovery of the working
capital. And finally, what is the initial investment? Initial investment now is how much? We
have made here is that is a 100 million rupees because working capital is recovered.

So, it means initial investment was 100 million rupees and against the 100 million rupees,
now, we have to work out here is the operating cash flow. So, if you calculate the operating
cash flow here available from this entire thing.

So, we have to take here as what is the entire case, we have to say draw this information from
the previous calculations, previous slide or the previous sheet and the operating cash flow
comes up here as the 28.

In the next case it is 40.5 and then it is the 53.6, and similarly we will be going forward, so
53.6 is the operating cash flow for the year 3 and for the year 4 is how much is this? This
amount is going to be 37.2. and this amount is lastly 23.2.

So, in this case, this amount we have to correct it little and this will come out as 37.2
operating cash flow, how you have calculated operating cash flow? For your simplicity and
for your better understanding, I would say this is the total of the two columns, column
number 12, column number 8 and column number 9. So, this is a sum total of this.

577
So, what was there in these columns? Column number 12 is a PAT, we have to take this PAT
then we have to take the depreciation because it is a non-cash expense and 9 is the bad debts
because bad debts are also the source of the cash because it is only a book entry we make
here and this amount which is lost as a bad debt because of the non-recovery of the credit
sales that has to be recovered back by debiting the same amount in the profit and loss
account.

So, in this case it is 12 plus 8 plus 9. So, that gives you the total figure of the operating cash
flow and in this case of the operating cash flow, now, we have to look at the changes in the
net working capital. Next thing is the adjustment for delta that is this sign is delta changes in
working capital.

So, we have to look for the changes in the working capital now, here it was how much? 20
million rupees which was invested here and in the next year, this was how much? 10 was the
investment increased because how much was the investment we made in this case?

The working capital has increased from 20 to 30, 30 to 40. But after that it started going
down because being a 20 percent of sales, we have seen that the sales also went down or
started going down. So, we have to accordingly changed.

So, we have increased the working capital means initially it was 20 percent of the sales which
is 20 millions, then by the end of the first year it increased by 10 millions and at the end of
the next year it also further increased by 10 millions. And then it started decreasing and it
started decreasing in the year number 3 by 10, in this year also in the year number 4 by 10
and in this year there was no working capital required because we are not going to take the
business forward to the sixth year.

So, finally, we have to calculate now the terminal cash flow, column number 18 is the
terminal cash flow and terminal cash flow given to us is how much? Terminal cash flows are
only these two figures. We are going to get back 20 of the fixed assets and then 15 of the
working capital.

So terminal cash flow available is 35 because it is relevant for calculating the net cash flow.
So, we have to put it here, this is 35 terminal cash flow is 35 and the last column will come
out here is that is called as the NCF, net cash flow and this net cash flow comes up here as
120 as the outflow negative figure because we in the zero period, in the current period we
invested 120.

578
And then we have, we are left here with the 18, 28 minus whatever the total cash operating
cash flow was there, out of that 10 was invested. So, we are left with that net cash flow, at the
end of the first year we are left with the 18 million rupees, then here we are left with the 30.5
million rupees. And in this case now, I think we have the positive figures. So, it is now the
63.6.

So, now the recovery has started, recovery of the working capital has started because sales
have also declined. This is called as 47.2 this will be in this case and last year will be the sum
total of this and this. So, it means 35 plus 23.2 will be how much? T his will be called as 58.2
millions. So, the total, means cash flows we have worked out here is how much that outflow
is 120 millions in the current period.

Inflows are in the subsequent number of years and this inflow is in the year 1, we have
calculated which is called us net cash flow. You should not be confused. So, how we have
calculated it? Column number 15 plus 16 minus column number 17 plus 18, so it is for your
reference 15 plus 16, 15 plus 16 is how much, initial investment we have taken here and the
operating cash flow.

So, we this is relevant only for the cash outflow column number 15. And 16 is important for
us for all the remaining is years, year 1, 2, 3, 4, 5. So, we have taken here minus 17, 17 is the
changes in the working capital. So, we have taken this into account. And finally, we have to
then calculate the terminal cash flows, which is 35. And finally, the net cash flow we have
calculated here is 120, 18, 30.5, 63.6, 47.2 and 58.2.

So, this way we have calculated the net cash flows and after adjusting all the things, the
opportunity cost of capital and at the same time we have adjusted for the bad debt losses also,
we have adjusted for the non-cash cost which is called as depreciation also. For adjusting all
these costs, we have to take into account all these things and after adjusting for everything,
we have worked out the net cash flow.

So, the difference between this problem and the previous problem was previous problem was
given to us like this problem as it is given here. But the previous problem was already solved
in the PPT, so I thought that one problem we will do here, we will solve here. So, that finally
when we do it here and make all the calculations here and I show that how the cash flow, net
cash flow will be worked out.

579
Then it will be more clear to you, it will be more convenient for you to understand that how
the net cash flow can be estimated or how the estimation of the cash flow takes place. So, till
now what we have discussed is the estimation of the cash flows for the new projects. If we
want to have a standalone project or we want to add up the new product or the new item or if
anything new into the existing business for the growth of the business that we discussed.

So, we estimated the cash flows in two different ways. One was that when the cash outflow is
also constant, cash inflow over the years is also constant, how to calculate the net cash flow?
Then we added some more you can call it as wrinkles into the second problem, and we
moved towards more practical situation rather than the theoretical one.

And in that situation, what we assumed in this second problem, that cash outflow is constant
means that is only in the 0 period and that is only the one-time cash outflow, we do not need
to make time and again investment in the subsequent years also. But in the next 5 years, the
life of the project or that particular product was estimated to be 5 years, after the 5 years it
will be phasing out.

But the important point here was that whatever the revenue we have estimated or we have
tried to find out is that we estimated, that it will not be stable, it will not be constant, it will be
fluctuating, it will be changing. Sometime it will be going up or sometime it will be going
down. And that is more practical situation because practically it happens in the market like
that.

So, if that happens, how to estimate the cash flows and opportunity costs, bad debt losses, all
these problems also we could a factor for and when we did it here, we calculated the net cash
flow here and I think now, you should be clear about that how to estimate the cash flows for
the new products or for expansion of the existing business activity or maybe starting a new
business or evaluating any project and estimating the cash flows for that project when, it is a
standalone facility.

Next question arises now that if it is not the new project, or if it is not the addition of the one
more product into the existing range of products, but if it is a replacement, investment
proposal, replacement of the existing facility with the new facility and that is also a very-very
important decision we have to take sometimes.

Sometimes what happen? We have the plant of the lower capacity, so we have to dismantle
that plant and we have to replace it with the new plant, new machines of the higher capacity.

580
Because there is more better performance required in the market, bigger capacity machines
are required because possibility of selling more in the market has arised and we want to
manufacture more, we want to sell more.

So, if we want to manufacture more and we want to sell more, in that case, what we have to
do here is that, in that kind of the proposals or estimation of the cash flows it will be called as
the cash flow estimation in the replacement projects.

In the replacement project, if you want to replace the existing set of the machines with the
new machines, then how to go for the say estimation of the cash flows, that is going to be
now a typical problem and some important factors have to be borne in mind in that and in this
case, some important things or important factors to be taken care of here are given in this
table, why this table is important?

Because sometime we commit a mistake while workout the cash flows for a replacement
proposal, what kind of the mistakes we commit? We correctly estimate the cash inflows
expected from the new machinery or the new plant coming up as a replacement of the old
one, but we do not factor the negatives and positives of removing the old machine.

Because if we are only considering the cash inflows which is expected or the increased
performance which is expected from the new machine, it means you are only taking care of
the advantages of replacing the old machine with the new machine because revenue will
increase. It may be possible that because of the new technology the cost may come down.

So, the net cash flow may increase, but if there are the positives advantages of replacing the
old machine with the new machine, there are certainly disadvantages also. Because, when
you are going to estimate the cash flow, you should factor for, that had we not replaced the
old machine with the new machine, the old machine was the old plant, old machinery was
also going to give us certain revenue, salvage value then the cash flow.

So, if you have brought a new machine by replacing the old machine, so it means certainly
you are going to improve the performance, but the negative effect of removing that machine
also have to be borne in mind.

(Refer Slide Time: 25:54)

581
So, it is clearly written here, if the advantages of selling the old machine have been
considered, thus the disadvantages should also be considered. You cannot say that the old
machine was totally redundant. So, it should be totally thrown out and because of the bad
effects or maybe the disadvantages, because if that machine is not there in the business. So,
the advantages of that will not be there with us.

So, it means that is a disadvantageous position for us. So, we have to think it in totality that
what are the positives of removing the machine and what are the negatives of removing the
machine or replacing it with the new machine. So, this entire process we have to follow in
that calculation or in that situation. What is the process available here? Initial investment, you
have to calculate, how to calculate the initial investment?

For calculating the initial investment, now, you have to take into consideration initial
investment to acquire the new machine minus after tax cash inflows from the liquidation of
the old machine.

Because total cash outflow is not going, for example, the new machine is going to be
available for the 500 crores, new plant 500 crores and the old machine you are going to sell in
the market for 200 crores. So, what is the net cash outflow? 300 crores, so that is a very
important factor.

So, initial investment will be how much? Total cash outflow on account of the new asset
minus cash inflow available from the liquidation of the old assets. So, this is the first
important point. Next important point here is operating cash inflows, we have to calculate.

582
After the cash outflow, we have to calculate the operating cash inflows and for calculating the
operating cash inflows, what you have to do here is operating cash inflows from the new
asset or the new machinery minus operating cash inflows from the old asset, had it not been
replaced? Had it not been replaced, it is a very important point here, had it not been replaced.

So, what could have been there? It means we are talking about the, this part only advantages,
but not the disadvantages that if this will be there, this will not be there. You cannot have
both. So, if this is going to be there, then if it is not going to be there, then you cannot say
only we are going to have this, if this was not there, this was there. So, we have to factor for
this.

And finally, for calculating the terminal cash flow here, what you have to do here is after tax
cash flows from the termination of the new asset minus after tax cash flows from the
termination of the old asset had it not been replaced?

So, these are the 3 important components to be borne in mind. While going for estimation of
the cash flow for the replacement proposals, you have to bear in mind the three important
things because otherwise also in the cash flow analysis or estimation of the cash flows, we
always bear 3 things in mind.

First of all, we workout the initial investment in the current period or in the 0 period, then
second thing is we workout the operating cash flows by estimating the revenue for the
foreseeable number of years, subtract the cost expected and that gives you the operating cash
flows, cash inflows largely.

And then for calculating the net cash flow, we calculate the terminal cash flows and finally,
we calculate the net cash flow. So, this process we have been following, we will be following
the same process now also, but only point of question here is that disadvantages of replacing
the machine will also be taken into account and we have to follow this methodology for
initial investment you go like this, for operating cash inflows you go like this and for the
terminal cash flows you go like this.

So, how to calculate the cash flows or how to estimate the cash flows for the investment
proposal, which is basically related to the replacement of the existing machine or existing
asset with the new asset, if it is a replacement proposal, a capital investment proposal, but the
replacement proposal not a new investment proposal.

583
So, in that case, how to estimate the cash flows? One more problem we will see, we will
discuss, we will see, I have got the problem also, I have got here in the PPT, the solution also.
So, we will see here that what important points have to be kept in mind while estimating the
cash flows for the replacement proposals that we will do in the next class. Till then, thank
you very much.

584
 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 36
Estimation of Project Cash Flows Part VIII

Welcome all. So, after just initiating the discussion on that cash flow, estimation about the
replacement projects. Now, we will learn practically how we calculate or how we estimate
the cash flows for the replacement proposals. And here is one more problem, the third
problem with regard to the estimation of the cash flows. So, first we will read the problem
carefully, understand it, what is the information given here and then we will see what
important things happened taken into account for calculating or for estimating the cash flows
in case of the replacement project.

(Refer Slide Time: 1:05)

So, for example, this information given here is Ojus enterprises is determining the cash flow
for a project involving the replacement of an old machine by a new machine. So, in this case,
the old machine bought a few years ago has a book value of 400 thousands or the 4 lakhs
rupees. And it can be sold to realize a post tax salvage value of the 500 thousands or the 5
lakh rupees.

It has a remaining life of five years after which its net salvage value is expected to be 160
thousand rupees, 160,000 rupees. It is being depreciated annually at a rate of 25 percent under
the written down value method. The working capital required for the old machine is rupees
400 thousand rupees.

585
It means the book value of the old machine is four lakh rupees and the working capital
required for the old machine is four lakh rupees. The new machine which is going to be now
added as a replacement of the old machine, costs 16 lakh rupees, 1.6 million rupees 1600
thousand rupees, this is going to be the cost of the new machine. It is expected to fetch a net
salvage value of the 800 thousands after 5 years when it will no longer be required means the
machine will be purchased today as a replacement of the old machine will shell out 16 lakh
rupees, 1.6 million rupees will use that machine for a certain number of years.

And after that, it will be sold as a secondhand machine in the market or maybe as a salvage
value for the firm or whatever it is at the 50 percent of the purchase price and that is at 8 lakh
rupees after 5 years, it is given here after 5 years. So, there is a possibility of the use of the
machine for the next 5 years. After 5 years we can dispose of the machine at half of the price
of the purchase value and that is that 8 lakh rupees.

The depreciation rate applicable to it is 25 percent under the same written down value
method, because in India it is compulsory that the depreciation for the income tax purpose
has to be calculated under the WDV method, not under the SLM method. The networking
capital required for the new machine is rupees 5 lakhs. The new machine is expected to bring
a saving of 3 lakhs annually in the manufacturing costs, this is the major point.

Why we are going to replace the old machine with the new machine because it is more
efficient is more effective is going to bring us or causes the savings worth rupees 3 lakhs
annually as compared to the old machine in the manufacturing cost other than depreciation.
The tax rate applicable to the firm is 40 percent. Given the above information we have to
know estimate the cash flows.

But here the cash flow which you will call it as in case of the replacement projects the cash
flow estimation or whatever the cash flows we estimate are called as a incremental cash
flows, are called as the after tax incremental cash flows which are associated with the
replacement project. So, why we are going to change the machine? because some cash flow is
going to be available with the old machine also, but we are going to have the better cash
flows, higher cash flows.

So, it means net result is that we are going to have the incremental cash flows. So, that is it
one more correction here we have to do that in case of the replacement projects we do not
means evaluate it as a standalone, alone proposal or maybe addition to the existing project or

586
adjusting series of the products. It is the same project, same manufacturing process
everything only what we are going to do here is we are replacing the old machine with the
new machine.

So it means when the old machine is there, some cash flow is coming at that time also. But in
case of the new machine, additional incremental cash flow is going to be there. So, that if you
calculate the after tax cash flow that is going to be more as compared to the cash flows
coming from the old machine. So, the net result here is we have to work out the incremental
net cash flow and that is after tax. So, for now calculating or working out or estimating of the
cash flows for the replacement projects, it is done here already.

(Refer Slide Time: 6:25)

Now, one problem, first one was like this, second we did our self and then now that this third
one in case of the replacement projects is given to us here. So, we can just look at it that how
the cash flows have been worked out or in case of the replacement projects, how the cash
flows are worked out. So, again we are taking the same thing here we have taken the years on
this side and then this is the years on this side or you can call it as a particulars also.

This side is a particular this side is a years and now we are taking the same number of years,
the functional years are five 1, 2, 3, 4, 5 and the current period is called as the 0 period. In the
0 period, we will estimate largely the cash outflows and then in the subsequent 5 years, we
will factor for the cash inflows and then the net cash flow will be worked out at the end of
this entire process. So, in the 0 period, will have to first of all calculate the investment outlay,
this is the first requirement.

587
Number one is the investment outlay, which we are going to work out here and this is
something like you call it as the first thing is the cost of the new machine. What is the cost of
the new machine? It is given to us that is 16 lakh rupees, since we are giving rupees in
thousands, so it means it is 1600 thousands or 16 lakh rupees or 1.6 million rupees. Number
two is now the salvage value of the old asset is 500 rupees.

So, this figure is positive it will come and 16 will go right increase in the net working capital
will be 100, because net working capital required in the old machine was 400 million rupees
in this it is required as a 500 million rupees which means, the net working capital is going to
increase. When the net working capital is going to increase because of the new machine. It
means that increase is going to be 100 million rupees.

Ttotal investment if you work out 16 plus 1, 17 minus 5 is going to be the 1200 thousands. 12
lakh rupees actually the net investment is required total net investment required for this
replacement project is 12 lakh rupees or the 1200 thousand rupees not 16 lakh rupees or 17
lakh rupees because some cash inflow will be available from the sale of the old machine or
the liquidation of the old machine.

Now, we go to the point number two, point number two here is that is operating estimation of
the operating inflows and now, because we have to work out the operating cash flow. We
have to now take here into account the operating cash inflow and cash outflow. On account of
revenue, the inflow will be there and on account or different expenses cash outflow will be
there. We will have to work out the net operating cash flow.

So, for calculating the net operating cash flow, it may be outflow also, it is not all the times
inflow, because if the revenue is less than the cost is more so, it will turn out as a negative
cash flow. So, I am calling it as that cash flow not the cash inflow. So, what is the operating
cash inflow from the project? Here now, we will not talk about the revenue, we will talk
about the savings, extra saving.

So, it is clearly given in the proposal if you look at the information given in this PPT. It is
clearly given the new machine is expected to bring a salvage value of 3 lakh rupees annually
and this is more important. This is the source of revenue because it was also giving you
revenue, old also had the cost, new machine is also giving the revenue and new machine also
has the cost. So, what is the net difference? In terms of savings, what is the net difference that
is important for us?

588
And here if you look at this, so, savings is how much? Saving is we are taking here after tax
savings in manufacturing costs after tax saving, it is clearly given here that is the new
machine is expected to bring a savings of 3 lakh rupees annually in the manufacturing costs
other than depreciation. So, what is the after tax savings because total savings on that we
have to pay the tax also. So, there is a tax rate, tax rate here is the 40 percent.

So, what is a total? 3 lakh rupees, we are going to say and minus 40 percent, so, it means
finally we are going to have with us is the 180, 180, 180 here 180 here. So, this is the after
tax savings in the manufacturing costs, first source of revenue and then extra cost we are
going to have the depreciation of the new machine. So, what was the rate of depreciation
given? Rate of depreciation was given here as 25 percent and what is the cost of the machine?
60 lakh rupees, so 25 percent of 60 lakh is 400,000, 300,000 because it is a written down
value method.

225 then it is 168.8 and then it is126.6, this is the on the new machine. But there will be the
depreciation on the old machine also. What is the depositional old machine? If 25 percent is
the rate again and then the method is also the WDV, so it means that old machine was costing
to us was how much? 200 thousands and 25 percent of that is 100. So, similarly that
appreciation for the old machine you have to work out.

Now how much is the incremental depreciation? Everything is incremental in terms of the
revenue also, in terms of the costs because the appreciation we were paying earlier also
depreciation we are charging now also. So, how much is incremented appreciation? So, this
figure is important for us, it is called as incremental depreciation and if you take this
incremental depreciation that is 300, 225, 168.7 million 126.6 millions and 95 million rupees.

(Refer Slide Time: 12:52)

589
Tax savings on the incremental depreciation because when you show this depreciation in the
profit and loss account, how we call it as a tax saving because when you show it in the profit
and loss account we are talking about as that this is your profit and loss account and you write
here as a one cost is To depreciation. And finally, then we calculate To PBT - Profit Before
Tax, then we talk about the To tax and then we talk about the To profit after tax this is the
process.

So, when you are showing this as a cost, it means profit before tax will come down by the
depreciation amount and when the PBT is lesser, so certainly the tax due on the profit before
tax will also be lesser. So, but basically it is a non-cash expense, it is not a cash expense. So,
that is a very important point because it is different from the normal expenses. So, that is why

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we are calling it as tax savings on the incremental depreciation will be this much 100, 20, 90
because tax rate is 40 percent. Tax rate is 40 percent, so 90, 67.5, 50.6 and 38.

And then lastly, net operating cash flow, it is written here in flow, but always you say that net
operating cash flow because it can be negative also, if that revenue is negative, and the cost is
more, or the revenue is lesser the cost is more than the inflow will become negative or the
cash flow will become negative not inflow, cash flow will become negative. So, in this case
what is the situation that, this is a tax savings and finally, net operating cash flow is how
much? 300,000 because, it is the total amount which is available with column number 5 plus
9.

So the after tax saving in the manufacturing cost is 180 and the 9 is going to the tax saving.
So, these two will become as a 180 plus 120 will be 300. So, this will be known as a net
operating cash inflow. So, if you look at this process of calculating or estimating the cash
flows and if you look at the previous process in case of the new projects or expansion
projects, if you look at the cash flow analysis, totally different. In this case, source of revenue
is only the differential savings, in the manufacturing costs.

And then only we are calculating the differential amount in terms of the outflow also, in
terms of the inflow also, in terms of the sales also, in terms of the cost also. What is the
differential amount? So, the process is a little different as compared to the process we
followed for the previous things. Now, tax savings and then finally, the net operating cash
flow we have calculated here.

Third important point here is now to calculate the terminal cash flow, to calculate that
terminal cash flow because ultimately we have to calculate this fourth item which is called as
a NCF, net cash flow. For calculating the net cash flow NCF, you have now to calculate the
terminal cash flows. Terminal cash flows are net terminal value of the new machine is how
much? 8 lakh rupees we have already seen information is given that it is say 50 percent will
be realizable on the sale of the new machine after 5 years because we are going to use
machine for 5 years, maybe the life of the project is 5 years.

And let terminal value of the old machine is it is given to us 160,000 rupees, it was purchased
for 4 lakh rupees and terminal value is going to be 160,000 rupees. And next source of the
terminal value will be recovery of the incremental networking capital. So, how much
networking capital we are going to invest more here? Earlier case was 400 million. Now it is

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500 million. So, it is the extra amount of the 100 million which we are going to recover the
back in full.

So, finally, terminal cash flow is how much? This has been calculated as 11 minus 12, 11
minus 12 means the cash flow from the new machine value from the new machine, but if it
was not there and only old machine was there, then we could have got 160 that case also. So,
incremental terminal value is how much that is 800 minus 160 plus the working capital part
100. So, the total amount here we are getting the terminal cash flows is total terminal cash
inflow is 740.

And finally, here if you look at then we have calculated the NCF net cash flow, which is a
sum total of the column number 4, 10 and 14. So, column number 4 is this much, because we
are only not talking about the inflows, we are talking about the outflows also while
calculating the NCF net cash flow. So, in this case, we are talking about this also. So, 1200 is
the outflow because not 16 but 12 and inflows we have calculated here.

So, we have taken the 4 plus 10 plus 14, 4 is this 10 is this and 14 is this. So in the 14, 14 is
important because we have to take into account the terminal value also in calculating the net
cash flow. So, it means here the in the first year the main source of that net cash flow is the
operating cash flow. Second year also operating cash flow, third year also operating cash
flow, fourth year also operating cash flow and fifth year is sum total of the operating cash
flow and the terminal value.

Operating cash flow and the terminal value is going to be the net cash flow in the year 5,
which is 958. Out of this 740 we are going to get as the terminal cash flows and the operating
is how much? 218, so this plus this figure, this comes out as 218 plus 740 this becomes 958.
So, this is how the cash flows for the replacement projects are worked out and this process is
entirely different from the process which we followed in the earlier cases.

In the first case, we saw that the proposal is the standalone proposal, or it is a new investment
proposal, everything is constant, your cash outflow is constant, cash inflows over the
foreseeable period are constant. And then we calculated the net cash flow we estimated the
net cash flow. In the second problem, we saw that it is a addition of the one more product into
the existing 16 products.

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And in that case, when you are adding, so, there are some problems of like bad debt losses,
the problems of opportunity cost, and we learned there and then the important consideration
there was that we assumed that cash inflows are not going to have a straight line. They are
going to have a zigzag line of kind of the structure. We have the one amount in the first year
then it is going up, remaining stable or again going up then coming down, coming down.

So it means this kind of the cash flows are going to be there, cash inflows are going to be
there, because of the changing value of the sales and the revenue. So, we adjusted those
problems there in the second. Third one was a totally different, which was with regard to the
estimation of the cash flows for the replacement projects. So, in the replacement of projects,
always bear in your mind, we have to calculate the incremental figures, differential figures
and in that case, we are going to take both advantages and disadvantages of replacing the old
machine with the new machine replacing the old asset with the new assets, if you are taking
about the advantages increase in the savings in the manufacturing costs or maybe changing
the working capital requirement or change in the sales value. All fine, these positives are
there, but if this machine is not replaced, and when you remove this machine, some negatives
also we have to keep in mind.

So, that is a very important question. So, both advantages and disadvantages of replacement
of the old machine with the new machine have to be kept in mind. And then finally, we have
to calculate the cash flows, which is basically based upon the incremental analysis or the
differential calculations. So, that major differences there in case of the traditional projects or
the difference between the standalone projects cash flow estimation or addition into the
existing range of the products and in case of the replacement of the old asset with the new
asset. So, this is the entire process available here.

So, I will do one or two more problems also in the next classes. But in the meantime, one
more concept is here to be to be known here, which is very important, and that concept is of
the inflation and before that or more concept here is the is about the biases in cash flow
estimations. So let us know about these two important concepts, biases and then the impact
upon the impact of the inflation on the cash flow estimation.

After talking about these important (())(22:14) of the cash flow estimation, I will do one or
two more problems here, so that you are thorough with the entire process of estimation of the
cash flows for the capital investment projects. Now, we talk about here the biases in the cash

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flow estimation, whatever the cash flow estimation process, we saw here, we learned here in
the real life, we commit some mistakes.

And when you commit the mistakes in estimation of the cash flows, because mind it project
has not come into the picture at the time of estimation of the cash flows, it has not come into
picture. It is not really there on the surface, it is only estimation, is only the DPFR,
preparation of that DPFR and whatever the value of sales and demand we have analyzed or
found out in the DPFR after the market and demand analysis, and the technical analysis on
the basis of that we are only estimating.

And when we are only estimating for something which has to be done in future, in that case,
mistakes are bound to happen, biases are bound to exist there. So, what are what kind of the
biases could be there, what kind of the mistakes could be there, these are divided broadly into
two parts, overstatement of the cash flows, understatement of the cash flows.

Sometime we become very optimistic, very positive and we say that cash flows are going to
happen as per our expectations. Sometimes we become very pessimistic and we commit some
mistakes that the estimated or expected cash flows give us the lesser than the real values or
the say the optimistic or you can call it as the optimum figures, what could be the reasons?

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(Refer Slide Time: 24:11)

First thing is overstatement, why? Intentional overstatement sometime because we want to

get project approved from every source. Especially in case of the startups, in case of the new
projects or when the firm is coming up for the first time into existence. So, what we do to
impress upon the venture capitalists, private equity providers, angel investors or maybe some
time for borrowing the fund from the financial institutions, we exaggerate the cash flows. So,
intentionally we do it because by hook or by crook, we want to get it approved.

Lack of experience. Who is the person who is estimating the cash flows? Who is a person
who has gone for the market and demand analysis and technical analysis? What is their
experience in the field? If they are not experienced people, so what is going to do? What is
going to happen? That because of the lack of experience we are sometime going to put
ourself into the problem of the overstatement. And it is always bad. So, lack of experience
can be the second reason.

Myopic euphoria – Myopic euphoria is basically a term of psychology, which you can call it
as in other way around is the polarization effect. Because there is a team of the people, when
the people who estimate the cash flows, they are a team of the people, it is not only one
person. So, if the one person the team says that no, the sales in the next 5 years will be this
much and our cash flow will be this much.

So sometime other members of the team also subscribe to that statement, that idea and this
means a team gets a polarized, they start moving in the same direction, they start thinking in

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the same direction. So it is not the opinion of the whole team, originally, originally, this
opinion of the one member of the team, but later on, everybody agreed to that somehow. And
they means agree to what access say out of the 5 or 6 members team and everybody said that
yes, the cash flows will be this much or we agree with that figure, which is coming out or all
the figures coming out for a period of next 5 years.

So, this is called as the myopic effect or the polarization effect. And last one is a capital
rationing, because, everywhere if you for example, if it is the say addition of the new project
by the existing firm, that it may be possible that the capital for the new project in the new
project has to come from the existing firm. So, sometime there must be a team of the people
who want by anyhow get this project approved by the top management of the firm, because
capital is limited with the firm also because finance is always scarce resource.

So, what they do is they overstate the cash flows. They impress upon the top management of
the firm that if we take up this project, then certainly we are going to have the better output or
the better cash flows. In many cases when you even have to go to the venture capitalists,
private equity providers or the venture capitalists, even to the financial institutions, we know
that venture capitalists also has the limited resources and they always select the best projects,
which are going to give the higher cash flows or cash inflows.

So, they always as a rate it to influence upon the venture capitalists that our project is very
good and from the limited stock of your capital, ration capital, you give us the desired amount
of the capital and you fund this proposal. So, these are 4 important component or maybe you
call it as the reasons where we can overstate the cash flows and they are basically because of
the biases towards the project or maybe because of the estimation in the error in the
estimation of the cash flows.

Similarly, if there is an overstatement, there is a possibility of the understatement also. And in

case of the understatement, why the understated? Number one, salvage values are
underestimated. Now in the previous case we have seen that the salvage value of the machine
which is purchased for 16 lakh rupees and used for 5 years will be sold for half of the price 8
lakh rupees.

Or the first machine which was purchased for the 4 lakh rupees salvage value will be 160
lakh rupees, it may be possible that the machine may be sold for the higher price. Because
when you are charging the depreciation on any fixed asset, you are simply talking about the

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technical value of that asset. So, depreciable value is different value actual reduction in the
value of any asset is a different value.

So, sometime the salvage value which we have estimated can be much less as compared to
actually that asset can fetch from the market at the time of its placement or the termination of
the project. So, one reason could be the understatement of the cash flows. Then second is
intangible benefits are ignored. Now, for example, when you are coming up with the project,
there could be the intangible benefits also, for example, there is the increase in the goodwill.

If you do a good kind of business or maybe the appreciable kind of the business, so sometime
then we are supplying a good quality product in the market at a very reasonable price or at a
very competitive price. So, it creates a goodwill in the market and when it creates a goodwill
in the market, so, more than the expected number of the people start buying the product and
that we have not estimated. So, it means your sales increase.

So, intangible benefits what happens that though it is a tangible benefit but coming out
because of the intangible effect of the good bill. So, sometime be forget to estimated and their
causes and statement. Last point is value of future options is ignored, value of future options
is ignored. For example, now I give you the example here how this factor causes
understatement. What is the written here? The value of the future options is ignored.

So what is that future option? For example, some company or some group of investors, they
propose to construct a hotel, they want to establish a new hotel, construct a hotel. And they
have two plans, that initially we will construct the hotel which is for the residential purpose.
But later on will add a very good quality restaurant also to the hotel. But currently when we
are estimating the revenue and that addition of the restaurant is immediately after one year or
two years now, we are not waiting going to wait for very long period of time.

Currently, it may be possible that the people who are going to construct the hotel they are not
very experienced in the restaurant business, so they want to gain some experience. And then
they want to see also that let us see how many people come and stay in our hotel. What is the
occupancy rate over the number of 1 or 2 years? And then we can see that if we add up the
restaurant also in this hotel, can we increase the occupancy rate or can we increase the
revenue of it?

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So, tomorrow what happens that we had estimated the cash flows of the hotel as a standalone
facility but later on after one or two years, when we added the restaurant also in the hotel, so
it means people who were earlier not staying in the hotel because there is no food facility
available in this hotel. But later when you added the restaurant also, so what may happen,
people who are not staying in the hotel, they may also have to stay in the same hotel.

So the occupancy rate, which was estimated to be 70 percent, at the time of the estimation of
the cash flows that will go up to 90 percent. So what will be there? We have ignored the
value of the future options. What was the value of the feature option? The feature option is
adding the restaurant in the hotel. So, when people get the same means the food facility also
in that in the same hotel, so, they prefer to stay in a hotel where the restaurant is also there,
the room service is also there.

And in that case, it doesn't give you the additional revenue because of the additional service
you are giving that is of the food and restaurant, but the occupancy rate of the hotel also
increases because that limitation which was causing the lesser number of people occupying
the rooms in the hotel that has been removed. And now, more occupancy, more number of
the people, more footfalls are there and more people are coming and staying in the hotel.

So, all these options we have to bear in mind. So because of these, some factors listed out
here can cause overstatement of the cash flows or understatement of the cash flows. There
could be other reasons also which are not listed out here. So, we have to be very careful,
more rational, more not optimistic but optimum in estimating the cash flows. So, that
whatever we are going to estimate that is more realistic that is more acceptable value adding
and more reliable.

So, this is all till now, what we could discuss about the estimation of the cash flows. First we
learned about conceptually how to estimate the cash flows, then we did 2-3 problems in the
different situations that how to estimate the cash flows if this thing is there or that thing is
there or the replacement proposal, replacement project is there. And then we are now means
we are through with these biases, which could cause the errors in the cash flow estimation
maybe in terms of the overstatement or in terms of the understatement.

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(Refer Slide Time: 33:52)

So, one more concept is there that is the effect of the inflation on the cash flow estimation
that is how to adjust for the inflation while estimating the cash flows. This particular
component and some more problems, one or two more problems on the estimation of the cash
flows. I will discuss with you in the next couple of classes. After that, we will close the
discussion on the estimation of the cash flows and move to the next topic. Till then thank you
very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture No: 37
Estimation of Project Cash Flows - Part IX

Welcome all, so continuing the process further in the Estimation of the cash flows for the
new investment proposals, we will discuss in this class the last concept which is with regard
to the inflation that is the adjustment for inflation in the cash flows that is an important
component, important part of the estimation of the cash flows because, inflation is a very
very necessary feature of any developing economy like India.

And when we estimate the cash flows, naturally because we are means getting affected, this
economy is getting affected by the inflation and the prices are going to change over a period
of time they are not going to remain stable, so the effect of the inflation must be reflected in
the estimation of the cash flows also.

So, how to deal with that particular part and how to adjust for the inflation, how to reflect the
impact of the inflation on the cash flows and how to take care of that we will discuss in this
class and then in the next one or two classes I will discuss one or two more problems with
regard to the estimation of the cash flows and then we will close the discussion on this
particular topic and move to the next part that is the risk management in the capital budgeting
proposals that is the next topic.

So now, in this class we will learn very clearly that in estimation of the cash flows how to
adjust for the inflation, because inflation is a very very important necessary feature of any
developing economy.

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(Refer Slide Time: 02:02)

It is written here that inflation is a persistent fact of life in India and many other countries, so
it must be properly reflected in the capital budgeting process. So, because when we are
estimating the cash flows we are not going to give shape to the business or to the project now,
that will be in some future period of time.

(Refer Slide Time: 02:26)

When you go for the cash outflow that is in the current period so, for example we required to
invest 10 lac rupees in the project or the 1 million rupees’ investment is required. That we are
going to make in the current period, so inflation is not going to impact that. But, when you
going to say that our than expected life of the project is say going to be next 5 years or 6

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years, so in that case for example 1 2 3 4 5 6 7 years, so in this case we are going to, now the
estimate the inflow so this is a 0 period when we are going to invest 10 lac rupees.

This is going to be the cash outflow and in the subsequent years from the year of one onwards
at the end of every year we are expecting some cash flows, so when we are expecting the
cash flows it means, we are expecting this at the end of the first year. How much cash inflow
will be there? So when you say that cash inflow, so price level of the different input as well
as outputs is different today and after one year it will be different, certainly it will be different
because, the price does not remain the same because of the influence of the inflation.

So, we may estimate that for example if inflation is 0, there is no impact of the inflation, then
the cash inflow at the end of the first year will be 100,000, but because we are estimating that
the price level will be the one which is presently existing, the existing price, for example, the
product we are going to manufacture, per unit we are going to sale that in the market at the
rate of rupees, 100. But, this 100 is the current price and, for example, we are going to
manufacture 100 units per year, so it means total cash inflow will be 10,000 rupees but, this is
going to be 10000 rupees if the price remains 100 rupees per unit.

But if the price becomes 110 rupees or price becomes 120 rupees or price becomes 150
rupees, so it means though the number of units are going to remain same, which we are
manufacturing and selling in the market. But since, the price is changing from the 100 to 110
and 120 and 150, so it means this value of the 10,000 will also change accordingly, so what
will happen? When we are estimating the cash flows these cash flows must be adjusted for
the inflation that we are saying that by the end of the first year the per unit price will be that
is expected per unit price is 100 rupees or current price is 100 rupees so, maximum you can
expect to change of 110 rupees.

So, this revenue for example we are expecting this revenue of 100,000 rupees or may be
10,000 rupees for 100 units at the rate of rupees 100. 10,000 rupees, so it will not be same at
the end of the year because, price will change from 100 to 110. So, in this case what we have
to do is, you have to adjust for this and the 100 units must be multiplied by 110 and when you
multiply it by 110, so the amount is going to be different their amount is going to be 10,000,
but the amount is going to be 11,000 so, this inflow is going to change.

Number of units is remaining the same to 100 but the price is changing. So, requirement here
is, that whatever the cash flows they are estimating here we have to adjust it for the inflation,
because we are going to talk about the next 7 years, we are not going to talk about the next 1

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year or 6 months or 3 months. We are going to talk and estimate the cash flows for the next 7
years’ period of time.

Where your price of the input will also be changing, price of material will be changing,
labour will be changing, overheads will be changing, and when the price of input is changing,
when the input cost is going to go up, so certainly the price of the output is also going to
increase. And since, inflation is going to play the role, for example, inflation today is 5
percent, tomorrow it becomes a 7 percent, it becomes 7.5 percent. So, what is happening?
Accordingly, all the prices are going to change, so whatever the inflow we are going to
predict here or estimate here.

There are two ways for that one for that is, that either you show these figures, these cash
flows as a real cash flows or second could be that is the inflation adjusted cash flows. If you
talk about the real cash flows, it means you are assuming that the price of our finished goods
which will be selling in the market will be as same as the price is today. It will not be
influenced by the inflation and that is not acceptable, that is not a correct process, because
certainly the price will change, price will increase.

You can be sure about the production that what capacity of the plant we are going to have,
what capacity of machinery we are going to have, what kind of the technology we are going
to have, what kind of the raw material is available in the market, we are sure about that. But
we cannot be sure about the selling price in the market, because when the input price will
change certainly the output price has to be change, keeping our profit intact.

If you do not change the output price so what will happen? Either the firm will start incurring
a loss or we have to compromise with our own margin, our own profit, and if we are not
earning any profit and margin then what kind of the business we are doing. So, it means we
have to deal with this inflation factor. So, when we are looking forward into future and not
for one or two years, we are looking forward into future for the next 7 years, so inflation rate
will be different here, it will be different here, it will be different here, it will be different
here, and it will be different here in all the years. It may go up or it may come down.

But since, we are the developing economy, we are a growing economy, so we expect that the
rate of inflation is always going up, so first we have to find out the real cash flows and then
we have to multiply them with the inflation factor and then the real cash flows we will be
able workout. So, it means in nutshell we can say that when you are going to predict the cash
flows, estimate the cash flows always account for the inflation factor and adjust those.

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Even the cash outflows also. sometimes it may be possible that cash outflows are not required
in 0 period, they are required here also, they are required here also, they are required here
also, so when it is required here, fine it is at the current price, but when it is required here
also, when it is required here also, when it is required here, then it means the price of input
will change.

So, we are expecting that we will be investmenting here, 10 lac rupees and we will be
investmenting as per today’s price is 1 lac rupees again, 2 lac rupees again, or 2.5 lac rupees
again, that is as per the today’s prices. At the end of the second year what will be the price of
input, so it means outflow will be changing certainly, in the fifth year what will be the price
of input? So you are estimating the inflow as per the todays real price that will not be the
same.

So, both outflows and inflows have to be adjusted for the inflation and we have to then
calculate the net present value depending upon that at what rate your inflows are growing and
at the same time second important concept is the discount rate. Because if the discount rates
are remaining the same what is the discount, what is the cost of capital today. The cost of
capital today may be 12 percent but, because cost of capital is otherwise related to the rate of
return.

Cost of capital is not only simply the cost of borrowings from the market, that is more than
that and that is basically the as per the required rate of return. So, when you are talking about
the cost of capital, we are taking into consideration the weighted average cost of capital
WACC which includes a cost of equity also, which includes a cost of debt also, so it is not
simply the cost of equity and cost of debt plus some premium for the risk we are taking.

So it has to be more than the standard cost of the borrowings. It means it is not the rate of
interest that which we are going to borrow the funds, we are going to add up the equity cost
also. And equity cost includes the premium for taking the risk because, the promoters are into
the business they are not into any activity which is without any kind of risk, so once we are
taking the risk we are expecting the compensation for that so, it means weighted average cost
of capital when you are going to use as a discount rate that is also going to increase over a
period of time because, value of rupees going to decrease, value of money is going to
decrease.

So, rate of return expected or cost of capital which is 12 percent currently, after one year
cannot be same after two years or three years or five years or seven years down the line. That

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has to change, so certainly when your numerator is changing, when your cash flow is getting
adjusted for the inflation certainly your discount factor also has to be adjusted for the
inflation then the real or correct NPV figure can be worked out.

So, it is a complex decision because, dealing with the inflation is not easy process it is not
easy job, it is a complex decision, it is a complex process. But, somehow we have to find out
the solution to the nearest possible extend so that inflation does not create the problem. So,
here what we are going to do, we have the two ways of making adjustment for the inflation
what are these two ways?

(Refer Slide Time: 12:24)

First is express all cash flows as real cash flows and discount them with the cost of capital
that is adjusted to a real rate by by abstracting away the inflation premium. A real cash flow
we assume that no inflation is going to be there, what is the current price level that will be
same after one year, after five years, after seven years. And at the same time the discount rate
will also not change, that is what is the cost of capital today that will be same after 5, 7 or
whatever the number of years are.

So, it means when the numerator and denominator are not adjusted for inflation then, there is
no issue then whatever the NPV you are calculating that is going to help us to arrive at the
right decision. Second option available is, second method available here is, second, express
all cash flows in the nominal terms and discount them at the nominal cost of capital. And
when we use the nominal here, nominal means it is the inflation adjusted cash inflow.

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It is the inflation adjusted cash flow, so it means in the nominal term you can say that our
inflation will be this. Selling price is 100, and inflation will be you call it as the 5 percent, so
what will be there, the next year the selling price will become 105 and after that whatever the
level of inflation is going to be there, so accordingly your price will be changing.

So, as a selling price is changing per unit, number of units remaining the same your total
revenue expected from the project will also be changing towards the higher side towards the
upper side so we have to adjust for the inflation. And similarly discount rate will also be
changing because, of cost of capital will be changing required rate of return will be changing
so, both have to be done, and when you talk about in the real life so, it means second way is
more relevant because, inflation is an unavoidable phenomena of any developing economy or
any growing economy.

So, when the inflation is going to impact the cash flows, inflation is going to impact the cost
of capital, inflation is going to impact the discount rates so, why not to take care of that? Why
not to adjust the inflows for the inflation and the discount rates in the same way for the
inflation? That will give us the better results. But the million-dollar question here is, it is a
very tedious job because, predicting the inflation over the next 5 to 10 years period of time.
And then multiplying the real cash flows with the inflation factor will sometime be a
cumbersome job, but we have do it in anyway.

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(Refer Slide Time: 15:10)

So inflation is a persistent fact of the life in India and many other countries so it must be
properly reflected in the capital budgeting it is a point of question here then only the real cash
flows will be possible to be worked out. Bias caused by inflation or read this statement very
carefully, if there is no inflation, and then the r, real rate and the nominal rate, the real rate
and the nominal rate would be same.

If there is no inflation, then what is the difference in the two because, what is the selling price
today that will be same but 10 years down the line, so when there is no change in the selling
price because, there is no inflation, then there is no issue problem is solved, life is very
simple. But, that does not happen. In addition, the expected real net cash flow RCF for a
given period t year t, and the expected nominal net cash flow NCF for the given period t
which is affected or means say multiplied by the inflation factor would also be the same.

Then real and the nominal cash flows will be same which means both the things are going to
be same, your discount rate is going to be same because, cost of capital is going to remain
stable your cash flows are going to be same, there is no difference in the real cash flow and
the nominal cash flow, so inflation is assumed to be in this case as 0, and it is not going to
affect, there is no inflation at all.

And there is not going to be any difference between the real cash flow and the nominal cash
flow, bear in mind that the real rates and the cash flows do not reflect inflation when you are
assuming the price will be same, what is today that will be same after 3 years, 5 years, or 7
years then that will be the real cash flow whereas nominal rates and cash flows reflect

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inflation, bear in mind that real rates and cash flows do not reflect inflation, whereas nominal
rates and cash flows reflect inflation.

In particular, all nominal market interest rates include inflation premium. So, what will be the
problem now? Estimation of the cash flow is in our hands but, discount factor is not in our
hands because, cost of capital will change in the market. Interest rates will also change, cost
of equity will also change, so when the discount rate is inflation adjusted then why not the
cash inflow, the numerator? But we write that, that is the cash flow in the year t divided by 1
plus r in the year t.

So, we give the power so it means when both numerator and denominator are inflation
adjusted because, denominator is largely inflation adjusted, because whatever the cost of
capital we use, the discount rate we use, that is the market based and that is already discount,
inflation adjusted.

So, when you cannot change the denominator, we should make the numerator also same, as
the denominator is and then calculating the NPV in that capital budgeting process will give us
the better results. Better way of comparing the present value of the cash outflows with the
present value of the cash inflows and the NPV worked out of the project will be more correct
or nearer to the truth.

(Refer Slide Time: 18:45)

Now, this entire process will explain us the whole thing very clearly, all these equations will
help us the entire thing very clearly, first thing is let us, assume that the expected rate of

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inflation is positive, and all of the projects cash flows (including depreciation-related) are
expected to rise at the rate i that is the inflation rate.

Also assume that the same rate of inflation is included in the market cost of capital, it is
anyway included in the market cost of capital as inflation premium. Because, cost of capital
keep on changing. Cost of capital keep on rising in the market, so as a inflation premium,
under these assumptions, what these assumptions are, your inflow is also inflation adjusted
and your discount rate is also inflation adjusted. So, what will happen?

Here we are creating now this situation NCF, nominal cash flow for the period t, any year is
equal to real cash flow multiplied by 1 plus i for the year t so, it means 1 plus i is what, i is
basically the inflation rate. For example, inflation in the market is 3 percent from 0 to 3
percent so it means certainly your price will grow by 3 percent. Price of the input will also
grow, price of the output is also expected to grow by 3 percent and certainly, when your 100
units are going to be sold for 103 rupees per unit.

Next year it is going to become 105 rupees per unit certainly it is going to impact your net
nominal cash flows. So, it means nominal cash flows can be worked out that first you
calculate the cash flow without giving any effect of inflation to that and that will be known as
the real cash flow. And then you multiply the real cash flow by the expected inflation factor
that is only thing we are doing here, RCF real cash flow for the period t multiplied by 1 plus i
power t.

And this is for the upper the cash flow that is equation 12.2, and the lower part is for the
discount rate, so discount rate we are taking here as 1 plus nominal discount rate, nominal
discount rate means which is the inflation adjusted discount rate, which is not a real discount
rate.

So, how it will be calculated? It will be calculated on the basis of this that is 1 plus r, that is 1
plus real rate of return multiplied by 1 plus i that is the inflation, so it means when the real
cost of capital or rate of return will be multiplied by the inflation growth or the inflation
factor which is i here in this case also. So, it means you will be able to find out this particular
thing which is called as nominal rate and cost of capital will become nominal because, the
real rate is multiplied or adjusted for the inflation.

What is next thing written here? The NPV considering the effect of inflation would be
calculated as follows. How? NPV with inflation when the cash flows are inflation adjusted

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and discount rate is also inflation adjusted, so NPV with inflation is, nominal cash flow,
which is real multiplied by the inflation factor for the year t divided by the 1 plus r that is a
nominal, r is nominal now, because it is also adjusted for the inflation that will be equal to
RCF, real cash flow multiplied by the inflation factor and the discount rate also 1 plus r
multiplied by the inflation factor.

So, in this case what is common, this is common, if you subtract it, so you are left with this
part, you are left with this part and we are left with finally this part. So, NPV will be
calculated now, that is the real cash flow divided by the 1 plus r that is the real discount rate.
So, what I mean to say here is that, if the inflation factor is not taken into account then what
will be there will be, say discounting those cash flows which are the real cash flows with the
real discount rate which is not influenced by the inflation factor at all.

So, in that case it is then immaterial whether you calculate the net present value with the
nominal cash flow and the nominal discount rate or real cash flow or real discount rate,
because both the things are going to same. Your numerator is same denominator is same in
this case whether this is the inflation adjusted cash flow and discount rate and this is the real
so if we cancel out, 1 plus i power t terms which appear both, in the numerator and
denominator we are left with this part, and basically it is called as the real cash flow to be
discounted with the real discount rate or cost of capital.

So, in that case, if you are following this or if you are following this it does not make any
difference, while calculating the NPV of the project, because here both are inflation adjusted,
numerator and denominator in this case and here both are not adjusted, when the problem
comes up that when the real cash flows are going to be discounted by the nominal discount
rate then the NPV of the project will be downgraded. Then the NPV of the project will be
downgraded then comes a problem.

When you have not adjusted that numerator cash flows are real but discount rate you are
picking up from the market being it as a cost of capital and that is inflation adjusted so, it
means there will come the problem that you are deliberately keeping your numerator smaller
as compared to the denominator and then whatever the NPV we are calculating, even in that,
case a project which is going to be a profitable proposition, which is going to be a beneficial
proposition, may turn out to be a negative proposition because we may find up, find out or
we may end up with the outcome that the project is giving us a negative NPV because, NPV
has been wrongly calculated.

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So, it means we have to abandon the project. So, we have to very careful while discounting
the cash flows and we have to be very clear in mind that if the discount rate is market or the
inflation adjusted your numerator cash flow also has to be nominal which is inflation adjusted
and if it is, the real discount rate then, yes, the numerator can also be real, because no
influence of the inflation is there on the numerator as well as on the denominator.

(Refer Slide Time: 25:37)

Thus, if nominal cash flows are expected to rise at the same inflation rate that is reflected in
the nominal discount rate then the inflation adjusted NPV is same regardless of whether
nominal cash flows are discounted at the nominal rate or the real cash flows are discounted at
the real rate.

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This is what I am saying here, if you are multiplying both, if you are adjusting both
numerator and denominator in this case so it is the nominal cash flow discounted by the
nominal discount rate and this is the real cash flow discounted by the real discount rate so, it
means no issues, no problems are going to be there. However, some analysts commit the
mistake of discounting constant real cash flows means the cash flows which are not inflation
adjusted or adjusted for inflation.

(Refer Slide Time: 26:47)

Normally we have seen that when we are going to find out the cash flows what we do here is,
we have the 0, 1, 2, 3, 4, 5, so we show here that we are going to have a 10 lac rupees is
going to be the investment we are going to make here, and then the inflow will be something
like a say 3 lac rupees every year, here also 3, here also 3, here is also 3, here is also 3.

We are going to create a problem here, because then there is a inflation in the market and
when we will use the cost of capital as a discount rate for discounting these, so what we will
do, we will write 3 lac here, and discount it by 1 plus r and this r for the first year when you
pick up the r, then r will be picked up from the market and this r will be already adjusted for
the inflation, it will be little higher because the inflation adjusted discount rate will be
certainly higher than the real discount rate.

So, what will be there? We are treating it as a constant same, same here all, but this is
considered as influenced by or adjusted for inflation and the problem will come, so this is a
wrong approach. Do not follow this approach we will have to always take care of both
numerator as well as the denominator. So, it is clearly written here however, some analyst
commits the mistake of discounting constant real cash flows, cash flows which are not

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adjusted for inflation, with the market determinant cost of capital figure, which typically
includes an inflation premium.

Or in other way around which is adjusted for the inflation. Put differently the numerator does
not reflect the inflation, whereas the denominator does reflect the inflation as a result the
NPV of the project is biased downwards. We are wrongly committing a mistake and we are
calculating a wrong NPV because we have undermined the importance of the project because,
you are discounting the lower stream of the cash flows with the higher discount rates, so NPV
has to be negative or certainly lesser than what is normally expected.

(Refer Slide Time: 29:18)

So, finally I would say that 3 important points are relevant when you talk about the inflation
adjustment in the capital budgeting proposals. First point is, inflation is a critical factor in
capital budgeting decisions and it must be properly dealt with. So, whatever I discussed just
now, it should be seriously taken care of, and both your cash inflow as well as cash outflow is
not a problem if it is only in the 0 period, if it in the subsequent years also, then yes, then you
have to adjust the cash outflow also.

Suppose, the numerator and denominator has to be adjusted but the problem comes here, the
bone of contention still remains is at what rate you are expecting the inflation to grow? So,
that is a tedious job, but still to the extent we could predict the inflation we should do that.
Point number 2, the most effective way of handling inflation is to reflect it explicitly in cash
flows and discount rate, you multiply both the numerator also and denominator also, you
multiply by the inflation factor.

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And third point is since, future inflation rates cannot be estimated precisely inflation adds
uncertainty and complexity to capital budgeting decisions. So, capital budgeting decision
overall itself is a complex decision because on here in the academics, how simple it looks like
it is not that simple in that way.

I told you many times as I refer to the example, for example that anchors proved projects,
they also had done all these calculations, DPFR was also prepared, the market demand survey
was also done, technical analysis was very sound, and everything was got weighted and
approved from the practical or the practitioners or consultants in the market. And after that
when they made the investment of 350 crores cash outflow of the 350 crores that ended up
with the the failure of the project.

So despite doing all, everything, estimating the right cash flows adjusting it for inflation and
identifying the right, discount factor, depending upon the cost of capital in the market at that
time, all precautions are taken, all cares are taken but, sometimes the complexity still
remains, uncertainty still remains in the overall decision of capital budgeting and in inflation
adjustment or finding out the inflation adjusted cash flows and discount rate adds further to
the complexity and uncertainty of the capital budgeting decisions.

But still we have to be very careful and while estimating the inflows even subsequent
outflows and discount rates we should either go for nominal or real but, both at the numerator
level and at the denominator level. In both the cases then the problem is not going to be there,
largely we are going to solve the issue before any problem comes up, so this is all, I stop the
say conceptual discussion on the estimation of the cash flows. We have discussed almost
everything concerning the estimation of the cash flows, all important issues I have dealt with
and I have discussed here with regard to this particular topic.

So, conceptually the discussion is over, theoretically the discussion is over, and in the
previous class is also we have done one or two problems, one was with the, the simple
problem, one or two further simple problems and the one was the replacement problem, so in
the next one or two classes I will do one or two more problems, one may be the simple and
another may be the replacement of problem again and after that we will close the discussion
on this particular topic.

And for the detailed reference, you can again refer to the book that is Financial Management
by Prasanna Chandra and detailed discussion very nicely given in that book. I also have taken
most of the things from that book, so you can refer to that book for your further readings and

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further understanding and clarity on the different topics including the estimation of the cash
flows in the capital budgeting, project evaluations and decisions. Till then thank you very
much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture No: 38
Estimation of Project Cash Flows - Part X

Welcome all, so as I told you in the previous class that after completing the conceptual
discussion on the estimation of the cash flows in the capital budgeting decisions. Now, we
will do one or two more problems, where we will learn about the estimation of the cash flows
and after that we will close the discussion on this particular topic. So, in this class I will
discuss one problem, similar to what we did earlier also and we will learn that in this case
also how we can estimate the cash flows for the capital budgeting decisions.

So, again first of all I will read the problem for you and you can understand first of all, this is
my suggestions to you also, that before solving any problem whether in the examination or
otherwise in the class room, first you read the problem carefully, try to understand what kind
of the inputs are given, what kind of the information is given and then try to move forward to
solve it. So, let us read it, try to understand what is the requirement of this problem and then
how to go for solving it, and estimating the cash flows for this particular cash, capital
budgeting decision.

(Refer Slide Time: 01:32)

For example the problem is that the finance director of XYZ limited called the manager,
Management Services Division of the company, to explore way and means of improving the
management information system in the company. On the basis of their discussion, it became

616
obvious that the company needed a computer system for processing efficiently and accurately
the growing volume of information generated in the business.

It was felt that the computer system would also facilitate the timely preparation of control
reports needed by the management. Finance director asked the manager to find out which
computer system would be suitable for the needs of the company and estimate the cost and
benefits expected from it. So, in the companies, normally when you talk about the computer
systems, they want to install the bigger IT systems, means full flashed IT systems which
completely take care of their accounting process, the financial decision making process.

And when they follow that kind of the computer systems naturally they are very expensive
decisions and many times you can call them, they are the decisions which fall in the category
of the capital budgeting decisions. So, the manager talked to the representatives of a few
manufacturing companies.

On the basis of his discussion with them, he felt that Alpha 3 system supplied by the
Computronics Limited was quite suitable for the needs of the XYZ limited. He estimated the
cost and benefits associated with this system as follows.

Cost of the computer along with accessories was 1.5 million or 15 lac rupees. Operations and
maintenance cost was 0.25 million per annum. Savings in clerical cost was 0.6 million per
annum and Savings in space cost was 0.1 million per annum. It means, what is the total
savings? One is a 6 lacs of the savings, 6 lacs worth of the savings they are going to have in
the clerical cost, because computer is going to take care of the clerical cost and the 1 lac
worth of rupees they are going to save upon the cost.

Because so many people must be sitting in a big hall, which has a big cost, 1 lac rupees per
annum, so when a computer system or a IT system you have, that requires a minimum space.
So, we can save upon the use of the space also and that is equal to 1 lac rupees, so total
savings we are going to have that is 7 lac rupees or 0.7 million rupees. And the cost is going
to be how much? 1.5 million for the purchase of the system and operations and maintenance
cost because you need the technical people to take care of that.

Very few people not large number of peoples and somewhere 0.25 million per annum you
have to spend for that, it means roughly 2.5 lacs you have to pay for the operation and the
maintenance cost. The computer would have an economic life of 5 years and it could be

617
equally depreciated at the rate of 33 and 1/3 percent per year as per the WDV method -
Written Down Value Method.

After 5 years, it would be disposed of for a value equal to its book value, the tax rate is 50
percent. So finally, on examining the given information how the finance director and the
manager have projected the cash flows that we are going to do here.

Means we have to assume that we are the finance director and the manager of the company
and we have to project the cash flows taking into account the information given here, which
is with regard to the cost of the system, operations of the system, savings because of the
introduction of or adpoting the IT systems. So, how you picturize in your mind that how the
finance director and the manager would have done it, same way we are going to estimate the
cash flows for the company.

In this capital budgeting decision which finally they would have submitted to executive
committee of the company because they have to take the decision to provide the finances, 15
lac rupees they have to provide and then the operations cost is also 2.5 lac per annum.

So, finally the decision had to be taken by the executive committee of the company but this
all evaluation and estimation of the cash flows had to be done by both these peoples, so
finance director and the manager, management information systems division, they have
predicted or they have to estimate the cash flows for this capital budgeting decision. So how
it has been done by them?

Let us do it, and let us try to find out what is the net cash flow available from this capital
budgeting decision. So, we are going to estimate those cash flows. It is going to be very
simple process but, you have to learn it and you should be practicing that how to estimate the
cash flows. So, again we will prepare this cash flows statement.

(Refer Slide Time: 08:18)

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So, we will write here as the Estimation of Cash Flows for computer system or for
installation of computer system in XYZ limited. So, this we are going to learn, first of all you
take here the Particulars then we are going to write here as the Years.

So, in the Particulars you have to put all the items which are required here and when we talk
about the years, the life is given to us that the system will have a 5 years life after it is put
into the place, so we are starting with the 0, 1, 2, 3, 4, and 5 years we are going to take here
all the years and now we are going to start with the particulars.

So, first thing we are going to do here is the part A, you can number it is better because
sometime we have to add or subtract something, so it is better to explain what we have added
up, what we have subtracted to arrive at the final figure. First thing is the cost of the computer
we are already given the cost that is the 1.5 million or 15 lacs.

Write here 15 lacs, this is the cash out flow in the year 0, so this is the cost of the computer
which is going to cause a cash out flow of the 15 lac rupees or 1.5 million rupees. Next is B
savings, we are going to have the savings, so how many savings are going to be there, it is
clearly written here if you look at the problem which is given that savings in the clerical cost
will be to the tune of 6 lac rupees and savings in the space cost will be to the tune of 1 lac
rupees.

So, total savings will be how much, that is 7 lac rupees every year we are going to write here.
This is 7 lac rupees, this is 7 lacs, 7 lacs, 7 lacs, 7 lacs because all the 5 years till the
computer will be there we will have the savings in terms of the clerical cost and in terms of

619
the space cost. Then we talk about the C and C component is, C component of the
information is what?

C component of the information is we take here as this, so C is operations and maintenance

cost. Operations, I am writing here O and M cost, so how much is going to be O and M cost?
O and M cost is going to be we have to find out here which is given to us, O and M cost is he
is saying that it will cost the operation and maintenance cost will be 2.5 lacs, so this is going
to be the cost here, 250,000, 250,000, 250,000 again 250,000 and 250,000. This is the
operation and maintenance cost.

Next cost head of the cost is depreciation. So, what is a depreciation 33 and 1/ 3 so if you
take the cost this here, that means say the depreciation cost here, so the rate we have to apply
here is, in the first year it is going to be how much? 33 and 1/3, the rate of depreciation means
one third of the computers cost will be depreciating in the first year, it will come down.

So, it means the depreciation amount will be how much? 500,000 here. And because, it is a
written down value method, so next year the depreciation amount will be this much amount,
333,333. So we will be taking this 333,333 so, this will be the amount of depreciation in the
second year. Third year will be how much, it will come down to 222,222, then it will come
down to 148,148, and last year the depreciation amount will be how much, 98,675.

So, this is the depreciation cost. Cost of the computer is 15 lacs, savings are going to be 6
plus 1, 7 lacs, operation and maintenance cost is going to be 2.5 lacs per annum, and
depreciation cost is going to be, we have calculated as per the rate, that is 33 and 1/ 3 and the
method depreciation is the WDV that is the written down value method. And now the E.
There is no other head of cost, so we have to calculate now the profit before tax that is called
as PBT.

So, what is a profit before tax? This is the savings we have going to have 7 lacs and the cost
are 2, so it means in the first year there is going to be a loss and this loss is how much, 50000
rupees. So, because why the loss is there? Because the amount of depreciation is very high,
one third of the cost is going to depreciate in the first year, so we are ending up with the loss.

So, there is a negative cash flow you can say in the first year. Then in the next year is how
much? There is a positive cash flow profit before tax is positive 1,16,667 is the profit in the
second year, third year is 2,27,778 in the third year, and then fourth year is going to be how
much, fourth year is going to be if you subtract this, is going to be 3,01,852 if you subtract

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this from the 7 lacs, if you subtract operation and maintenance cost and depreciation, this is
going to be the figure here, 3,01,852 and last year is going to be 3,57,235. So, this is going to
be the PBT.

Now, we take the next part and we are going to take here as that is the tax. So, what is the tax
rate? Tax rate given to us in this case is the 50 percent. So, if you talk about this is going to
be the negative tax if at 25,000 and in this case it is going to be tax is how much, it is going to
be 58,334 half of this, 58,334. Then is how much, 1,13,889, then is 1,50,926 and then last
figure is 1,75,618. So, these are the say figures of the tax out of the PBT you have to pay this
much as the tax 50 percent of the amount we have to pay as the tax.

And finally, we are to calculate here the G that is the PAT – Profit After Tax, so we have to
calculate the profit after tax here and exactly the 50 percent is left here. So, this is in this case
loss of 25,000 profit means, after tax is 25,000, then here it is 58,334 because it is 7 so we
will make it now 58,333, not 58,334, and then it is 113, exact 50 percent. So, 1,13,889, in this
case is how much 1,50,926 and then exactly half here 1,75,618, this is the profit after tax.
These are the figures of profit after tax only in this year there is the loss which we have to
now take it seriously.

Finally, we have to now calculate the net salvage value. What is the next thing, that is the net
salvage value is going to be how much? We have to find out the net salvage value which is
given to us already we have been given here and that is going to be in the year 5. So, what is
the net salvage value? That is going to be the remaining amount. So, it means what was the
total? That was the 15,00,000 minus depreciation over the number of years.

So we subtracted it the depreciated computer system by 5,00,000, so we are left with the
remaining amount of 1 million that is 10,00,000. Then next year be depreciated by this
amount, this amount, this amount and last depreciation rate was this amount, so salvage value
was given here to us was, the written down value method. What is the final value which is
left after 5 years is known as the salvage value, which is the otherwise you can call it as equal
to the book value?

So, net salvage value is equal to the book value and that is left the computer in the fifth year
is left of worth 1,97,531, so it is the net salvage value we have calculated here and after this
what we have calculate here is, that is now the final closing of because, we have to calculate
the operating cash flow. So, what is the initial investment we have to take here as the initial

621
investment was 15,00,000 and this is again outflow only this much how is the outflow is
there.

And then now we calculate the operating cash flow. So, what is the operating cash flow here
we calculate the operating cash flow here, so operating cash flow we have to take here is
what, we have the two sources of the operating cash flow here and these two sources of the
operating cash flow are one is the profit after tax, profit after tax is how much this column we
have to take into account and then, second is the depreciation we have to take into account.

So this is how much you have the depreciation that is a cash flow giving as a cash flow of the
5,00,000 rupees but there is a loss, means profit after tax is not the profit, but, it is a loss so,
your cash flow will not be 5,00,000 rather it will come down to 475,000 cash flow will be
here and in the second case will be taking care of this 58,333 and depreciation of this
3,33,333 so the operating cash flow total will become how much 3,91,667.

Similarly, the next year it will become as the operating cash flow 3,36,111, that is in the year
3 and then it is 2,99,074 and then last is 2,74,382 so, these cash flows are the operating cash
flows which we have calculated here by taking into account the profit after tax and the
depreciation. So, these are the operating cash flows here with us and if you look at now the
operating cash flows now we have to on the basis of it calculate the your net cash flow.

Like next thing which we will be finding out is the net cash flow and that net cash flow will
be found out after taking into consideration in the terminal value. So, the next thing is the
terminal value, or terminal cash flow. What is the terminal cash flow means finally we will
have the terminal value and terminal cash flow is the figure which is now the book value of
the computer system after depreciation means whatever is the salvage value that will be the,
the terminal value the book value is going to be the terminal value, so it means here it is how
much, it is going to be it has to be in this year.

So, for calculating the net cash flow you have to take this into account and for taking this into
account that is 1,97,531 lastly you have to now calculate the net cash flow NCF. Net cash
flow we have to calculate and for calculating the net cash flow in this year, this is going to be
the final, net cash flow, so in this year we are going to, 0 year we are going to spend
15,00,000 rupees on the accusation of this computer system and then we are going to have the
first year the cash inflow and this is going to be 4,75,000, then it is going to be 3,91,667 and
then it is going to be 3,36,111 and then it is going to be 2,99,074 and the last one is going to
give us a bigger value which will be this plus this.

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So, it means operating cash flows is how much, 2,74,382 and the terminal cash flow is
1,97,531 so finally, total it up so it is 4,71,913 this is going to be the terminal cash flow in
the last year. This is the cash outflow and in the 0 period, in the current period, when we will
buy the computer, first year, at the end of the first year we will get the 4,75,000 we will get
this much at the end of the second year, this much at the end of the third year, this much at
the end of the fourth year and this much at the end of the fifth year.

So, roughly if you get an idea so, this is going to be what, this is going to be a not a bad
propagation I think because, if you look at the total savings available from this process. This
capital budgeting decision 7,00,000 and then the additional cost and finally the cash flow
which will be available to us over a period of 5 years so, if you discount it, though the
negative I expect that the NPV should not be negative or if it is negative, it will be a very-
very nominal amount.

So, I think because currently it may be not giving us the very positive value, very high NPV
or a very positive NPV but in this case our major concern should be in this kind of the capital
budgeting decisions that to improve the efficiency of the organization because replacing the
human efforts with the IT, be I can expect multifarious other advantages also, which we are
forgetting at this stage, so finally, whatever the cash flows we have worked out, finance guy
will say that okay this I am going to shell out.

15,00,000 I am going to spend for installing the system and over the period of 5 years, which
is the foreseeable life of the computer or expected life of the computer, I am going to get this
much of the cash inflows, so finally at the some acceptable cost of capital as a discount rate
will be discounting these 5 cash inflows and then we will try to find out that at least NPV is
0, not positive or very high, it should be 0.

So that how much we are selling out and how much the benefits we are expecting from this
capital budgeting decision, there is no profit no loss situation. But it can be the one possibility
that even there is a some negative NPV available from this kind of the decisions. We can
expect that overall efficiency of the organization will improve, the performance of the overall
firm or organization will improve, so it means the controlling process will be improving, it
will become better.

So, what will happen that it will give us, you can call it as the byproducts of taking this kind
of the decisions which cannot be quantified in the monitory terms but, otherwise that they are
very-very useful decisions, they are very-very useful outcomes. And we should also consider

623
them which are qualitative factors you can say not quantitative factors. So, quantitatively you
have to compare these cash outflows of the 15,00,000 rupees with this after discounting it.

So, this will be equal to 100 percent and these will be discounted at the cost of capital and
then, finally we will take the decision that whether we will, go for this system, installation of
this computer system in the firm or not. But, in this case at this particular stage our job was to
estimate the cash flows, cash outflows and the cash inflows as the finance director and the
manager of the XYZ limited would have done.

So, here we have practically learned how to do it, and this is the way how to estimate the cash
flows in the capital budgeting process or in the capital budgeting decisions. So, with this
discussion, I will stop here for now and one more problem, which is basically a replacement
problem, I will discuss with you but, that will in the next class. Till then thank you very
much.

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 Financial Management for Managers
Professor. Anil K. Sharma
Department of Management Studies
Indian Institute of Technology Roorkee
Lecture-39
Estimation of Project Cash Flows Part XI

Welcome all. So, now we are in the last leg of this discussion of the Estimation of the Cash
Flows in the capital budgeting decisions and this is as I told you in the previous class, we are
going to discuss one more problem which is basically the replacement decision, means the
replacement of the old asset with the new asset, because of certain changes in the market or
because of certain changes in the technology, many a times firms have to replace their assets,
maybe the old assets with the new assets.

It may not be the case that the asset has become obsolete or maybe the technical value has
become 0, it is not the case. But it maybe the situation that if we replace the old asset with the
new asset, it is going to give us a better revenue means our savings are going to increase, our
cost of production is going to decrease and sometimes the quality of production which comes
out of the new asset or by using the new asset maybe much better, so it may have a better
place in the market, better acceptance amongst the buyer of the customers.

So, if there is a situation that we have to take the replacement decision because if the sum
required for replacing the old asset with new asset is quite bigger, quite higher, so it means
certainly it also comes in the category of the capital budgeting decision. So, again we have to
evaluate it in the same manner, how we normally take the normal capital budgeting decisions
in case of the new asset, new projects or the fresh beginning of any business activity or
adding up of a new product into the existing product line.

So, it is an independent capital budgeting decision, only difference is that whatever the cash
flows we work out here, they are incremental cash flows because something is already
existing with us. So, we have to replace that with something new, so the good and bad effect
of the old thing or the old assets also have to be kept along with the positives or may be the
negatives of the new thing we are putting in place.

So, ultimately it is going to be something called as a incremental. So, we are going to

calculate the incremental cash flows that is a only difference in the replacement decisions,
otherwise the estimation of the cash flow process is same, we try to find out that how much

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cash out flow is going to be there in the current period, in the 0 period and how much cash
inflow is going to be there over the coming years foreseeable life or useful life of the asset,
same way we are going to do.

And ultimately be begin with the investment outlay in the current period and we end up with
calculating the net cash flow, which will be available out of this replacement decision. So, let
us do it and like as we have seen the previous problem in the previous class, now I will again
read this problem for you so that we can understand the problem well and then we can
calculate the cash flows.

(Refer Slide Time: 03:17)

So, what is the problem here, see simple problem, Raja Engineers is considering a proposal to
replace one of its hammers. It maybe technical asset or a machine, the following information
is available. Number 1, the existing hammer was bought 2 years ago for 1 million rupees. It
has been depreciated at the rate of 33 and 1/ 3 percent per annum. It can be presently sold at
its book value.

So, you have to calculate the book value, that is the depreciation that total is 10 lakhs rupees,
the purchase price for which it has been purchased and the depreciation rate is 33 and 1/3
percent per annum, method is the written down value, so you have to calculate the
depreciation for 2 years on the WDV method.

And then calculate the book value and that is the value which this asset can fetch from the
market if it is deposed of after acquiring the new asset. It has a remaining life of 5 years after

626
which, on disposal, it would fetch a value equal to its then book value. Today after 2 years,
the book value is different and after 5 years, the book value is different.

B, point number 2. The new hammer cost 1.6 million; it will be subject to a depreciation rate
of 33 and 1/3 percent. After 5 years it is expected to a fetch a value equal to its book value,
because we have to calculate the terminal cash flows, so this amount is important.

The replacement of the old hammer would increase a revenue by 0.2 million or 2 lakhs
rupees and reduce its operating cost excluding depreciation by 1.5 lakh per year or 150,000
rupees per year. Now, what we have do it, on the basis of it we are given both the
informations, we are given the information about the old asset also, we are given the financial
information about the new asset also, we are given the information about the savings in terms
of the cost also and the increase of the revenue also.

So, what have to do now? Required is, compute the incremental post tax cash flows
associated with the replacement proposal, assuming a tax rate of 50 percent.

So, now our job is that we have to evaluate this replacement decision capital budgeting
decision, but before that at this particular point we have to only estimate the cash flows later
on as a next step we can discount the cash flows both outflow and inflow if it is in the
subsequent period, the outflows are in the subsequent period also and then we can calculate
the NPV out of this decision and then finally we can decide whether to go for this particular
decision or not.

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(Refer Slide Time: 06:30)

So, now let us calculate the cash flows. So, same way I am proceeding further, for this case
we are going to calculate the cash flows, so we write here Cash Flow for Replacement Project
or the replacement decision and similarly we are going to have the columns like here is the
particulars, then we are going to have the years, particular and years, we are going to have the
same years, we are going to have the 0 year, then we are going to have 1, 2, what is the life
given here? 5 years, 3, 4 and that is 5.

So, first item is as usual first item A is the Net Investment in New Hammer, we have to now
calculate the net investment in the new hammer, because what is the cost of new hammer? 16
lakhs rupees, 1.6 million rupees, but I have calculated here it is that is 11,55,556. And what is

628
written here? Net investment in the new hammer, it is not investment in the new hammer, it is
a net investment in the new hammer.

So, how we have arrived at this figure? I would like to explain it to you that what is the cost
of the new hammer? 16,00,000 rupees, this is the cost of the new hammer. But this we are not
going to, we are going to sell out 16,00,000 rupees to purchase to pay to the supplier, but we
are going to get back something as a book value of the old hammer.

So, we have to first calculate the book value of the old hammer. And if you calculate the
book value of the old hammer, so what is the cost of the old hammer? That was the, that was
acquired for the 10,00,000 rupees, 1 million rupees. And what is the depreciation rate? At the
rate of 33 and 1/3 percent, it has depreciated at the rate of 33 and 1/3 percent and for a period
of how many 2 years.

So, you have to calculate the depreciation on this 10,00,000 rupees for a period of 2 years by
applying the or by following or by adopting or by working on the WDV method written down
value method and finally if you calculate that depreciation, so the book value which will be
you will be arriving at after subtracting the depreciation for the 2 years on the written down
value method the book value will you be arrived at is 4,44,444, this is the book value of the
old hammer.

So, it means this book value can be realised after selling this hammer in the market as a
second hand machine and once we are selling out 16 but we are getting back 4,44,444 so
what is the net investment we are making? We are making the net investment of 16,00,000
minus 4,44,444 this investment is the total investment we are making and this works as out
the same amount here that is 11,55,556.

So, we have to calculate the net investment incremental investment? We have not to calculate
only investment. So, that is a very important consideration here, so I will remove all this
because it decided for explaining it to you.

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(Refer Slide Time: 10:33)

Now we will move to the next part, because this is the cash out flow in the 0 year, so we have
nothing, we are not doing anything here because no inflows are coming in the 0 period, so it
means nothing here only we are going sell out additional 11,55,556. Now, what is going to be
the effect of this change in the machine? B is the increase in revenue, increase in the revenue,
how much increase in the revenue we are going to have?

Increase in the revenue we are going to have here is 2,00,000 rupees, it is given to us
2,00,000 rupees it is increase in the revenue is 2,00,000 rupees’ net increase in the revenue is
2,00,000 rupees every year for the 5 years’ period of time, that is why we are going to have
the better machine, so it is 2,00,000 rupees, that is increase in the revenue.

Third important component is the savings in the operating cost. How much saving in the
operating cost is going to be there? We are going to save some amount called as 150,000
rupees, we are going to save, this are the for the period of 5 years.

Next thing is now depreciation; we will have now talk about the cost part. Depreciation on
new hammer and again the depreciation rate on this hammer is going to be how much that at
the rate of 33 and 1/3 percent again as it was on the previous hammer the same depreciation
rate, so if you calculate the depreciation on the new hammer, what is the depreciation on the
new hammer?

630
The first figure comes you here is 5,33,333, then is the next year is 3,55,555, then is 2,37,000
depreciations we are calculating on the new hammer as per the WDV method and applying
the rate of 33 and 1/3 percent and then he rate is 1,58,025 and last depreciation is how much
105350. So, this is the depreciation on the new hammer. Similarly, if the old hammer would
have been not replacing by the new hammer then it also would have given us some inflow in
terms of the depreciation.

So, now we have to calculate the depreciation on old hammer, because we have to calculate
the incremental deprecation only. So, the deprecation on the old hammer is how much?
148,148 again then it is 98,765, then it is 65,844, then it is 43,896 and then it is 29,264 this is
on the old hammer the deprecation. So, both the deprecation figures we have calculated. And
finally what is the incremental deprecation? Incremental deprecation is how much?

Incremental deprecation here it is, that is this minus this D minus E, so incremental
deprecation is going to be 3,85,185 then it is 2,56,790 then 1,71,193 then it is if you subtract
the other one from the other then it comes as 114,129 and then it is 79,086 this is the
incremental deprecation or this is the differential deprecation you can call it as, this is
incremental deprecation we have to calculate.

So, incremental deprecation we have calculated which is the figure of importance for us, this
is incremental deprecation we have calculated that is the deprecation on the new hammer and
minus the deprecation of the old hammer and the incremental figures we have arrived at, we
have worked out here. Now, G is incremental taxable profit, how much is going to be the
incremental taxable profit now we have to calculate.

Because we have to find out here that is the savings are 3,00,000, this 2,00,000 plus 1,50,000,
3,50,000, so out of this we are going subtract some amount some amount. So, this amount is
going to be how much? 35,185 is going to be the taxable profit, but this is not the profit
actually this is the loss, because the total amount which we were going to have, the saving
upon that is increase in the revenue is 2,00,000 rupees saving in the cost is 1,50,000 rupees.

And when you talk about the incremental deprecation, so incremental deprecation as a cost
because already know deprecation is a cost which is 385,185 so this is the difference that is
the, the difference is coming up 35,185, this is a loss. We have calculated here this is loss.
And then the incremental profit in the next case is going to be how much? The incremental
profit in the next case is which is an incremental taxable profit. We have to write here

631
incremental taxable profit here. And for calculating this incremental taxable profit in the first
case it is 35,185 which is a loss not a profit.

In the second case it is 93,210 and in the next case it is 1,78,807 then is the taxable
incremental taxable profit 1,78,807 and then is 2,35,871 and then it is a 2,73,914. So, this is
the taxable profit or in the first year there is a taxable loss, means there is no profit at all and
the loss is to the tune of 35,185. And in the next year there is a profit 93,210 and then it is
next year it is 1,78,807, then it is 2,35,871 and then it is a 2,73,914.

Now, we have to calculate the incremental tax. So, it is the incremental tax we have to
calculate. So, for calculating the incremental tax. Now, what is your tax rate given here? The
tax rate given here is the 50 percent, so we have to take this incremental tax we have to
calculate, so if you calculate at the rate of 50 percent, what is the rate given here? That is the
50 percent.

So, we have calculated the incremental taxable profit which is 35,185, which is the loss in the
first year, no profit, but in the other 4 years 2, 3 and 4 and 5 years, there is a profit. And now
the incremental tax at the rate of 50 percent, we have to take here, so because the tax rate
given to us is 50 percent. And if you take, calculate the tax on this rate, at the rate of 50
percent, so it means what is the total incremental taxable profit or loss, so and if we apply
this, so this works out as how much? 17,593.

And in the other years we have to take as the 46,605 and the one more is 89,403 and then this
incremental tax we have to take here as 17,593 in case of the first year which is the loss, but
the tax savings will be this much amount and then in the second year there is going to be the
tax at the rate of the 46,605. And in the net year it is going to be how much? 89,404, 403 or
404 we take it as a 403 and or we take it as a 404 and then later on we will take it as the 403.
So, this is going because it is 50 percent, so 89,404.

And next case it is going to be 1,17,936 is the incremental tax and then it is lastly 1,36,957,
this is incremental tax. So, now lastly we have to calculate here is that is the incremental
profit after tax, so if you calculate the incremental profit after tax, how much it comes up as,
it comes up as 17,592, so it is again the loss that is after this if you take into account this is a
loss, 17,592 is the loss, in the next case it is going to be how much? 46,605 is going to be the
profit after tax incremental profit after tax.

632
And then it is going to be the again same figure 89,403 is the incremental profit after tax. And
then in the next case it is going to be again same figure 1,17,936 and or 35 we will have to
make because there is difference of 1 rupee, so will be have to make it 35 here, this is 35 and
last amount is going to be incremental profit after tax is again same amount 1,36,957. So, this
is incremental profit after tax we have calculated.

Now, we will calculate the net salvage value. How much is the net salvage value? We have to
calculate the net salvage which is coming up in the last year, 5 years. And this is going to be
how much? That is the value left after the deprecation. And deprecation we have to charge
for a period of 5 years at the rate of 33 and 1/3 percent. So, the salvage value is going to be
the market value which the asset is going to fetch after selling it of in the market after 5 years.

So, this is going to be this much and next thing is the net initial outflow ,initial investment or
outflow is how much, this is 11,55,556, is the initial investment we have done. And finally on
the basis of this you can calculate the operating cash flow, so we calculate the operating cash
flow it will be taking account the operating part of the firm and in this case operating cash
flow we are going calculate, so we have calculated he initial investment of 11,55,556.

And the operating cash flow is going to be how much? It is going to be in this case 3,67,593,
and in the next case it is going to be 3,03395, in the next case it is going to be 2,60,596, next
case it is going to be 2,32,064. And next thing is 2,13,043 is going to be the operating cash
flow. And now the terminal value, terminal cash flow, what is going to be the terminal cash
flow?

Nothing here, nothing here, nothing here, nothing here, nothing here and we are going to get
the same amount that is 1,52,172 as the terminal cash flow is going to be this and after all this
calculation we are going to find out the last figure and the final figure which is called as the
net cash flow and this ultimate objective of doing this all analysis.

So, net cash flow is going to be a the sum total of all the calculations we have done here that
terminal cash flow, we have to add up into the operating cash flow and then we will be able
to find out the net cash flow. So, in this case net cash flow is going to be how much? Net cash
flow is going to be in this case 3,67,593, in this case it is going to be the same figure no
change 3,03,395 and in this case it is going to be 2,60,596 and in this case it is going to
2,32,064, in this case only we are going to make this plus this plus.

633
So, if you make this plus this plus it works out as 3,68,215 is going to be the final amount is
the net cash flow in the year that is called as a year 5. So, in this case if we look at the total
cash flows, the cash out flow which we have worked out is a net cash flow that is 11,55,556
and in over the subsequent 5 years, when we have calculated the cash inflows, we have been
able to find out that is the cash flows here, in the first year though there was a loss, but that
loss has been finally as given us because of the deprecation amount.

And what was a deprecation amount? That was the incremental deprecation when we
calculated it was 3,85,185 and from this when we subtracted the loss figure after setting aside
the text part because that benefit we will be taking up in the next year, from the profit of the
next year the loss of the previous can be adjusted, so that benefit we will be taking. So, in this
whole case after the whole analysis at the end of the first year we had the positive cash flow
and that cash flow was 3,67,593. And in the subsequent years you have the positive cash
flows anyway.

And in the last year the cash flow which we have worked out is in that the cash operating
cash flow we have added up the terminal cash flow also which is basically the book value. It
was given to us that after buying the machine and using it for a period of 5 years; we have
bought it for 16,00,000 rupees and used it for a period of 5 years. So, the book value,
whatever the book value will be at the end of the fifth year, that will be realizable, that will be
the market value also, that will be realizable from the market.

So, we have found at that this is the book value of the machine of the new hammer purchase
for 16,00,000 rupees that was 1,52,172. So, at the end of the fifth year one cash flow will be
operating cash flow and second will be the terminal value. So, two cash flows will be
available with us. So, finally if you try to find out how much is the sum total value of this
cash flows so it is 3 3 6 and 2 8 and then it is to 10 13.

So, I think the non-discounted figures are going to be more than the cash outflow, net cash
outflow has taken place that is 11,55,556. But if you discount this figures for the given
discount rate or the cost of capital, I am still hopeful that the decision should not be negative,
there may be some sum negative NPV, but simply just taking the decision on the basis of
marginal negative NPV, if this machine is going to give us other multiparous advantages
maybe as the byproducts.

634
So, which cannot be quantified normally you can call it as they are the qualitative benefits.
So, as I discuss in the previous problem here also I would emphasize upon, that after
calculating the cash flows the next thing is calculating the net present value. So, this value
will remain the same, but these values we have discount and after discounting we have to
calculate NPV. So, whatever the NPV comes normally the rule of thumb says NPV has to be
at least 0. So, that cash out flow is equal to cash present value of the cash inflow.

So, normally that is the rule of thumb. So, if that rule of thumb is applied by the company in
this case, so maybe the decision goes against the replacement of the old asset with the new.
But if some other multiparous advantages are also kept in mind, then the management of the
company may decide that ok still we are going for the replacement of the machine because it
is going to give us so many other say qualitative benefits also, improve the product quality,
customer satisfaction.

And anyway the saving are going to be there and increase in the revenue is also going to be
there. So, this decision has to be taken in totality, but at this point of time our job was because
we are learning about estimation of the cash flow in case of the capital budgeting decisions.
So, we have done that and we have learnt sufficiently I think after doing 4 - 5 problems of the
different types, that how to estimate the cash flows both out flow and inflow which will be
more relevant useful for the any kind of capital budgeting decisions.

So, with this discussion I would stop here and I will complete discussions on the estimation
of the cash flows. So, next time we will talk about the new topic, new part of the discussion
with regard to this financial management and the next topic which I will start talking in the
next class onwards is that is the Management of risk in the capital budgeting decisions or in
the capital budgeting projects, you call it as management or you call it as the assessment of
the risk in the capital budgeting decisions that I will start in the next class or from the next
class onwards till then thank you very much.

635
 Financial Management for Managers
Professor. Anil K. Sharma
Department of Management Studies
Indian Institute of Technology Roorkee
Lecture-40
Risk Analysis in Capital Budgeting Part I

Welcome all. So, now we are going to start the next part of discussion or a new topic or the
next topic that is the Risk Analysis in the Capital Budgeting projects. So, till now we have
seen that the capital budgeting process, how it is important in the new investment proposals.

And we have seen that once we have got the cash flows, both cash outflows and cash inflows
then we discount that and try to find out that if it is a discounted criterion then we compare
the NPV. In case of the net present value method we try to calculate the NPV and there we
calculate the present value of the cash outflows and compare that with the present value of
cash inflows.

And that the, minimum NPV should be 0. If it is positive that it is very good, that is the
selection criteria or rejection criteria of a project or sometime we follow the internal rate of
return or the third discounted criteria we followed was the benefit cost ratio. And then we
could see some non-discounted criteria also. So, that was in the capital budgeting process, the
evaluation of the investment proposals whether we should make investment into any project
or not.

And then we moved forward with the next part that was the estimation of the cash flows,
because cash flows under the capital budgeting were given to us, but how to estimate those
cash flows? we learnt after that. And now the same way connected to the capital budgeting
process, we are going to learn about the third thing which is the third important thing about
the evaluation of the capital investment proposals and that is the risk analysis of the capital
budgeting proposals or risk analysis in the capital budgeting proposals.

So, because when we are talking about the new investment we want to make or the any
capital investment we want to make in the new projects. So, because when we are planning to
make investment and when we will actually make an investment there is a difference in the
time gap. And that difference in the time gap creates so many problems, because when you
are planning to make investment then we are in the abstract form and when we are actually

636
going for making investment then we really find out or realized that what things are going to
take place in the market or how the things are going to happen in the market?

Similarly, when we plan for a new investment we estimate the cash flows, that how much
cash out flow is expected that how much investment is expected to be made, how much cash
inflows are expected from the project over the period of time over the subsequent years.

And then we try to calculate the NPV or IRR or the benefit cost ratio and at the same time the
payback period. What about the cash flows we are estimating at the time of preferring the
DPFR or evaluating the capitally investment proposal, if those cash flows do not hold good or
do not come true at the time when we really make the investment in the market, so it means
there will be a element of the risk involved in this investment proposal.

It may be possible that whatever the investment we are planning to make in the beginning or
at the time of planning, for that capital investment we had anticipated, some given amount,
but actually when we started making investment, so there was no end of the cash outflow.
Building the project, we thought some 1 million rupees will be required, but actually it cross
the 2 million rupees.

So, it means the whole estimate will get disturbed, because whatever the cash inflow now we
are analysing and comparing and calculating NPV is, that is related to the cash outflow. So, if
the cash outflow has become now double, then the estimated amount or expected amount, so
in that case what will happen? Means your cash inflow should also change at the same
proportion or in the same ratio.

But it may be possible that cash outflow has increased and has become double but the cash
inflow is not changing in the same process, of the other way round you can see there element
of risk maybe because of the cash outflow is same that whatever we have anticipated some
you can call it as some 10, 15 percent of the difference was there, which is we have kept the
provision for the contingencies, but the inflows have got negatively hit, means whatever we
plan to receive at the end of the first year, that much of the inflow we have not received.

Because inflow depends upon the revenue and revenue depends upon the sales of the product
of the service, we are going to generate out of this project. So, for example whatever the
anticipated demand was there in the market we could not get that much in the response in the
first year. Similarly, in the second year, third year or the in the other years, so the revenue

637
because of the sales has fallen down and whatever we anticipated that will be selling this
much of units in the market.

Or this much of the market share will be able to grab from the total market or maybe snatch
from our existing players in the market that has not happened or even if the product is new in
the market for the first time we are introducing. So, in that case we had planned that we will
make a big difference in the market, but people rejected the product, people rejected the
service, so in that case it may be possible that whatever the cash inflows we are anticipating
they are not up to that mark.

So, cash outflow already has occurred, but the cash inflow is not up to the mark. Because all
your capital budgeting processes or the evaluation of the new investment proposal that all
depends upon, your NPV we are calculating, for example, we have found out that NPV from
the proposed project is going to be quite positive, but it will be positive only if the anticipated
cash outflow and inflow take places, or are coming out of the project in the same estimated
amount.

But if any of the amount is disturbed sometime the cash outflow is more sometime the cash
inflow is lesser then the expectations or sometime both get disturbed, that cash outflow we
had anticipated is 1 million rupees, but it has become or gone up to 2 million rupees. And
cash inflow we were expecting that on an average at the end of the first year we will getting
some 200,000 rupees then it will grow to 400,000 rupees then to 600,000 rupees but it is not
growing because the market has not responded like that.

So, when I was talking to in the beginning of discussion about the Anchor who fruit beer
project, it happened the same thing there, there company anticipated that the cash outflow is
expected to be 300 or 350 crores and they were ready to make investment. But when the
product came to the market, that was reject by the people, that was not appreciated by the
people, was not accepted by the people.

So, what happened? cash outflows happened as per the anticipations, but cash inflows did not
come back as per the anticipation or as anticipated. So, what happened? There was a
mismatch and when there is a miss match how long you can sustain the project in
anticipations that though the cash inflows are not up to mark say first 1 or 2 years, but over a
period of time they will improve. How can you expect like that?

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So, it may be possible that we have to close down the manufacturing facility or may be this
process. We have to close down this entire project, so it may be possible any kind of things
may be possible any kind of thing may happen. So, wherever we are estimating for anything,
we are planning for anything ultimately planning is planning, ultimately anticipation is
anticipation, ultimately estimation of the cash flows is only estimation.

It is not the actual process or it is not the case that has actually happened in the market. So, in
that case for example if we are not sure about the success of the product of the service, so we
should move forward in the market the way Karsanbhai moved while manufacturing the
Nirma washing powder for the first time in 1982, though he knew it that it is going to be a
good a product people may expect it or people may have a very good response.

But still he did not go for the large scale production right from the beginning, he started the
process of manufacturing at a very small level, he distributed to his neighbours free of cost,
then he distributed to his relatives free of cost. And when he saw the response is very good
people are liking the product, people are accepting the product then he started making the
commercial production and then gradually he increased the scale, gradually he upscaled the
production.

So, that kind be the one strategy, that can be the one possibility that yes you can not take the
risk or you should not take risk that immediately you make a big investment, huge investment
and then you anticipate that the performance will be this much and we will have this much of
the response from the market. Because in that case if the response is not up to the mark then
whole investment is expected to go down in the drain.

So, we have to be very careful, what is the point of discussing this particular thing here risk
analysis in the capital budgeting is that we should be very careful, we should be very
particular while deciding or looking for the investment in the new proposals and risk element
is always present there. So, we should try to keep that risk factor in mind, so that if that risk
affects our firm negatively, then it is anticipated and we have already known that if the
element of the risk is this much we will have the control measures.

We will take care of the risk or we will look for the new market or we will add some new
feature in the product or we will reduce the price, so that way we will have to go for finding
out or making some strategies in the beginning. So, if you are making the investment like
what the Anchor did investing 350 crores in the fruit beer project and finally it ended up as a

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failed proposition. So, ultimately it is going to only create a big loss and you can call it as a
disaster to the existing firm.

And may be the existing reserves and surpluses if there is any they may be totally depleted
and even the existing shareholder even the existing owners and promoter of the existing firm
they may put them self into the risk. So, we have to analyse the capital budgeting proposals
from this angle also and careful risk analysis has to be done, so that whatever is expected to
happen that is largely known to us in advanced and we are prepared to take care of that.

So, because of any reason the things may change, because of any factor which is not even
anticipated the things may become negative or the estimates may become negative. So, we
have to be very careful and we have to take the corrective actions, we have to propose that if
any wrong thing happens, what are the corrective actions we can take. So, this all we are
going to discuss now in the next few classes about the risk analysis in the capital budgeting
processes or the capital budgeting proposals.

So, that if anything wrong happens in the market or if negative factors affects our project or
the investment, this proposal then the corrective action which we already have kept in mind
will be taken. So, when you talk about the risk analysis in the capital budgeting proposals, we
will have to discuss so many things with regard to this and the things which we are going to
discuss now in the next few class, they are these important points we are going to talk about.
First we are going to learn about is sources and the perspective of the risk. From where there
is risk expected and if the risk take place how to deal with that risk?

This is in the first part and then different methods of taking care of the risk or may be
anticipating the risk. And how much risk can be there? And if any risk factor affects the
project or the project proposal negatively what corrective action we can take in? So, different
methods are there we will be learning about all these methods. To the extend we can learn
different methods, like sensitivity analysis is there, scenario analysis is there, break even
analysis is there some other models are there, specific models are there like Hillier’s models
is there, simulation analysis, decision tree analysis and then we will go for the corporate risk
analysis.

And then we will learn about how to manage the risk, if the risk takes place how to manage
the risk. And then we will lean about is the project selection under the risk that how to go for
the project section under risk. And the risk analysis techniques in a practice largely in the

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Indian industry or in the Indian industrial scenario if any kind of the risk takes place how to
manage that risk or how to analysis at first and then later on manage that risk .

So, all these things we are going to learn one by one and once we complete the discussion on
the risk analysis of the capital budgeting proposals we should be clear about that if there is
any kind of the factor or any kind of the situations happen which are totally unanticipated
then how to deal with that? And how to save the project or the total investment proposal from
getting negatively affected or getting negatively hit.

(Refer Slide Time: 15:05)

So, now we will move to the next part that is learning about the techniques for the risk
analysis or methods of the Risk Analysis that how to deal with the risk, if risk factor affects
the firm or risk takes place in the firm, how to take care of that, how to deal with that.

When you talk about the techniques of the risk analysis, you have largely 2 kind of the
techniques, broadly 2 kind of the techniques given here, 1 is the analysis the analysis of the
stand-alone risk and second is the analysis of the contextual risk. When you talk about the
stand alone risk analysis it means here we walk about the only project in question the
proposal which we are going to the take care of now or we are going to means make a new
investment.

See, when you talk about the new investment proposals largely you can divide it into 3 broad
categories it can be the R&D for the existing firms I am talking about, if they want go for the
new investment or process, it can be either the R&D proposal, research and development or

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it could be the expansion of the extending facilities or third it could be the replacement of the
some existing asset with the new asset.

So, this kind of the projects can be undertaken by the existing forms. So, for example there is
a pharmaceutical company, they are manufacturing number of drugs already but they want to
find out a new molecule, new drug for securing another or may be a disease which is
commonly there in the market for example very effective drugs are not there to cure the
dengue fever or the dengue problem in the market, people are getting affected because of the
mosquitos.

So, if you want to find out any company may be Sun Pharma or may be the Ranbaxy or may
be the Reddy’s laboratories, these existing companies. If they thing of that ok let us try to
find out a new molecule for curing this particular disease or this particular problem or
different kind of the fevers are there, people are getting affected children’s are getting
affected and sometime this common drugs are not working on that.

So, there is a problem identified and for say looking for the solution for that problem or that
disease that new drug company planned to find out. New drug means finding out the new
molecule, once that molecule is found out then the drug that can be as that can be converted
into a drug by processing that. So, R&D projects are consider to be most risky, maximum risk
involved is there in the R&D projects whether it is the pharmaceutical industry or whether it
is any industry in the manufacturing sector.

When we start looking for any product to be manufactured and we start or initiate the R&D
process and when we end it up and when we look back that how complex and tedious the
entire journey was. So, in that entire process huge investment is required to be made and at
the end of the day we not know whether we will be able to find something or not. If we are
able to find out something then fine that we will be able to recover the whole investment, but
if we are not able to find anything then you can see that entire investment go done in the
drain.

So, as I told you sometime in the previous classes also that as per some estimates in the
Indian market or as per the Indian conditions or the Indian pharmaceutical industry,
identifying or finding out a new molecule, a new drug for treatment of any disease takes
minimum 10 years time period, minimum period of time required is 10 years.

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And minimum 10,000 crores of investment, even 10,000 crores of investment is old estimate.
It has further gone up to, but even you assume that even today also it is 10,000 crores, so it is
a very big amount. So, if we spend 10 years period and we spend that 10,000 crores also, but
if we are not able to find out that molecule you can understand how much risk we are going
to take. But you have to take risk, because without taking any kind of risk you cannot think
of having any break through.

So, R&D projects are the most risky projects. We have to go for very careful analysis and
then to start the project. Second, the next less risky is the expansion projects, for example we
are manufacturing some 4 – 5 products, we want to add up 1 more product and it may be
possible that product is not acceptable to the people, we lost the total investment in the
market. What happened to Anchor that was the case that they were into the electrical product
segment, but when they thought of introducing a new product in the market that is fruit beer
that was rejected by the people.

And after that it could be the replacement of the asset. So, if you move into the hierarchy of
the risk R&D is the most risky investment proposal, then is the expansion proposal and then
the least risky is the replacement of the asset proposal. Because there we know that, we are
going to replace the old machine with the new machine though the investment requirements
are very high.

But revenue growth will also be very high, cost will come down, quality of the production
will improve and automatically it is going to be a win-win situation for all of us or for all the
stakeholder of the company. So, this is about the existing firms, but the risk for the new
firms, new entrepreneurs is very high. For example some person who has recently graduated
or done MBA or may be a B.Tech or may be any other degree.

And he decides that no he will not go for the placement, he will not look for the placement in
any company but rather he like to become an entrepreneur. He must have a very good idea in
mind and even the venture capitalist also came forward to get the funding and that the project
was given the shape and product, the service started coming out in the market. But somehow
the product failed or the service failed and the entire firm have to be closde down.

So, it means huge amount of the risk is involved for the new entrepreneurs also for the start-
up also, but because of this risk or existence of the element of the risk you cannot stop the
business activities any way you have to look forward you have to grow. So, it means the

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point of caution here is that you go for the business, you go for the new investment
opportunities, you go for the new investment proposals, but be careful and make a proper risk
analysis before making any kind of the investment in the market practically.

So, what are the techniques available? That is individually for the new projects before
starting making out the investment in the market we will have to make a proper risk analysis,
for that different techniques are there. And these techniques ae very commonly available in
the market and we can learn here and then any one amongst you want to apply them in their
own organizations while selecting the new projects you can make use of these techniques.

So, first technique is like sensitivity analysis, then is the scenario analysis then is the break-
even analysis, then is the Hillier’s model, simulation analysis and decision tree analysis. So,
these techniques are there to look for or to try to find out the risk involved in the project
which is been seen as a stand-alone facility that only to a new investment proposal. We are
not comparing it with existing products of the firm or the existing business processes of the
firm who is going to propose the new investment proposal.

Or we are not going to look for anything, we are only trying to find out that the firm, maybe
existing firm they are going to have only this project they do not have anything in the past.
There are not doing any kind of the business, this is the first project and if we make this much
of investment as required as per the DPFR, and we are expecting this much of the cash
inflows over a next 5 to 10 years foreseeable period. So, it means if this much investment we
are going to make this much of the cash flows we are expecting, so any kind of the
fluctuations are going to affect that project or not?

Our estimates in terms of cash outflow and cash inflow, are they correct? and you can
consider, they are nearer to the true or correct estimates, if they are not then we have to take
the corrective actions. So, that if we are anticipating what kind of the problems are going to
take place it may be possible there, sales we are anticipating per annum, they are not able to
attain those level of sales in the beginning of the year. So, it means if the sales are getting
affected everything else will get affected, your profit will become a loss and if the loss is
there then there will be the negative cash flow.

Similarly, we are anticipating out the variable cost, we thought that the raw material will be
available at this much of the price in the market, but if you do not anticipate then you can end
up paying the very high price for the raw material. So, what will happen? The cost of

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production will go up in the market and either you have to recover that increase cost of
production from the market by jacking up the selling price or if you are not able to jack up
the selling price, you end up making the loss.

So, in many cases you have to be very-very careful, I give you a example here, for example,
the products which are based upon the agriculture products, maybe the companies which
establish the new projects or the new investment they make in the market, establishing the
new units, new industries or new firms, when they create or the new products which they add
up. If they are based upon the agriculture products, maybe the agriculture products are been
used as a raw material.

So, many a times when we estimate the price of the raw material per quintal, per kg or per ton
that this much will be the price we will be paying to buy the raw material from the market
and then we will be processing that raw material and converting into the finished product. So,
we maybe estimating a price which will be payable at the time of the harvesting season, if
you buy the raw material in bulk and that to in the harvesting season then it may be possible
that you get the product that input at a very-very reasonable price.

Now, for example, some entrepreneur thought about establishing a mustard oil manufacturing
unit, it is a very simple unit, you have to have one or two expellers, you have to have the
cotton seed, you have to crush those seeds and then you have to have the main product that is
mustard oil that will be produced out of this process. And then the by product will be the oil
cakes which will be available and they can be used for manufacturing the cattle feed.

So, if we have a planning that we are going to establish this unit and we are going to
manufacture the mustard oil, so manufacturing the mustard oil you need the mustard seed and
mustard seed price is different. When you buy the mustard seed from the market at the time
of harvesting of the mustard seed and that to in the markets or the mandis, which are known
for say the mustard seed you go to Rajasthan you go to some parts of Haryana or some parts
of Punjab or even MP were the mustard seed is grown.

So, if you go at the time of the season and then you directly contacted with the farmers and
you as a first hand buyer without any kind of the middleman you buy their seed in bulk, so
you will be paying the different price. But if you plan to buy it later on from the mandis or
from the markets, now who have purchased and stored it, then the price is going to be totally
different. So, in that case even a expected or proposed or anticipated profit making mustard

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oil manufacturing unit may turn into the loss making mustard oil manufacturing unit, because
cost of the raw material we had anticipated was totally different.

Now, what we are paying here is totally different. So, must have seen that all this companies
who manufacture the products which are based upon the agriculture material like Parle’s, like
ITC, even to some extend the Hindustan Unilever, who are manufacturing this wheat flour or
may be the biscuits or may be even honey also, even some even talk about the Patnajali
largely most of their products are based upon the agriculture products. So, they have the
direct contact with the farmers.

Even these multinational companies who are manufacturing the potato chips they are, even
your McDonalds, the French fries which they are manufacturing and selling in the market,
they have the different quality of the potato’s and directly they have the contact with the
farmers, so that is the way they are going to manage the price. Otherwise, if they are going to
buy the potato from the market it may be possible that that quality of the potato is not
available and second thing the price which they are paying is very high.

So, the total calculations will get disturbed and whatever we are thinking about that may not
happen. A profit making project proposal may turn out to be a loss making proposition and
we have to close down the entire facility. So, when you go for this as a standalone analysis
we look at the different techniques which are available here, we can change some of the
variables and then we can go for the sensitivity analysis, we can go for scenario analysis,
break-even analysis and other these models.

So, practically we will discuss these techniques one by one, we will learn about how to
implement sensitivity, how to use a scenario analysis, how to use break even analysis for
making the risk analysis in the capital budgeting proposals, so that practically we can use it.
Second part of this risk analysis is the contextual risk. When you talk about the contextual
risk, 2 important components are here corporate risk analysis and the market risk analysis.
Corporate risk analysis is concerned only if some existing firm is going to start the new
project or going to make a new investment.

Then the outcome of that new investment can affect the existing operations of the firm also or
the existing processes of the firm also, because of every corporate, every firm the main
concern that pertains to is of the shareholders. Because all other stakeholders are external
stakeholders only the shareholders are the ones, the owners are the ones who are internal

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stakeholders. So, for the internal stakeholders the ultimate objective of every firm, every
business is the maximisation of the value of the firm. And when the value of the firm is
maximized shareholders are stand benefited to the largest extend.

So, if you are going to start a new investment process, the objective is that you want to add
up a new value, additional value to the existing value of the firm, so that the value of the
value of the whole firm is maximized. But if the project then which we are going to start,
adopt if that is turning out to be a risk making proposition or risk taking proposition, then
even the profit making capacity of the existing firm will get negatively hit or get negatively
effective.

So, we will have to look for that the new investment proposal is going to increase the value
for the existing shareholders or is going to erode the value for the existing shareholders, so
you be have to look it at that the impact should be synergetic. Means adding the value to the
existing value of the shareholders and if there is any factor going to cause any negativity we
will have to check for that. And then the market risk analysis, market risk is called as the
systematic risk also, market risk comes because of the different kind of the factors because
business depends upon the market.

And market has the different kind of the situations which some time create the problem even
for the well-functioning organizations. For example, the market situation is getting affected
by the interest rates in the market, inflation in the market, import export situation in the
market, purchasing power of the people in the market. Now, these days for example market is
negatively hit, that there is a recession in the market, Indian market is badly gripped by the
recession.

And you might have seen that recently to support the industry give some breathing period to
the industry during this recessionary period government had to reduce the tax rates from 30
percent to 22 percent. So, that tax incentives are given to all the sectors by the government
just to help the industry that for the time being, when the sufficient sales are not taking place,
when purchasing power of the people is negatively getting hit, so how we have to take care of
that.

So, market factors are there which we call as a systematic factor also, causing the systematic
risk. Normally what we do, when shareholders make investment in the market they do not
miss put all their eggs into one basket, they do not buy, total investment they do not make

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into the stocks of one company, but they keep their total investment sufficiently diversified.
So, that if there is one loss in one company they can have the profit in that other companies
shares.

Or if there is a loss in the one industry where there company belongs to where they have
made the investment, so there is a better performance by the other industry, so the loss in the
one company stocks can be offset by the profit or the dividend earned by the investment
made in the other companies stocks. So, diversification, normally the shareholders use to deal
with the systematic risk. But to a larger extend we have to anticipate that in future how the
market will behave, how the inflation will behave, how the intrastate will behave, how the
say demand and supply situation will behave?

What is the government policies will be? So, in totality we have to make this risk analysis,
we have to make the risk analysis for the standalone risk also, risk analysis for the stand alone
project also and risk analysis in the contextual way also, there we have to analyse a risk for
the firm as a whole which is going to start a new investment activity and to some extend
analyse the market risk also. So, the main focus in this discussion will be upon the standalone
risk, how to deal with the standalone risk which is going to be only to the new project and to
some extend we will deal with the corporate risk also.

Market risk analysis we will talk more while we will discuss and talk about the cost of
capital. There we will discuss this risk, contextual risk that is a market risk in detail, but here
also for the reference purpose we will be dealing with, we will be talking and discussing. So,
in totality we will be talking about all 3 kind of the risk and trying to find out the ways and
means how to deal with this. But the larger focus will be upon the analysis of the standalone
risk and the corporate risk.

So, I stop here with the initial discussion up on the Risk Analysis in the Capital Budgeting
proposals. And further more into this process we will go and we will learn about that how we
can apply the sensitivity analysis, scenario analysis, break even analysis and the other
techniques or the methods and models given for the analysis of the risk in the standalone
projects. But that we will be doing in the subsequent classes. For the moment I will stop here
with this initial discussion and remaining discussion we can have in the next class, till then
thank you very much.

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 Financial Management for Managers
Professor. Anil K. Sharma
Department of Management Studies
Indian Institute of Technology Roorkee
Lecture-41
Risk Analysis in Capital Budgeting Part II

(Refer Slide Time: 00:46)

Welcome all. So, in the previous class while initiating the discussion about the risk analysis
in the Capital Budgeting Proposals. Now, we will be talking about the say the next part of the
next important component of this particular topic, the Risk Analysis is the Sources and
Perspective of Risk, Sources and Perspective of Risk. That from where the risk comes? What
causes a risk to the investment proposals, capital investment proposals?

And how to deal with that? Because if you know the source of the risk then we can probably
try to find out the remedies also that, yes, if this kind of the risk comes I will deal with this
risk this way and if that risk come comes I will deal with the risk that way. So, yes, first we
have to try to find out the source of the risk and type of the risk and then once we know the
source and the type of the risk, we can try to find out the remedies, ways and means also how
to deal with that risk.

So, first try to let us try to know about the sources of the risk. And when you try to know
about the sources of the risk these are the 5 important sources which cause the risk through
the capital investment proposals like project specific risks are there, then competitive risks

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are there, then industry specific risk are there, market risk are there and then we have the
International risk.

So, when you talk about the say project specific risk, project specific risk can be that when
you talk about the project specific risk in that case what we have to do is that we have to say
estimate the cash flows which I discussed in the previous class also and main cause of the
risk is the estimation of the cash flows, because there can be any kind of the error and if even
a minor error is there in estimation of the cash flows that may cause a big loss, that may be
cause big problem.

So, in the project specific risk major source of the risk is, major cause of the risk is the cash
flow estimation. Because in both ways when you estimate the say investment we are going to
make in any project, whatever the investment we are anticipating or we are planning that may
be not up to the mark, so or cannot be means correctly anticipated or estimated. So, if the
cash outflow increases or start increases increasing or it unendingly increases.

So it means we are planning for some amount and it is becoming 2 times or 3 times of the
planned amount, so it means in that case the problem comes up and we will have to means
deal with that problem. So, cash outflow estimation should be correctly done and if we know
that how much is require for this investment or this proposal, how much investment is
required then I think we should be prepared for making that much investment some
difference of 5 - 10 percent even 15 percent can be taken care of.

But if it becomes 100 percent, 200 percent, 300 percent then I think it is going to be may be a
profit making proposition can become the loss making proposition, so that is one. Second is
the say as I told you in the previous class also estimation of the cash inflows, because they
depend upon the market and when you go for conducting the market survey you ask the
potential buyers or the people that if this product comes in the market if this services comes
in the market would you like to buy it, yes, people may say, “Oh! Yes, if this survey comes I
am looking for this I am waiting for it.”

But actually when that product comes in the market, when the services comes in the market
some time people do not like the feature in terms of taste, in terms of quality, in terms of the
size, in terms of the say price even sometimes and sometime people feel that yes this is not
my requirement at the moment, I can postpone my need. So, simply at the time of conducting
the survey people have the different opinion but at the time of actually buying the product

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when it is available or it is provided to them people have different opinion, so that affects the
cash inflows.

Because sells are affecting the revenues and revenues are affecting the cash inflows, because
ultimately, the source of cash inflows is the sells and sells depend upon the acceptability or
non-acceptability of the product by the people or non-acceptability of the service by the
people. So, major source of the risk which is called as the project specific risk is because of
the error in estimation of the cash flows. Then is the competitive risk, then is the competitive
risk, competitive risk is because of unanticipated emergence of the competitors in the market.

Or sometime unanticipated actions of the competitors in the market. Now, for example, you
talk about the emergence of Jio in 2016, Airtel and Vodafone and Idea these were the
companies who were giving us mobile service. And when Jio came up in the market, they
came up with the such a lucrative schemes, that for a few initial months they started given the
service free of cost, now who can afford to give the service free of cost, means as a
promotional expense they treated as a promotional expense.

They knew it that this market is competitive and existing very you can call it as strength full
sound player are existing in the market, Airtel in already there in the market, Vodafone in
there in the market, Idea is there in the market, even BSNL is there in the market and if we
have now say become the another service provider in the market, we have to give something
different to the people.

So, with the emergence of the Jio or with the entry of the Jio reliance Jio in the market, you
see that even it was a time we have seen that we were means we were being given the 1GB or
2 GB or 1.5 GB data for 300 rupees. And we were is very carefully using that data that we
were when using it for internet surfing and we see how many MB’s of the data we have used,
but today is the time when you get how much? You get say 1.5 GB data per day, 1.5 GB data
per day and the price you are paying is somewhere is 300 to 400 rupees.

So, the telephone expense, your mobile expenses have means significantly fallen and this has
created the problem for the existing telephone mobile service providers, but Jio had to adopt
this strategy for say making their presence in the market, for entry in the market. So, in the
one sense it was the win-win situation for the users of the mobile services, but it was the
very-very pathetic situation a pathetic state of a fears for the existing mobile service provider
or the companies who were in to this particular sector.

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So, that as a result of that to deal with this competition or to sustain in the market Idea and
Vodafone had to move into say for forming the joint venture, now they are means a one
company because they thought there is competition coming up from the Jio in the market, it
will not be possible for them. Vodafone means it is a multinational company UK based
multinational company, but they also could not means stand with the competition and they
had means find out a strategy.

So who had anticipated that Jio will come means nobody even thought about that Jio will
come in the market and when they will come to the market, they will come this way in this
big way that means it will create a problem. It was a challenge to Airtel also who is the leader
in the mobile telephony market, it was a challenge to them, even for some period of time
Airtel turned into a loss making business or maybe the loss making company from the profit
making company. Even today, the profit of the Airtel is not very high.

So, this changes takes place in the market. Another very good example I would give you here
is that if you go back little in say ’98, ‘99 or 2000, in the electronic segment in India only 2
names were there Onida and Videocon, means people used to think about that if I am able to
own a Onida colour TV, I am really going to be a different person in the society and even the
say advertisement of the say Onida products was sometime like that it is the neighbour’s
envy, owner’s pride.

They were using this was the punch line of Onida neighbours envy, owner’s pride, so it
means people used to consider at the time to buy a Onida product and it was a means a proud
moment for the people when they use to acquire a Onida product. But where is Onida today,
where is Videocon today, there was a time till even ‘99, 2000 I would say they were having
the 45 percent market share in the electronic segment, means almost half of the market was
with these 2 companies and today there market share is just 1 percent 2 percent.

So, it means who has anticipated that competitors actions will be creating so series problems
that in case of electronics market just I am talking to you is that the idea, sorry say your say
Onida and Videocon who were the leaders in the market they are completely removes from
the market by this Korean and Japanese companies, Samsung and LG, 2 Korean companies
and Sony from Japan they had and some other means you can call it as in the row.

There are some Chinese companies, Xiaomi and others also there in the market even say
other companies, small companies are also there in the market. So, the leaders in the market

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who had 45 percent market share they must not have anticipated that Samsung will create
such a problem, LG will create a problem, Sony will create a problem or some Chinese
companies will create a problem to them in their electronic market and even the survival of
this leaders will become a challenge.

But it happen in the market. So, it means it is if it comes at the later years, for example, Onida
had already recover the investment they had already made sufficient profits and they had
means already means crossed that threshold level, then there is no problem. But in the
beginning itself once you are means just recovering your investment or you are looking for
forward that we had anticipated with the 5 year peaceful years, but from the second year
onwards the third year onwards competitors started given the problem, then it creates a
problem.

So, it becomes a very serious challenge, means the competitive risk becomes a serious
challenge for the firms who are new in the market, if they are establish firms in the market
shares may keep on means dwindling like some time it goes up sometime 1 - 2 percent is
goes down, then it does not make a difference. But means Airtel yours say Idea your
Vodafone could sustain in the market, because they were already a establish player in the
market. But if a new player comes in the market, for example, there was one company
Uninor, that could not sustain in the market they had to means sell of the business, there was
the Tata teleservices.

So, there Docomo was the service from the Tata teleservices that could not sustain the
market, they had to go out of the market and that all happen because of the risk caused by the
competitors. So, competitive risk is the another risk which is sometimes even never
anticipated and can create the serious problem. So, we have to be very careful in analysing
those risk. Then third risk is industry specific risk.

Third risk is the industry specific risk that sometime the industry has a hold gets negatively
affected, Say, now you talk about these days there is a hue and cry with regard to the plastic
industry. People are disliking the plastic products right from the polythene bag to the normal
plastic products, even people have started talking about that, even the government should ban
this bottled water, that this processed water that even this water is not good because this
companies are not producing water, this companies are producing bottles.

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So, means huge output of this huge manufacturing or maybe sell of this plastic bottles is there
and people have started rejecting it. So, means there was a time when polythene bags were
manufacturing of the polythene bags were supported by the government, even the employ
unemployed youth through the district industry centres were provided the loans also financial
assistance also the were ask to establish the polythene bag manufacturing units.

And they were even assisted by the to by the unsold product. Because output from even a
smallest say capacity plant capacity of manufacturing the polythene bags is so high that even
after selling huge sell say part of the production in the market some production remains
unsold which sometimes at that time government had to ensure the people that if or not able
to sell your 100 percent production in the market we will buy it from you.

And today you that how the say plastic industries scenario is? People are rejecting the
products we have realised it that plastic is not good for the help, plastic is not good for the
environment, plastic is not good for the ecology, so whole industry is under scanner now,
whole industry is under the threat. So, it means now the people who are into the plastic
product manufacturing business they must have started looking for the alternatives because
they know it that certainly is going to be a problem.

Another important thing could be that, for example, now these days we are talking about the
say electrical cars, now they are coming in the market in many companies have already
launched the vehicle and some are testing them. So, it may be possible that today oil and this
gas industry which is the fossil fuel I would say petroleum industry which is means they are
making dollars, they are making huge sales entire world is depending upon the Middle East
countries. But a time may come that this product is not required, this product demand for this
product may be even maybe may be cut down to half or maybe sometime 25 percent.

Because all your transport vehicles will be running on the electrical this fuel or the electrical
power. So, any time the things may change and when things may change then certainly what
happens, your sales declined, when the sales decline revenue is declined, your everything
your total cash flow statement get disturbed, your balance sheet get disturbed, even the well-
functioning organization initially becomes sick and then later on they have to be close down
or they have to liquidated.

So, industries specific risk is always there which I think people cannot very easily anticipate,
to some extend we can anticipate by the budget of the government. Every year when the

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budget is presented then the government gives some signals or some hints that budget
documents of the signals some hints to the people that which are the sectors, which are the
industries going to be supported by the government and which are the sectors are not going to
be supported.

So, it means government policy to a larger extend can help us to anticipate to find out that
how the market will behave and how the industries will get affected by the government
policy. That maybe the one indication or sometimes you can study and you can evaluate the
performance of different industries by studying the international trends. That in the other
countries which are the industries now coming up or being supported or being appreciated
and which are the industries or the products in the industries are getting discouraged.

So, we should move into that area which has the future, which has the time, especially when
we are going to start a new investment process and we are going to be a new entrepreneur in
the market, we are going to have a start up in the market or we are going to maybe even a
existing from going to add up a new facility. So, we should be very careful that future of that
industry should be secured, or the industries specific risk should not be creating a problem.
Then we talk about the next is market risk. Market risk I have already talk to you in the
previous class also, we call this risk as a, you call it as say systemic risk.

And systemic risk comes not because of one or other factors it comes because of the whole
system or the whole market. And market or the system gets affected largely by the micro
factors intrastate, inflation rates, export import, situations agriculture production or may be
the output of the similarly other industrial products in the market, demand for say demand
scenario in the market, supply scenario in the market all these things. Now, these days, for
example, recession is say affecting or hitting the Indian market where the purchasing power
of the people is down.

Now, RBI has reduce the repo rate by initially by last weak also by 0.25 percentage, 0.25
percentage point and it is they are expecting that you it will add further liquidity in the
market, loans will get cheaper and demand for the credited will say going up in the market
and will people willy availing more credited facility it will help you or say manufacturing
sector it will help your housing, it will help your even say the services sector also which is
negatively hit these days.

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So, different actions are taken by the government also by the regulators also, but largely the
risk the market risk comes because of the government policy, because of the regulatory
environment in the country and nobody can anticipate how the things will take place. But
means we should try to handle that if any change in the market takes place how we should be
taking care of that situation. So, means the point here is anticipating in advance, what is
going to happen in the market?

If you are able to anticipate and to guess what is going to happen in the market, I think we
can we means prepared about that how to take care of those kind of negative developments in
the market. And last one is the international risk, another source of the risk is the international
risk. This risk is largely to those firms, or those projects, or those investment proposals,
which are going to depend upon the say import and export processes, international trade I
would say.

And you cannot say that always international trade is affecting the large scale industries, even
the small scale industries, even the tiny units, even the tiny units are say getting affected by
the international factors. For example, we talk about in this northern part of the country
Ludhiana; we are the hosiery products are being manufactured by the people even are the
household level, they have started very small units, machines they have means say placed at
their houses and there are producing very good quality hosiery products.

And they are not selling those products in the market, they have the contact with the
exporters. So, exporters are buying their entire production in bulk and they are exporting to
other countries and supporting their business. So, it may be possible that sometimes when the
say demand in the other countries for the countries products changes, certainly it gets means
it effect on the manufacturers in the host country. For example these days the relationship
between India and Pakistan are passing through every, we can call it as a say bad phase grim
phase, so it has affected both the sides.

For example, vegetables and fruits are getting say the prices are soaring going up. But we
have seen the change in India also, the prices of the dry fruits, the prices of spices which are
importing from Pakistan they are means toughing, means rocketing sky high. So, it means
then the relationship with any 2 countries means improve or get means worsened or
deteriorated, it affects. Another case is the say exchanges it, when exchange rates get affected
it means your imports becomes costlier your exports become cheaper.

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Similarly, means say, for example, in case of the rupee dollar exchange rates, so if the rupee
is getting you call it as costlier then it is a direct effect that your say imports are becoming
cheaper and your exports are becoming are becoming dearer. But if the rupees becoming
means cheaper you have to sell out more rupees to buy the dollars, it has the means negative
effect upon the international trade. So, exchange rates, similarly your export import scenario,
similarly your say relationship of the 2 countries bilateral relationship of the 2 countries.

They affect the businesses and they affect all kind of the business, small business, medium
business, large business. When the car industry is getting hit, because say demand of the
Indian cars in the other countries is getting say reduced, even the hosiery industries also
getting hit, so car industry is a large scale industry, but the hosiery industry even a small scale
industry and both are getting hit, so it means international factors can also cause the risk. So,
we will have to be careful before establishing any unit or going for any investment decision.

That what are the potential sources of the risk and if any risk comes up in ever this
investment process how to take care of that. So, these are the 5 different sources we should be
means analysing and knowing them in advance and then we talk about the perspective of risk.

(Refer Slide Time: 22:52)

As I have discussed in the previous discussion also in previous class also that when you talk
about the say perspective of the risk or the even the techniques of the risk, we have seen that
technique of the risk we analyse in 2 ways that in terms of the standalone risk or risk for the
single project or the contextual risk.

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(Refer Slide Time: 23:02)

And here also in the case of the perspective of the risk that in what perspective you are
looking for the risk you are anticipating the risk, is it a standalone project risk or you are
talking about the firm risk or you are talking about the market risk. So, we have to manage
these different risk in the different manner. Standalone risk has to be manage differently, for
example, if there is a demand supply problem, so you have to look for how to improve the
demand for your product which is only means affecting the product in question or the project
in question.

It is not affecting the firm as a whole, it is not affecting all the say products other products of
the firm, so which risk we are talking about? In that perspective we have to look for the
solution, or you are talking about the firm risk, corporate risk, so if it is a corporate risk we
will have to look for that this project is positively supporting the firm or negatively affecting
the firm. And then if the standalone risk is causing the corporate risk also then both have to
be taken means together or to be seen together.

And we have to find out the corrective action or the solutions for say doing away that
particular kind of the problem. So, means perspective should be very clear or it is a market
risk. If it is a market risk then what do we do means you talk about the 3 risk, standalone risk,
corporate risk and the market risk. In the stand-alone risk what we do is, because ultimately
the objective of every business as I told you earlier is the maximization of the firm’s value, or
the maximization of the shareholders’ value.

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If there is a standalone risk but the firm is already existing, they have added a new product in
the market, so in that case, it is going to affect the profit of the existing operations of the firm
and ultimately the value of the firm will get eroded or negatively hit, so value of the
shareholders will get a negatively hit. So, for that purpose we will have to say look for the
solutions which are going to resolve the issues with the standalone project, so that it does not
affect the performance of the firm as whole.

When you are correcting the stand-alone projects problems you are automatically correcting
the firm’s problems. And then if there is a market risk then the strategy has to be different,
that for that what the shareholders do? Shareholders use the diversification strategy; they do
not make their investment, total investment in one business. If they are small shareholders or
retail shareholder, retail investors who are buying the stocks from the secondary market, in
that case they buy the stocks or they make their investments into the different stokes of the
different companies.

Warren Buffett the say you can call it as the best known investors in the market, best known
investors in the market Warren Buffett. He always advices the people, he says 2 things, 1
thing is that you do not put all your eggs into 1 basket, one, and the second thing you take
risk with the because without taking risk you cannot grow in the market, but always take
calculated risk. So, calculated risk and not putting all your eggs into one basket can be the 2
strategies to deal with the market risk.

So, diversification, investors do so that the loss in one say companies stocks can be made
good by the profit in the other companies stocks. So, depending upon the perspective we have
to find out the resolution or the way out, the remedy of the problem, so different 3 type of the
contexts are there, different 3 types of the perspective are there and different 3 kind of the
solutions we have to find out. What we should be knowing the perspective in advance? We
should be knowing the say the context in advanced and if we know it that firm way are the
potential is expected to come, we are prepare to deal with that.

So, this all is very important and required to be known in advance, so that we can take care of
the risk which is going to affect the firm negatively in the market. Then we now move
forward to the next part and now we start learning about the techniques of say taking care of
or dealing with the standalone risk. First we will deal with the techniques of the standalone
risk then we will move to the say techniques of the corporate handling the corporate risk. And

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as I told you the market risk we will talk more about the market risk while we will discuss the
cost of capital approach or the cost capital topic.

So, now we move to the different techniques of dealing with of or handling the say or
analysing the say standalone risk and first technique is sensitivity analysis, first technique is
sensitivity analysis. Now, what is the sensitivity analysis? We have seen that in the previous
slide we have seen 2 techniques are there majorly there are 2 techniques, 1 is the sensitivity
analysis another is the scenario analysis. In the sensitivity analysis, we try to find out how the
project is sensitive to the different variables, which are going to, which are going to affect the
cash flows of the project.

How sensitive the project is? How sensitive this investment proposal is towards the different
variables, which are going to impact the cash flows of the product of the project. Now, there
the different variables, one is the investment you are going to make, if the say outflow, the
investment which is required to made is so high and cash inflow is expected in relation to that
are not that much, so it means but the project will end up a loss making proposition. So, we
have to now, what we do in the sensitivity analysis?

One by one, we pick one factor, we take one variable, we change the value of one variable at
a time and then we see changing the value of one variable at a time how to impacts the NPV
of the firm. For example, we change the one variable is the investment what it much, how
much investment is required to be made? For example, the optimum amount we have already
worked out. So, we increase that investment, we say that no it will not be requiring 2 million
rupees, it will be requiring 3 million rupees.

For example, if 3 million rupees of the investment is required other factors remaining same,
how the NPV of the project will get affected? Then we change another factor we bring that
investment factor back to the pavilion again but then we change the another factor for
example senses we are anticipating we will be selling 1000 units per month if we start
manufacturing and selling the product in the market. Now, we say that no 1000 will be too
high we will be selling 500 units only, so in change the sales and keep other variables a same
and then see how the NPV of the project gets affected.

Similarly, change the variable cost, change the fixed cost and then see changing one variable
at a time how it is affecting the NPV of the project because minimum decision making
criteria requires there NPV of the project has to be 0. If it is positive very good, but if it is

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negative, it is not acceptable. So, we have to ultimately find out the NPV of the project and
when we apply the technique of sensitivity analysis for the project risk analysis we change
one variable at a time out of the given variables.

And then we try to see that if one variable is changed how it is going to impact the other
variables or the means the firm as a whole and the NPV of the firm is going to be get
affected. Whereas in case of the scenario analysis, in the scenario analysis we change more
than one variables at a time, we do not change only one variable, we change more than one
variables at a time and then we see that, for example, your investment is becoming higher
than anticipated.

Your sales are getting lesser than anticipated, your fixed cost is means going up more than
the anticipated, your variable cost is say going up more than the anticipated, so you will
create 3 scenarios in that case. The pessimistic scenario means optimistic was created,
because when we are preparing the DPFR we have created some estimates some situation we
have already calculated NPV and that scenario is called as the optimum scenario, most
optimum or the you can call it as the optimistic, not optimistic I would say the optimum
scenario or the most likely scenario.

But then you create 2 more scenarios, 1 is the most pessimistic scenario and then 1 is more
most optimistic scenario and then you try to see that if we create these 3 scenarios, if there is
most likely situation in the market we have already anticipated, we have already done the
calculations and we have already found out how much NPV will be there and that is why we
are taking the decision of making this investment. But if the pessimistic scenario comes up in
the market, then what is going to happen?

Should be go still go for the investment or if you the optimistic scenario happens, how it
positively it is going to affect the firm? So, all these factors we have to bear in mind, in case
of sensitivity analysis change the variable only one variable at a time and see the impact on
the whole of the firm’s performance and see how the NPV of the firms behave. In case of the
scenario analysis you change more than one variable at a time and then see how the whole
firms NPV behaves and how say the cash inflows and cash outflows means behave get
affected and how we can deal with that situation.

So, these 2 techniques are very means you can call it as prominently used in the risk analysis
of the capital budgeting process. And say on the basis of sensitivity analysis and on the basis

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of scenario analysis say many decisions are taken and finalised and risk element which is
associated to any investment proposal are say anticipated in advance. So, how we can apply
the sensitivity analysis, how we can apply practically the scenario analysis, I have got some
problem which are done here, we have already means anticipated the problem we have the
solution here, so we will discuss that in the next class.

And similarly we will do for the scenario analysis also, so one means say anticipated problem
or may be a problem like the one anticipated problem in case of the sensitivity scenario or the
breakeven analysis we will do here and then later on at the end of this say fundamental or
conceptual discussion I will do some problems, so that you can learn practically, how we can
analysis the risk associated to the capital budgeting proposals. This all sensitivity analysis and
scenario analysis and the practical problems associated to that I will do in the next class. For
the moment, I will stop here. Thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 42
Risk Analysis in Capital Budgeting - Part III

Welcome on. So, now, we will learn about the techniques of risk analysis and first technique
we are going to discuss in this class is the sensitivity analysis, that how sensitive the project is
or the investment proposal is towards the different variables. And when we change one
variable out of the different variables, may be the investment is one variable, which is a cash
out cash outflow.

And then if we change the sales as one variable or we changed the variable costs as another
variable or we changed up Fixed Cost as another variable, so how it is going to impact the
NPV of the project. So, we have created the situation here assume that this some company,
who they want to miss add up this new facility here, maybe you assume that it is a flour mill
and say, Raja flour mill, we can assume that they want to start up a new flour mill, they want
to establish a new flour mill, and they are evaluating the investment proposal carefully.

(Refer Slide Time: 1:49)

And they have estimated that how much investment is required in this new business and how
means the other factors are going to be there. So it means, we can see this total information
given here and if you talk about in this case, the investment requirement of the firm is how
much this information or these figures are in thousands. So it means it is the 20,000 thousand,
it means how much, it is 2 crores, the investment of the 20 million is required.

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So, this is the investment estimate, which has been estimated on the basis of the detailed
project feasibility report, largely based upon the technical analysis (include) included in that
report. So, technical analysis is that the requirement of the land, building, plant and
machinery, total investment requirement we have anticipated is that for establishing the flour
mill you need to spend minimum 20 million rupees or 2 crore rupees.

So, this is the investment which has been estimated here. And then we have the similarly, the
other variables say, out of this total say, analysis we have found out and the first thing is the
revenue that is because of the sales. How much sales are going to be there and what is going
to be the annual revenue? And the time period taken here is the 10 years. So, for all the 10
years, we are going to take the same figures, they are not going to change, means to this is a
limitation of the say this kind of analysis but still not doing anything is always better to do
something.

So, we have anticipated keeping the things simpler that sales are expected to be say how
much, 1 lakh and 80,000, sorry 1 crore and 80 lakhs, 1 crore and 80 lakhs and every year this
much of the sales are required. So, it means total sales are 18,000 and with these the figures
are in thousand.

Similarly, the say variable cost, if you talk about variable cost is two third of the sales and if
we talk about the variable cost this is going to be your 1.2 crores and similarly, the fixed cost,
fixed cost is expected to be it is say 1 million rupees and then the depreciation we are going
to say follow here as the say which one that is a straight line method, fix instalment method.

And we have calculated the depreciation here which is a you can call it as how much 20 lakhs
of the depreciation is going to be there, 2 million of the depreciation is going to be there,
because 20 million you are going to be the say total investment we are going to make. So, it
means the depreciation is going to be 10 percent and the salvage value expected out of it is 0.
So, total plant and machinery is going to be depreciated at the end of the 10 years.

Pre-tax profits if you see we have calculated here are say 30 lakhs and the similarly your
taxes we have calculated here are 1 million that is one third is the tax, tax rate is 33 and 1 by
3 percent is a tax rate. So, we have calculated these taxes here and after that profit after tax
calculated is 20 million, 20 lakhs or 2 millions and cash flow from operations is where we are
taking only two things. One we are taking depreciation and second we are taking the profit
after tax. So, cash flow from operations is the 40 lakhs.

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So, 4 million is the profit cash flow from the operations because the profit is 2 millions and
the depreciation is 2 millions. So, the cash from the operations is cash flow from the
operations is 4 millions or the 40 lakhs and finally, the net cash flow is the same amount,
there is no other change, this note terminal cash flow or something like that, because salvage
value expected from this investment is 0. So, and depreciation is rate is 10 percent.

So, we are going to depreciate this investment over a period of 10 years and at the end of the
ten years period of time entire the structure will have the 0 salvage value. So, we are
calculating the depreciation here as per the SLM method. So, if you look at all these
estimates, if you look at all these figures, then you can say that, say your sales are 1 crore 80
lakhs, your variable cost is 1 crore 20 lakhs, there your fixed cost is say 1 million, your
depreciation is 2 million, your pre-tax profit is 3 millions.

And because similarly, we are going to calculate this, variable cost we have calculated here is
some amount and from this say sales minus variable cost is how much, 18 minus 12 is 6, and
from the say this 6 we are going to subtract furthermore 6, fixed cost is the 1 million and then
the depreciation is 2 million. So, your profit before the taxes half that is 50 percent that is 3
millions and taxes are 1 million. So, it means profit after tax is 2 millions, 20 lakhs and cash
flow from operations in total adding up the depreciation into the profit after tax is 4 millions
and net cash flow is the same amount.

So, it means when you are going to get this net cash flow means this is without any kind of
the sensitivity analysis. This is basically the cash flow estimation, this is basically the cash
flow estimation. And after that, when we have say discounted these cash flows, when we
have discounted these cash flow. So, we have discounted these cash flows, we have
calculated the NPV. So, it is done here.

NPV of the project has been calculated that the total investment is how much this is the 20
millions of the investment is going to be made, 2 crores of the investment is going to be
made. And out of this the say the total cash flow available is how much it is available as the
40 lakhs of the four millions, but this is in annuity, this will be available, this cash flow will
be available for a period of next 10 years. This is in the annuity. So we have multiplied it by
the factor.

So how we have calculated this value. Let us do it, we can do it, we can calculate the NPV of
the project. By say discounting the cash flows, since the cash flows are going to remain same,

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so you can treat them as the annuity cash flows, cash inflows, because 4 million are going to
be available, 40 lakhs are going to be available all the 10 years. So, we can calculate the NPV
of the project.

(Refer Slide Time: 8:10)

So, it will be something like this, it is how, it is you can say that is the investment we are
going to make is 20 million or 2 crores. So, this investment is here we are making this is the
in minus, then plus how much is 40 lakhs, we are going to make this 40 lakhs. So, 20 million
or 2 crores you can say, 2 crores is the investment and every year you are going to get the 40
lakhs or 4 million of the cash inflow and that to for the next period, next 10 years period of
time.

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So, you can treat it as annuity. So, you have to discount it with some factor which is known
as PVIFA, you have the different table and table values or different process for discounting
the cash flows which are in annuity and r we have expected taken here is the cost of capital
we have taken here is that is 12 percent and n taken here is 10 years that is already given to us
and taken here is 10 years.

So, it means, finally, the value which we are going to get here is this is 2 crores. So, in this
case 2 crores value is going to be this much, mine 2 crores, yeah 2 crores plus minus 2 crores
plus 40 lakhs, 40 lakhs into the factor value when we have seen the table, the value of the,
this factor is 5.650. The discount factor we have applied for the present value interest factor,
we have applied it for the annuity and when you multiply it this and when you solve this
entire process, you will get here that the NPV of the project, NPV of the project is rupees 26
lakhs.

NPV of the project is 26 lakhs. It means when you solve it, so we have found it out if you
multiply, this you will find out some figure like you can call it as 2 crores 26 lakhs. This is
that I think outcome coming out if you multiply this by this factor, so this will come out as 2
crore 26 lakhs and we are already making the investment of how much, the total investment
we are making here is that is of the 2 crores.

So, it means finally your NPV of the project is 26 lakhs we have calculated here, this is the
NPV of the project and since NPV of the project is 20 lakhs which is a positive NPV. It
means the final outcome of this analysis on the basis of the cash inflow and outflow sees that
he has the project can be taken up and we can go ahead with the proposal. So, this is the
result of the most likely estimates that yes, if everything goes well, then our say anticipated
things will happen like that and we are going to have a positive NPV of this amount of 26
lakhs.

So, it means it is a positive proposition, is a good proposition, is a good investment proposal

and our cost of capital we are applying here is 12 percent. But now, as I told you that we have
to apply the sensitivity analysis, we have to go for the risk analysis. So, this risk analysis
done in the lower table, where we have say created the three scenarios, but these three
scenarios are not say based upon say changing or bearing the multiple variables in one go,
only one variable at one point we have changed and then we have seen the impact upon the
NPV.

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So here you, for example, you take the first variable is the investment we are taking. Here we
have taken the first variable is a investment, most expected or the most likely scenario is this,
where we have anticipated that 20 million of the this is the rupees in millions we are taking,
so it means that in the most likely scenario, in the most expected scenario 20 millions of
investment is required to be made in this project. And if 20 million of the investment we
make, if there is no change in the investment if then NPV of the project will be expected is
2.6 million.

But when you change it, you only varying only one variable at a time, if you change the
investment and move towards the pessimistic side set and not expect that only 20 million will
be required to be invested, we can say 24 million will be required to be invested. So when
(to) investment goes up by say 4 million, so you can say, finally the NPV, other factors are
remaining the same, we are not changing, so NPV of the project becomes negative that is by
0.65 million.

The NPV of the project is negative and the NPV of the project works out this like this. And in
the optimistic scenario, we are saying that we are not required to shell out 20 million rupees
rather it will be sufficient to invest 18 million rupees and if the investment goes down other
factors remaining the same, your sales are same, your variable cost is same, your fixed cost is
same, your depreciation is same. So, it means because depreciation will come down anyway.

Because it will be 10 percent so it will come down because the investment has come down to
18 million. So, it will come down to not, it was 2 million to 1.8 million. So, it will come
down accordingly. And finally, the NPV of the project will be in the optimistic scenario will
be 4.22 million, so it will not be 2.60 million, but it will be 4.22 million, it will go up,
because your sales are remaining same, your variable cost is remaining same, your fixed cost
other than depreciation is remaining same.

So, it means your NPV will have the positive impact. Second thing you can change the sales.
If you change the sales keeping the other factors the same, then this is going to be the NPV.
Because most likely scenario was 1.8 crores, 18 million of the sales were expected to be
made. But if the sales come down to 1.5 crores or the 15 million, then the NPV will also
become negative by this amount and if the sales go to 21 million, then the NPV of the project
will become say 6.40 keeping the other factors same.

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Similarly, we talk about the variable cost, if you change the variable cost, because variable
cost as a percentage of sales, because we have taken the variable costs as a percentage of
sales here and that works out as 66 and 2 by 3 percent. So variable cost we have taken here it
is the most likely in the most likely scenario, it will be 66 and 2 by 3, but it goes up to 70.
What will happen? This will happen. If it comes down to 65 this will happen, in the normal
circumstances, the NPV of the project will be same in the most likely scenario.

Fourth variable we have changed is that is the fixed cost, fixed cost normally is expected to
be other than depreciation, is expected to be 1 million rupees, but if it becomes 1.3 million
rupees, what will happen, this will happen, your NPV will be positive but will come down
from the 2.6 million to 1.47 million and if it goes down from the 1 million to 0.8 million, 80
percent of the most likely scenario, so what will happen?

This NPV will become this that is 3.33 right and in the most likely scenario, this is in any
way going to be there. So, this all analysis is done to apply the technique of sensitivity
analysis and sensitivity analysis be call it because how sensitive this investment proposal is
towards different variables that if one variable is changed at a time and other variables remain
the same, how this proposal will be looking like and what impact upon the NPV will be seen.

So, we are say trying to find out the sensitivity level of the NPV of the project because or say
towards the, say the variables towards the variables of the project and variables are
investment, variables are sales, variable is your variable cost, your fixed cost, your
depreciation all these variables. So, how sensitive your NPV or NPV of the project is towards
the different variables making the total project.

So, this analysis has been done like this. And I would tell you here I would like to share with
you that this is the most widely used analysis in the practice for every investment proposal.
Normally, we do the other kind of analysis also because one analysis is not complete is not
sufficient in all the cases we do other analysis also, but sensitivity analysis is always done.
And along with the sensitivity analysis, we can do the scenario analysis or we can calculate
the breakeven point or we can do any other kind of analysis.

But sensitivity analysis is always done, why we do it, because of certain say positives
associated with this method. What are the positives associated with this method? That say, we
want to find out by applying the sensitivity analysis that how sensitive the NPV of the project
is towards the different variables. So, it means how robust or how vulnerable other way

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around you can say sensitivity is seen as in terms of the robustness or the vulnerability of the
different variables and how they are going to affect the NPV of the project.

This is the one important thing and sensitivity analysis makes it possible so we use this
method. Second important positive of this method is that we can say that if they are going to
be some factors, which are going to create a problem, means, for example, sales are not going
to be as anticipated. For example, if your variable cost is not going to be as anticipated,
because we have seen the risk factor also, we have seen the negative part of the project also,
then how to contain it.

So, out of the different variables, out of the different variables applying one by one and
seeing the sensitivity of the change in the say NPV because of the change in one variable, we
are able to find out which variable is going to be the most vulnerable with regard to the
performance of the project. And if that is known in advance, we can take the corrective
actions, we can take corrective actions.

If more than one variables are there, then certainly we can take corrective action against all
but at least if the one is found, then we can contain the say the risk involved in that and the
corrective action can be taken. And third important the part of this this particular method is, it
is very simple to apply and very say easy to implement this method as far as the risk
assessment of the project is concerned.

There are some negatives also associated in this and when you talk about some negative
parts, the first negative part of this sensitivity analysis is that we can say that, say, for
example, we are talking about the sales are not going to be anticipated, but they are not going
to be as anticipated but less than that. So, we are saying that in this case, for example, we
have seen that sales are not going to be your 18 million, but 15 million. Now, what is the
basis of this change in the sales?

Or how likely it is going to be there, certainly be there and going to affect the performance of
the project? How likely? So, that likeliness is not answered by this technique, the technique
only says that if sales go down, if sales go down, but will happen, but how likely it is sales
will go down and how likely it is sales will go up that is not answered by this technique. So,
this is one more important limitation of this particular method.

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Another limitation is that we change only one variable at a time, whereas more than one
variable must be or may be affecting the performance of the project. So, for that we have the
solution in terms of the scenario analysis, but sensitivity analysis you can see, you cannot say
straight way rule out that this is not at all a good technique or acceptable technique, it has
many positives, it has many say associated benefits with it.

And third important limitation is that this is a treated as a very subjective analysis. Some
experts rejected that this analysis is very subjective analysis because all these changes we are
say making for creating different scenarios. Whether it is a pessimistic scenario or the
optimistic scenario, we are only expecting that this will happen or that will happen. But that
is only based upon the human estimates, though people are expert who make all these
estimates make all these changes, they are good consultants, they are good experts, they have
good long standing experience in the market.

But still the element of subjectivity is more in this method. So, because of these some
limitations, people criticize it. But you can still say this criticism is more theoretical and
practically, the method is very-very useful and hardly there is any investment proposal where
the risk analysis has to be done and the sensitivity this analysis is not done is the first and the
foremost. As I told you in the capital budgeting proposals, evaluating the capital budgeting
proposals, payback period method we cannot afford to ignore.

Maybe we can go for discounted criteria also but even the non-discounted criteria and in the
non-discounted criteria you cannot afford to ignore the payback period method. Payback
period method is always applied by you can call it as knowingly or unknowingly always the
payback period method is important and we make use of that, maximum improvement we can
do is that we can use the discounted payback period method or we can discount those cash
flows expected but yes that without that method, no capital investment proposal proceeds
ahead.

Same is the case here that in the sensitivity analysis also it has some inherent limitations, but
hardly there is an investment proposal where the risk analysis is done without the say
applying this technique of the sensitivity analysis. So, this is a first and the most useful
technique and we always use this technique. Then we go to the second technique and second
technique is the scenario analysis.

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(Refer Slide Time: 23:04)

As I told you the scenario analysis, and in the scenario analysis when we apply the scenario
analysis, we create these different scenarios. This is the expected scenario we have already
created and this is NPV we have already found out. And this is called as now the pessimistic
scenario, which is created here, this is called as optimistic scenario created here. And in this
scenario we look at that, say all the variables are changed.

So, if we are talking about the investment is not 20, investment we are expecting is 24, sales
are not 18, sales are expected to come down to 1.5 crores or maybe the 15 millions. Similarly,
variable costs we are not expecting to be 66.67 percent but 70 percent of the sales, fixed costs
we are expecting to go up by say, how much 0.3 million, it is not say 1 million, but 1.3
million, depreciation will automatically change because when the investment changes,
depreciation will also change.

So, it means we are changing all the variables as compared to these most likely scenario, we
are changing all the variables here and we are seeing that the NPV has now become seriously
negative, highly negative, because we have increased or changed all the variables. Similarly,
for creating the optimistic scenario, we have lowered down the investment, we have
increased the sales, we have lower down the even variable costs also from 67 or 67 percent to
65 percent.

Fixed cost is we are saying that it will be 80 percent of the most likely scenario and
depreciation is we are anticipating here is that naturally when the fixed investment will come

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down so depreciation will also come down and finally, means the changing all these 4
important variables, largely 4 variables, depreciation is outcome of the investment, so your
NPV is getting positively affected and it is increasing from the 2.60 million to 10.06 million.

Or you can call it as it is going to be 1 crore and 6 lakh rupees. So, very, you can say serious
growth in the or very effective, significant growth in the NPV of the project. So we can create
these different kinds of scenarios. The only difference is in the NPV in the sensitivity
analysis, we change only one variable at a time keeping all other variables the same. For
example, you will change investment, but sales will remain the same, variable costs will
remain the same.

Your fixed costs will remain the same. And then we will see the impact upon NPV or
sometime we can change the sales, but the investment will remain the same, your variable
costs will remain the same fixed costs will remain the same. So we change only one variable
in the sensitivity analysis. Whereas in the scenario analysis, we change more than 1 variable
and then we see the impact of the entire process on the NPV of the proposed project.

And then we try to find out that which scenario is expected to be there in the market, if
expected, is there then it is a win-win situation, optimistic is there far more a better situation,
but even if pessimistic scenario is there, then are we able to sustain in sustain in the market?
Should we still go ahead with the project or should we abandon the project? And here now, as
I told you in the limitations of the sensitivity analysis, only problem which is here is that how
likely it is?

These two, how likely they are going to happen? How likely it is the pessimistic scenario will
emerge? How likely it is the optimistic scenario is will emerge? So that likelihood finding out
or assigning the probability of emergence of any kind of the scenarios is a million dollar
question which is a very complex job that is why people call it as is subjective analysis. But
subjective analysis is done by the subject experts, by the people who are in the market for the
ears and who understands the market scenario very well.

So, if they suggest something to be done, I think we have to accept that and we have to say
create different scenarios and then try to find out that even in the pessimistic scenario if the
project is going to be viable, then there is no point rejecting the proposal. But under the
pessimistic scenario, the difference between NPV of the expected scenario and the
pessimistic scenario is a seriously high that we have to think twice.

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For example, in this case, NPV of this most likely scenario is 2.60 positive NPV, but here the
negative NPV and almost you can say it is approximately 3 times of the NPV which was
expected to be there in the expected scenario. So, now in this case, we have to be means
carefully look at it, whether we should go for establishing this flour mill or not. Because if
expected things happen, fine. It is acceptable. 26 lakhs of the NPV is expected over a period
of 10 years.

But if pessimistic things happen then means the existing firm who is going to have the
another say unit of manufacturing the flour, wheat flour or any kind of the flour is means
going to affect the health of the existing firm also or the sponsorer also. So, it means the
difference is too high between the most expected and the pessimistic. So, we have to be very
careful and we have to be means a very means reasonably taking care of all the factors so that
later on people have not to worry about that had to be means trusted the pessimistic scenario,
we would not have ended up say making this kind of the situation or severe losses to the firm.

So, this is the, these are the two techniques sensitivity analysis and that scenario analysis.
Next one is the third one is the again a very important technique and we call it as this
technique, we call it as the breakeven analysis. So, breakeven analysis we will learn as a
technique of analysis of the capital budgeting proposals in three forms? We can calculate
three breakeven points, we can calculate three breakeven points and under three breakeven
points we try to find out that whether we are able to reach at the no profit, no loss situation at
the earliest or not.

Because we all understand, what is breakeven point? Breakeven point is that point or that
situation of the firm, where the total say cost of the say of the firm, all kind of the costs are
equal to the total revenue and we are in this state of the 0 profitability. There is no loss, no
profit, the situation is no loss, no profit, the benefits of coming out of the project are equal to
the cost and we are we just breaking even that our cost is equal to the benefits or vice versa.

And there is no profit till this point, but objective of every business or every promoter of
every business is that should that they should try or their business should reach at the
breakeven point at the earliest. So that after crossing the breakeven point, after that whatever
the sales, they make production and sales, they make, the firm will start earning the profits.
So, we do the breakeven analysis also, because after breakeven analysis, there are the green
pastures available.

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So we will, we want to reach up to those green pastures. So, breakeven analysis helps us to
understand how quickly the firm is going to reach at the breakeven point where the total cost
of production is going to be equal to the total sales and we are going quickly we are going to
reach out of the state of the no profit, no loss. So as I told you, we are going to have the
3breakeven points.

(Refer Slide Time: 30:52)

So, first breakeven point we are going to learn about is the accounting breakeven point
accounting, breakeven analysis, or accounting breakeven point. Second breakeven point is the
cash breakeven point We are going to learn about is the cash breakeven point that is the cash
breakeven point is the second one that is we are going to learn about or we are going to
calculate the cash breakeven point and third one will be the breakeven point, which is called
as financial breakeven point.

Third one is the financial breakeven point. So, we are going to calculate these three
breakevens. We are going to learn about that when we in the accounting, for example, if you
have already studied the accounting, then you must have heard about the breakeven analysis
or maybe the marginal costing if you have already studied, you must have heard about the
breakeven analysis, but that analysis you have heard about till date must be the accounting
breakeven analysis.

So, how we calculate the accounting breakeven point? Accounting breakeven point is
basically we take these 2 this is a formula, we divide the fixed cost by the contribution
margin ratio, we divide the fixed cost by the contribution margin ratio, fixed costs when we

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take for calculating the accounting breakeven point is, so we take the fixed cost plus
depreciation, fixed cost plus depreciation so 2 fixed costs.

So, total fixed cost we take into account and divided by the contribution margin ratio.
Contribution how we calculate? Selling price minus variable costs or sales minus variable
cost is the contribution. So, in this case we have calculated the accounting breakeven point
which has been worked out as 9 million rupees. How it has been calculated? For example, the
details are given here.

Say, for example, the cash flow forecast of Raja Flour mill project which we discussed in the
previous case, in case of the sensitivity analysis and scenario analysis, we are taking that
example forward. So, we are again taking it means like that the most likely scenario and we
are treating here investment is 20 millions, sales are 1.8 crores or 18 millions, then variable
cost is 12 millions, fixed cost is 1 million, depreciation is 2 million and then similarly the
other things have been worked out.

So, we have first calculated the contribution and here we are saying that our variable cost is
66 and 2 by 3 percent or maybe you can say it is 66 and say 67 percent. So, in that case, if
you calculate the contribution margin ratio, you can say that is the contribution margin is
sales minus variable cost is the contribution and contribution here it is show is 0.333 or 33.33
percent. And in the numerator we have taken that fixed cost and depreciation, fixed cost
given to us here is the 1 million and it is 2 million.

So, we have added up the, this becomes 3 million, so 3 million divided by this contribution
margin ratio of 0.333, then it is equal to the 9 million rupees then it is equal to the 9 million
rupees, so it means your breakeven sales are 9 millions. How much sales we are totally
making here? The total sales expected here are say 18 millions of the sales, every year we are
going to make the sales of 18 millions, but after making the sales of 9 millions will be at the
breakeven point and after that, whatever the sales the remaining 50 percent of the sales be
make that will be giving us the profitability.

So, this is the concept of the accounting breakeven point. So that means may, say so that it
can help us that if you are satisfied with this 9 million, then fine, go ahead, but if you say that
reaching up to 9 million will be taking a longer time. So, we will have to look for the
improvement. How can you look for the improvement? Either you improve the contribution

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margin ratio that you reduce the variable cost. It can be done because variable cost is always
variable, it can be controlled or you can control the fixed cost other than depreciation.

So anyway, you have to means control the cost or you can improve the revenue also. You can
increase the selling price or you can increase the sales volume and then you have to increase
the total sales amount. So, either you reduce the cost or you increase the sales, so that you can
further improve upon the accounting breakeven point, but from the present calculations, the
accounting breakeven point workout here is 9 million rupees.

So, up till 9 million rupees, we will not be earning any profits, but after that remaining sales
50 percent of sales, yes, will be giving us the profit. Then is the concept of the your cash
breakeven point. When you talk about the cash breakeven point, in the cash breakeven point
what we do? In the cash breakeven point we take, we calculate it something like this that we
do not take the depreciation into account.

(Refer Slide Time: 35:53)

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We do not take the depreciation into account we take only, the formula becomes the cash
breakeven point, cash breakeven point, it becomes like fixed cost divided by the contribution
margin contribution margin ratio, this becomes like contribution margin ratio. So, in this case
if we calculate the cash breakeven point from this, so how we can calculate this cash
breakeven point, we have not to include now the depreciate this depreciation So, what is the
fixed cost? If we look at the fixed cost, only the fixed cost fixed cost is the 1 million rupees.

So, it is going to be one divided by 1 million divided by the ratio contribution margin ratio
and this is going to be how much? Point 0.333 and if you calculate this, then it comes up as
equal to 3 million rupees. It works out as rupees 3 million, so if you want to calculate the
cash breakeven point and you want to recover only the fixed cost which is other than the
depreciation, which is only one third of the total fixed cost because two thirds is the
depreciation, one third is the fixed cost.

So, if you want to calculate the cash breakeven point, you can say that recovering the,
because in this contribution margin, variable cost is already recovered, variable cost is
already recovered. So, how you calculate the contribution? Sales minus variable cost. So, we
have already calculated this ratio and in this contribution margin, variable cost has already
been taken care of, and then to arrive at the profit now, from this contribution, but you have
to subtract you have to subtract the fixed cost.

So, contribution minus fixed cost becomes the profit. But here because, to arrive at the profit,
you have to first meet the fixed cost. So, breakeven point can be calculated like accounting
breakeven point is the fixed cost plus depreciation divided by the contribution margin ratio

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and in case of the, case of the cash breakeven point only the one millions of the fixed cost,
only fixed cost of 1 million has to be, means the fixed cost which we are going to pay in cash.

For example, the your administrative expenses are there, general expenses are there,
employee salaries expenses are there, all those expenses which are paid in cash for recovering
those fixed expenses, you require only 3 millions of the sales and for requiring the fixed
investment part also which is in terms of the depreciation they calculate, if you have to
recover that also, then you need to make the 9 millions worth of the sales to arrive at the
breakeven point because depreciation amount is quite high.

But if you simply want to recover the cash, fixed expenses or fixed expenses incurred in cash,
then only the sales worth rupees 3 million are required. After 3 million rupees of the sales, all
costs stand recovered and after that whatever the sales, production and sales will we make
that will start giving as the profits. So, this is the concept of the accounting breakeven point
and the cash breakeven point which sometimes we use as a technique of the say risk analysis
in the capital budgeting proposals.

Third breakeven point that is the financial breakeven point is basically the one which helps us
to find out that at what level of sales, at what level of sales, the NPV of the project will be 0,
because there we want to find out. The financial breakeven point requires that at what level of
production and seeds NPV of the project will be 0, means at 0 level of NPV the project is
expected to be at the financial breakeven point. So at what level of the sales, the NPV of the
project will be 0. That point is called as a financial breakeven point.

So, how to calculate that financial breakeven point where means that amount of the sales with
the NPV will be 0 that we will discuss in the next class. We will learn about the financial
breakeven point in the next class. For the moment, I will stop it here after discussing the
techniques like sensitivity analysis, scenario analysis, and two types of the breakeven analysis
that is the accounting breakeven analysis and cash breakeven analysis and remaining
discussion about the financial breakeven analysis and other techniques of the say risk analysis
in the capital budgeting proposals I will discuss with you in the next class.

Till then thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 43
Risk Analysis in Capital Budgeting - Part IV

Welcome all, so in the process of learning about the Risk Analysis and Capital Budgeting
Projects tell the previous call we have discussed some techniques, 3 techniques that help us to
say analyze the risk in the capital budgeting projects or may be in the investment proposals and
there we talked about the Sensitivity Analysis Scenario analysis and in the breakeven point we
talked about the say accounting breakeven point and we talked about the cash breakeven point.

So now as I told you in the previous class itself that breakeven point can be calculated in the 3
forms, because it is a very important point breakeven point is a very important point because risk
of the project remains largely up to the breakeven point because our focus is always upon that at
what level of the sales, our cost is equal to is going to be equal to the sales or vice versa or sales
are going to be equal to cost of production that is our first approach.

Once we are able to means reach out the stage of the no profit, no loss after that means we can
say start thinking about the profitability but even if you are able to recover the investment or may
be the cost of production then it creates a problem for us, so break a new point when you talk
about the counting breakeven point there we simply talk about the level of the no profit no loss
or that point where the firm incurs no profit no loss and the cost of production is equal to the
value of the sales or the value of the sales is equal to the cost of the production.

In the accounting breakeven point, we discussed that it keeps in the numerator the yours say fix
cost which is being incurred in the cash plus the fixed cost which is non-cash which is
depreciation. So we have to recover the full, so for recovering that cash and non-cash fixed cost
we divided by the contribution margin which is sales value minus the variable cost and in case of
the cash breakeven point we simply can say divide or may be keep in the numerator only the
cash fixed cost which currently we are paying for paying of the salaries for the administrative
expenses for the general expenses, so all that.

We are to divide those cash fixed expenses being incurred in the current period by the
contribution margin again, so we have seen that level of sales, as per the accounting breakeven

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point is 9 million rupees and in case of the cash breakeven point it was 3 million rupees, so it
means you can understand what does it mean, that up to 9 million rupees of the sales will be
earning no profits.

The firm will not be earning rather this flour mill will not be earning any profits and after say the
sales which we make total level of the sales is 1.8 crore or the 18 million, so 18 million sales
means up to 50 percent of the sales there is no profit but after for the remaining 50 percent of the
sales, yes, there will be giving us the profit and in case of the cash breakeven point where you
have to only recover the cash fixed cost we could find out the will be attaining the breakeven
point or reaching at the breakeven point very early where by simply what we can say that by
selling just for 3 million rupees the cash fix cost will be recovered?

So that was all about the accounting breakeven point or the cash breakeven point. Now as I told
you in the previous class itself that now we will be learning about the financial breakeven point. I
think you have not heard about the financial breakeven point which you will be I think I guess
that you will be hearing for the first time and you will learn also how to calculate the financial
breakeven point.

(Refer Slide Time: 04:16)

And financial breakeven point is different from the accounting breakeven point. And on this the
focus is on the NPV of the project, NVP of the project and or the accounting profit under the
breakeven point we talk about the accounting profit but under the financial breakeven point we

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talk about the NPV of the project and for finding out the financial breakeven point we try to find
out that at what level of sales, will the project have the say 0 NPV, at what level of the sales the
project will have a 0 NPV.

Because in financial terms the breakeven point is seems to have been achieved when the NVP of
the firm is 0, so normally also in the NVP analysis our decision making process remains that
NPV of the project minimum should be 0, it should not be negative, if it is positive very good but
if it is 0 even then we can think about going ahead with the project. So here in case of the
financial breakeven point we try to find out the level of sales.

In the other cases we were trying to find out when we discuss NPV and IRR situation or those
techniques for the evaluation of the capital budgeting proposals there we discuss so many things,
cash flow was the one important criteria, cash out flow and cash inflow and then we had to have
the discount rate and other things but here we only try to find out the level of sales. The level of
sales which we have to say means finally you can say make in the market which takes a firm to
the level of the say NPV, where the NPV becomes 0.

So it means financial breakeven points says that at what level of the sales will the project have a
0 NPV because at present cash outflow how much is going out currently? How much is the cash
outflow that is in both the cases the current cash outflow means the cash outflow in cash as well
as the in terms of the non-cash that is the depreciation cost, so both we have to try to find out that
the total outflow has to be compared with the present value of the inflows.

And we want to find out that level of sales where the NPV of the firm will be 0, so how we can
find out that level of sales? Where the NPV of the firm will be 0? That can be easily understood
or can be say realized by means taking this example forward, for example I am again taking the
figures of this Raja cash flows particularly, cash flow figures of Raja Flour mill and this flour
mill project will help us to understand that how to calculate the say financial breakeven point and
then means will be calculating here by taking these particulars this information given to us will
be calculating that how the financial breakeven point can be calculated.

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(Refer Slide Time: 07:12)

So financial breakeven point, so we have to calculate the financial breakeven points, so we are
taking the example of this previous one which we used for calculating the accounting breakeven
point and the cash breakeven point. With the help of same example will be calculating the
financial breakeven point. So first of all what we have to see here is, what is the variable cost? If
you talk about the variable cost it is how much?

Variable cost is in terms of percentage it is 66.67percent, variable cost is 66.67 percent it is

already given to us. So we have to take this cost and we start with this variable cost because it is
important, this cost is important to calculate something which is called as contribution. And for

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calculating the breakeven point because breakeven point is basically a concept of marginal
costing right and in the marginal costing we do not end up directly to say a jump to calculate the
profits by subtracting the total cost from the sales or we move step by step.

So from the total sales we subtract the variable cost, we arrive at something which is called as
contribution and that contribution is called as contribution or why it is called as contribution?
Because that contribution is a contribution towards meeting the fixed cost, so we would like
absorption costing, in the adsorption costing we subtract the total cost, variable plus fixed from
the selling price or the sales value.

So we end up directly to the profit but in this case for calculating the breakeven point we follow
the contribution approach and in the contribution approach we take the sales first which is
already given to us or calculated and then from that at the first go we subtract the contribution
and that is called as a contribution because that is a contribution towards meeting the fixed cost
and from the contribution when you subtract the fixed cost you are at the level of the or you are
able to find out the profit, operating profit. So same processing will follow here that is variable
cost 66.67 percent.

Number 2 is now we have to find out the contribution, contribution we have to find out the
contribution and in the contribution how we can find out the contribution!? Because if this is the
level of the variable cost so it means the level of the contribution is already means you can find
out that is sales minus variable cost. So sales are 100, so means in terms of percentage and
variable cost is 66.67 percent of the variable cost, it means contribution is 33.33 percent of sales,
this is the 67 percent you can say of sales.

And it is the 33 percent of again sales and then we have to now take into account the third thing
that is the fixed cost. Fixed cost is how much? Fixed cost is rupees how much? 1 million, fixed
cost is rupees 1 million, it is given to us, if you go back to the problem this is the fixed cost
which is given to us this is 1 million and this is a depreciation 2 million we are taking this, so
fixed is rupees 1 million and number 4 is the depreciation.

And depreciation if you take is how much? That is rupees 2 million, this is rupees 2 million. So
number 5 pre-tax profit, pre-tax profit or profit before tax. If you calculate the pre-tax profit here
you can easily calculate like 0.333 into sales 0.333 into sales the information is given is the, into

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sales minus something we have to write here is rupees 3 millions, 0.33 percent of sales is the
contribution, this is the contribution and this is the fixed cost.

This is contribution and this is the fixed cost, so finally what will be the net result when you from
the contribution when you subtract the fixed cost you will be arrived at something which is
called as the pre-tax profit and now we go for the tax rate, let us go for the tax rate, what is the
tax rate here? Tax rate we are assuming here is it is only given I think tax rate yes it is given here
taxes we have calculated is the 1000.

So against the pre-tax profit of 3000, if the tax is 1000 it means the tax rate is 33.33 percent, so
tax at the rate of 33.33 percent, at the rate of 33.33 percent this is the tax at this rate we have to
calculate the tax of this rate of the percentage and if you calculate this tax rate percentage you
can calculate that what is going to be the tax value, so this is the in the percentage terms? So if
you take the tax here at the rate of 33.33 percent so it will be how much?

You can say that is 0.333 again into now you take this amount, this-this right, so we take these 3
values here and 0.333 because again we have to write the same figure so it is a tax part and 0.33
of sales because we are multiplying this our equation same and minus how much? Rupees 3
million which is the fixed cost minus 3 million is the fixed cost, so this is the tax rate, this is the
contribution margin and this is the fixed cost, so it means this component becomes, component
inside the bracket becomes the profit before tax, pre-tax profit and then the tax rate when we are
multiplying with 0.333.

So you are finally coming up with the something which is called as profit after tax PAT, we are
calculating the PAT profit after tax which will be 0.667 and other things remaining is the same
0.333 that is the profit after tax 0.667 into 0.333 sales minus (3 rupees) 3 millions minus rupees 3
millions that becomes the profit after tax because it is the 0.33 is the tax rate, so profit after tax is
the to 1 minus 0.333 is equal to say (67) 66.67 percent of the profit is means pre-tax profit is
going to be the post-tax profit.

Because one third of the profit is paid as the tax, as we have paid in the previous this thing, we
have also paid out of the pre-tax profit we have paid the 1000 which is the 33.33 percent of tax,
so pre-tax profit we have calculated. Now we are going to calculate the cash flow they are going

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to calculate the cash flow, so what is the cash flow now available with us? This would be you
can say column number 4 plus column number 7.

Column number 4 is what? Depreciation, column number 7 is PAT, so what is PAT, so what is
the depreciation here? This is rupees 2 million plus we are taking this same amount 0.667 into
0.33 of sales this is of the sales 0.33 of the sales minus 3 millions, minus 3 million so if you take
this total amount here will be able to find out the final cash flow amount and if you take the final
cash flow amount you have to means in this what is the profit after tax?

In this profit after tax you have to add up the depreciation amount which is a non-cash expense
so this becomes the cash flow which is some total of it if you solve this, this will become as 0.22
of sales, this is the cash flow we have already calculated, so it means this cash flow is we have
calculated from this entire analysis and this cash flow is only for 1 year. But what is the life of
the project here? We are assuming here the life of the project is 1 to 10 years means 10 years.

So it means for all the 10 years this much of the cash flow will be coming what the firm will be
earning, so what we have to do now is, you have to calculate the present value of cash flow,
present value of the cash flow, so if you calculate the present value of the cash flow, so what you
have to do is because it is going to be NOT, so you have to do is 0.22 of sales right, so what we
have take here as the present value, interest factor for NOT and that is for how much?

For 10 years period of time and at the rate of how much, 12 percent? That is given to us the
discount rate is given to us is the 12 percent or we have already assumed it as 12 percent, so it
means if you say discount it as NOT because we have taken here as that is the present value
interest factor for NOT for a period of 10 years and the discount rate is 12 percent, so if you
discount this by applying this discount rate of the 12 percent for a period of 10 years, so you will
be coming up here with the value of something which is called as 1.254 sales of the sales.

1.254 of the sales, so it means we have got this amount 1.254 of the sales and this amount is
called as the present value of the cash flows arising out of the say project. So now what we have
to do is, our objective is to find out the cash sorry financial breakeven point and as I told you the
financial breakeven point is objective of finding out the financial breakeven point is 2, find out
that level of sales where the present value of the project is 0.

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So it means in this case you can say now we have to find out the present value of the sales where
the NPV of the project is you can call it as NPV of the say we have to find out the amount of the
sales where the NPV of the project is 0, so in this case what we have to do is, what is your total
investment we are making in the project? The investment we are making here is of the 20
millions.

(Refer Slide Time: 18:38)

So it means the formula can be for the financial breakeven point present value of cash flows
should be equal to some total of, means present value of all the cash flow should be equal to the
investment. So it means if you take this as the investment it should be equal to the investments,

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so if you take the investment here, so this is the investment. What is the present value of cash
flow? We have already got the present value of cash flow is here and this is the present value of
cash flows which is 1.254 of the sales, we can again means if you write it we will say that this is
the present value of the sales, that is 1.254 sales this is the present value of the cash flows.

So now what you have to do is, present value of the cash flows is who much? 1.254 sales is equal
to, how much is the investment? Initial investment is how much? Rupees 20 millions, this
investment is the rupees 20 millions, so it means if you solve this entire process you will be able
to find out level of sales will be here is how much? Rupees 15.95 millions, if you solve this it
will come up as rupees 15.95 million, so what this is the figure of the 15.95 millions?

This figure of 15 .95 millions, we have got some figure which is called as the sales and this is a
value of the 15.95, so it means this is the financial breakeven point that a point of means the
amount of sales which will take the NPV of the project to the 0 level or the level of sales where
the NPV of the project will be 0 is 15.95 million is 15.95 million and if you compare it with the
accounting breakeven point, if you compare with the accounting BEP how much was it?

If you recall it accounting BEP was how much? Accounting BEP was if you recall that figure
that was 9 million, it was 9 million and if you call about the cash breakeven point it was 3
million. So these are the 3 figures, this is called as the financial breakeven point F BEP, this is
the financial breakeven point, this is the accounting breakeven point and this is the cash
breakeven point, so this is the lowest one which is the 3 million rupees and why it is a lowest
one?

Because we followed the formula that is the fixed cost divide by the contribution margin ratio
CMR and in this case we talked about the fixed cost which was only 1 million which was the
cash fixed cost, so we have to recover only the smallest amount only 1 million from the
contribution margin ratio, so because of this reason we were able to reach at the cash breakeven
point by just selling the total amount of or the total product of or by attaining the level of sales
that is equal to 3 million.

Further we add it, in this one more thing which is called as depreciation, so if we came
something like this fixed cost plus depreciation this became the accounting breakeven point and
contribution margin ratio remained the same, so what happened our say here in this case 1 plus 2

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plus the contribution margin we have to say means this ratio was the contribution margin ratio
was this, so then we have to recover this it means your fixed cost level bent y 2 more times so it
became to 3 times of the of this level when we have to recover this.

So it means in this case we have to means sell more and according to this level or to attain this
level of the say contribution to recover the fixed cost which is the cash plus non-cash fixed cost,
so we have to increase the level of sales that this level of the fixed cost will be possible to
recover if we are selling worth rupees 9 million rupees. But you see the main point of
comparison is between this figure and the, this figure.

Here accounting breakeven point says that we are reaching at the breakeven point by just selling
for 9 million rupees but in case of the financial breakeven point we say that we have to sell for
about approximately 16 million rupees. So there is a difference of how much? Approximately 7
million rupees, approximately 7 million rupees of the sales, why this difference of the 7 million
rupees of the sales is there?

The reason for the difference is that in the accounting breakeven point we have not calculated the
present value of the cash flows, we have not discounted the cash flows accounting breakeven
point you can say it is a non-discounted criteria, it is the non-discounted criteria and the financial
breakeven point is the discounted criteria. So when you are calculating the present value of the
cash flows, so it means the total amount which we are showing the cash flows whatever that
amount of the cash flows is coming to us that is with the value of that is decreasing because we
are discounting against the cost of capital and that is 12 percent.

So when you are discounting, so it means the value to be added into the cash flows means as per
the present value of the cash flows that values is coming down, so that is the only reason that to
attain the financial breakeven point in terms of NPV, so that means that level of sales where the
NPV of the firm becomes 0, we have to sell more and this is the real analysis here that actually
the cash flows have to be means considered as the discounted cash flows not as the non-
discounted cash flows.

That is why always when we talk about even the capital budgeting proposals evaluation of the
capital budgeting proposals there also we more believe into the discounted criteria rather than the
non-discounted criteria and that is the main difference means explain here also that accounting

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breakeven point is a non-discounted criteria and the financial breakeven point is a discounted
criteria and that is why level of sales is different.

In one case you have to sell for 16 million then you are reaching at the breakeven point and that
is the real means comparison, in the other case you have to means only sell for 9 million at 50
percent of sales you are reaching at the breakeven point in case of the accounting breakeven
point which is a non-discounted criteria but to arrive at the say financial breakeven point or as
per the financial breakeven point we have to sell as high as 16 million worth of the sales to arrive
at the financial breakeven point.

So the point of difference here is that the level of sales has increased tremendously almost
touching double or 90 percent of the say accounting breakeven sales because the cash flows
considered here are the discounted cash flows that is why your financial breakeven level has
gone up from the 9 million of the sales to the say almost 16 million of the sales to attain the
accounting to attain the financial breakeven point.

But I think you have to clearly understood it because financial overall breakeven energy is a
very-very important analysis and in the risk analysis also breakeven helps us to understand that
at what level of sales we are able to recover our investment or the cost. So in case of the
accounting breakeven point we talk about the recurring cost, the current cost. We forget the
investment cost that is you call it as reconsider it as sum-cost.

But whatever the say current cost is there that is the fixed cost in terms of the, your say cash
fixed cost and the depreciation that we are more concerned about. So we take into account the
variable expenses, we take into account the fixed expenses and then we try to calculate the
accounting breakeven point and you can say that accounting breakeven point is basically the or
any breakeven point is basically the any breakeven point is basically the replica with the of the
payback period.

In the payback period also we arrive at the level of sales where we are going to recover our
investment our cost. In one way you call it as investment and in one way you call it as the cost,
so in the breakeven point also we are talking about at what level of sales we are going to recover
the cost? Or when we are going to reach at the breakeven point where the cost of production is
equal to the level of sales or sales are equal to the level of the cost of production.

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Because that is the most important point, once our whole investment is recovered after that now
we have to only think about the profitability and if the project is going on production is going on
and we have the capacity to produce and sell more in the market so remaining amount of the
sales will give us the profit. So it means if our own investment is recovered it means level of the
risk has almost become 0 at lest we are not going to lose our own investment and if the
profitability is concern it can be more or it can be less.

But it is going to be a profit but risk is going to be or if the situation which is going to create
means a situation or the situation which comes up as that if you are able to recover our own
investment also then that is a grave situation and is a very serious situation, so in the breakeven
point we are more concern then why it is a risk analysis tool because we are more concern first
about the recovery of our own investment.

Once it stands the recover after that we have to think about the profits whether the profits are a
high or profits are low or they are not right we are means concern but not that much as we are
concerned about the recovery of our own investment. So focus has to be first we have to try to
find out that level of sales, we are going to recover our own investment. Once the investment
stands recovered after that how much profit is available from the project?

There you talk about means the profitability but risk stands fully means taken care of and now
the investment is not going to be a risky investment. So these are the 3 techniques we talked
about is the sensitivity analysis, scenario analysis and the breakeven analysis where we learned
about the 3 breakeven points. After this we will talk about some complex risk analysis tools.

I will touch upon those risk analysis tools not in detailed manner but yes means to the extent
possible I will try to explain them but because we are studying the risk analysis and the capital
budgeting so, they are equally important or at least being a student of finance or financial
management we should have an idea that how many different techniques are there to say look for
the risk analysis of the capital budgeting projects.

So most importantly used are 3 only sensitivity analysis, scenario analysis and breakeven
analysis but these other techniques are also there and it should have an idea that other techniques
are also there, so after this I will talk to you is the fourth technique, technique of a risk analysis

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that is the Hiller’s model then we will learn about the stimulation and then we will learn about
the decision tree analysis.

These 3 more techniques I will talk to you and after that will close the discussion on this
particular topic that is the risk analysis of the capital budgeting projects, so these remaining 3
techniques Hiller’s model and then the stimulation and the decision tree analysis, I will discuss
with you in the subsequent classes, till then thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 44
Risk Analysis in Capital Budgeting - Part V

Welcome all, so now after having talked about the 3 basic techniques of the Risk Analysis in
Capital Budgeting I will take you to the next 3 techniques. They are little complex but not that
much complex that we cannot understand. They are very interesting tools where the
mathematical models have been say doubt to go for the risk analysis in the capital budgeting. So
one important technique is called as a Hillers model.

And in this Hillers model very simple concept though it looks very complex here but very simple
concept has been applied by Professor called as FS Hiller, so if you see what professor Hiller has
tried to do, do develop this model he has done one thing is that he has say that there are the
projects where the say cash flows are either correlated or they are uncorrelated. Especially the
cash inflows. So because they are more important for say calculating the NPV of the project.

Whatever the outflow is going to be there that is the largely in one go, it may be in the
subsequent ends also but largely it is in the beginning. So that outflow is fine but inflow is
coming over the number of years depending upon the life of the project, so he says for explaining
this model he says that you have to divide the projects into 2 categories or it belongs to either of
the 2 categories. The project which is in question for the valuation by us.

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(Refer Slide Time: 02:03)

The project may either fall into the first category where the cash flows are uncorrelated or second
category where the cash flows are perfectly correlated. So when we talking about the
uncorrelated or we are talking about the perfectly correlated means what does it mean? That
normally we see that we have seen 2 kind of the cash flows by re-valuating the capital
investments proposals.

One was that we were keeping the cash inflows like cash outflow as it was say only in the 0
period or in the current period we were considering, cash inflow we were considering as a
constant cash inflow that for example 200 million are going to be there in the first to last 10
years or may be in the previous case also there we discuss the financial breakeven point, we also
considered that the cash inflows will be constant or they will be correlated.

You can see they are going be constant means correlated, so we can easily find out that what is
the cash flow in the first year? Same amount of the cash flow is going to be the 2 nd year, 3rd year,
4th year or even the change in the cash flow is going to be there even then that is a predictable
change that yes, we will be increasing our sales by 10 percent which is in our hands, does not
depend on the market, that is in our hand so we will be selling for 200 million in the 1 st year next
year will be selling for 220 million then will be increasing the sales at the rate of the 10 percent.

May be of the base value or may be of the say the previous year, so if it is possible to correlate
the cash flows then it is one category of the project but sometimes the project may fall into the

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category where the project, where the cash flows especially the inflows are uncorrelated. So if
the cash inflows are uncorrelated it means the element of risk is high. The projects where the
cash flow is correlated or they perfectly correlated then you can say that the element of risk in
the project is quite less.

But those cash flows where the say which are uncorrelated, correlated cash flows the element of
the risk is quite high, so he has applied the concept of the standard deviation of the say cash
flows, so he says that we should calculate the expected NPV from the project and then we should
calculate the expected standard deviation of the cash flows from the project. So it means you can
say NPV will be calculate what we do.

We simply sum up the cash inflows and then discounted we are talking about, discounted cash
inflows we sum them up and from that figure of the discounted summed up figure of the cash
inflows we subtract the cash outflows so we are left with NPV, so in a way you call it as that is
called as the say expected NPV is basically the mean of the cash flows expected over the life of
the project.

And standard deviation you can call it as another name of the standard is variance, so he has
applied the concept of mean variance analysis on the risk analysis of the capital budgeting
projects and he has proposed that we should try to find out that if the cash flows are correlated,
perfectly correlated then what is expected NPV from the project and what is the expected
standard deviation of the cash flows of the project and they are if they are uncorrelated then both
the things should be calculated.

So what happens that is the higher the amount of NPV, expected NPV and lower the amount of
say standard deviation of the cash flows then what is the situation? Project is least risky as
compared to the situation when the say expected NPV of the project is lower and the expected
standard deviation is very high right, because standard deviation is basically called as the
synonymous to risk.

Then in the financial terms we go to measure the risk in the market whether you call it as the
mean variance theory of the say portfolio theory which is basically given to us by the Harry
Markowitz so that theory which is called as a portfolio theory which is a basically the base of the
CAPM Capital Asset Pricing Model which we use for calculating the cost of capital which we

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use for the calculation of the cost of the capital in the next topic we will discuss the CAPM say
Capital Asset Pricing Model for discussing or calculating the cost of capital.

So that is the base of the CAPM is the mean variance theory or you call it as a portfolio theory
given to us by the Harry Markowitz, William Sharpe has given us the CAPM and Harry
Markowitz have given us the portfolio theory both are awarded the Nobel prize for their
contribution into the financial economics. So here the Hiller model also says or FS Hiller also
says that while applying this concept means in this case when applying this concept of the say
risk analysis in the capital budgeting we should try to first of all try to find out which category
the project belongs or falls into.

Whether it falls into the category where the cash flows are uncorrelated or it falls into the
category where the cash flows are perfectly correlated. If it falls into the category of the cash
flows uncorrelated then be careful right because element of risk will be very high because when
you calculate the standard deviation of the cash flows in the different years you will certainly
find the standard deviation will be very high.

So one point of question but if the cash flows are perfectly correlated. So means the next year’s
cash flows is correlated to the previous year’s cash flow so you can predict the changes in the
cash flow and we can understand certainly there the level of sigma standard deviation will be
quite low and if the level of standard deviation is quite low it means the level of risk I too low or
quite low.

So what is written here, just read the important points for your means understanding, first see,
under certain circumstances the expected NPV and standard deviation of NPV may be obtained
through a mathematical model suggested by FS Hiller, so FS Hiller has suggested this model and
what he has said, 2 cases of such analysis are discussed here, no correlation among the cash
flows and the perfect correlation among the cash flows.

No correlation among the cash flows and perfect correlation among the cash flows. Next thing
what he says, when the cash flows of the different years are uncorrelated the cash flows for the
years T is independent of the cash flow of the year T minus m, this is a very important line.
When the cash flows of different years are uncorrelated the cash flows for the year T, for the

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cash flows for the year T is independent or are independent of the cash flow for the year T minus
m.

If the cash flow for the different years are perfectly correlated the behavior of the cash flows in
all periods will be alike. So you can understand either we have the constant cash inflows or even
they are changing, they are changing in a predictable manner in predictable fashion.

(Refer Slide Time: 09:28)

For example, you I can draw the two trends like this, the one cash flow is moving like this. So
you have this level then you have this level, then you have this level, you have this level so it
means you can understand that what is the level of the standard deviation, this is very high level
of standard deviation you cannot predict whether we will have next year we have this level, so
we will have this level of the cash flow, we will have this level of cash flow or it will fall down
to this level of cash flow.

Whereas, in case of the correlated cash flows either you can have a straight line, if they are going
to be the constant or even they are rising also, they are rising in this fashion. They are not
creating a situation that or even if there is a rise and fall also you can say it may go like this, it
may go like this. So it is something like this. So it means if it is we say that initially it was there,
initial this place it may come down to this level, so they are correlated to some extent.

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But more level of correlation will be exhibited by this when it is the constant cash flow or it is
growing up in a predictable fashion, it is considered as a perfectly correlated because this year
cash flow is impacting this years, so this year cash flow depends largely or is correlated to this
year. Similarly, you talk about this year, so it means you can easily find out what is going to
happen with regard to the cash flows.

And in this case it is very easy to find out the cash flows that how they are whether they are
correlated or not correlated or what is going to happen. In this case the standard deviation if you
calculate of this particular trail it will be very high but in this case if you calculate the standard
deviation means in this case it will be quite low, in this case it will not be there at all because the
cash flows are constant, they are moving in the same fashion or is in the same design.

(Refer Slide Time: 11:12)

So further he says, if the cash flows for the different years are perfectly correlated the behavior
of the cash flows in all periods will be alike. You can understand, you can predict in advance it is
where you can predict the cash inflow the element of risk is very high because level of standard
deviation in the cash flows is very high, sorry is very low, the level of risk is very low sorry the
level of risk will be very low not very high.

Because you can easily predict that how much is going to be the cash inflow in the next year or
in the next 2 year, 3 years, 4 years, 5 years or 7 years or 10 years. Because they are perfectly
correlated. So level of risk will be very low because level of sigma or standard deviation of the

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cash flows is quite low but where the trend is something like this. So it means standard deviation
is very high and higher the amount of standard deviation in the cash flows brings the higher
amount of risk.

So this is a simple concept of mean variance analysis has been applied by FS Hiller and finally
he says, thus the NPV, expected NPV and the standard deviation under these two circumstances
are calculated. So it means what we are doing here, this particular model is helping us to
calculate the expected NPV where it is n is the number of years’ summation of the cash flows T
CT is the expected cash flow and this is the you can call it as i, yes this is a point of difference
here.

i is basically what? Is basically the risk free rate of return, i is not the cost of capital it is called as
r, it is the risk free rate of return, so it means we discount it with the risk free rate of return,
minimum you call it as. What is the minimum rate of return available from the risk free means
no risk involved in that, that much of the return is always available? For example, you have 2
options, if you have your surplus savings available, if you give your savings to the bank or you
deposit them in the bank.

It means the rate of interest being offered to you is the risk free rate of interest or the risk free
rate of return because bank is certainly going to return you that much of rate of interest or that
much rate of return, so it means your total risk averse you do not want to take any kind of risk
though you are satisfied with the say given return or rate of return by the bank, so that is called
as the risk free rate of return.

But the investor if he is not satisfied with the, satisfied by the returns given by the bank, so he
has a number of options, he can invest as savings into the real estate, he can buy the stocks or he
can go to the stock market and invest them to the shares of different companies, so the moment
he goes to the real estate market or the moment he goes to the stock market he is considered as
the risk pro, risk neutral and he is ready to take the higher amount of the risk for the want of
higher amount of returns.

So how much returns you want accordingly the level of risk will be there, so in this case we are
saying that the minimum return which is a risk free rate of return which is taken here as I, it is
not cost of capital normally we use a cost of capital as the say discount rate but in this case we

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are saying that, that level of return should be known to us which is a risk free rate of return. If
any project is not able to return even the risk free rate of return, then I think element of risk is
very high in that project and we should not go ahead with that kind of the investment proposal.

So here we are calculating with the help of this, this is the say model for calculating the expected
NPV of the project and with the help of this model you can calculate the standard deviation of
the cash flows occurring in the different years and in both the cases whether it is the uncorrelated
cash flows or whether it is the perfectly correlated cash flows, in the first case we have calculated
the expected NPV, we have calculated the expected this your standard deviation.

So NPV indicates the or represents the average returns available from the investment proposal
and this indicates the element of risk associated with that proposal, so our decision criteria
should be or to define the risk, how to look at the risk in this kind of situation is only those
projects should be say undertaken or should be expected where the average expected return is
quite high and the expected standard deviation is quite low.

The projects which gives us the high standard deviation but low average returns or expected
NPV those projects should be abandoned; we should not go ahead with making investment
because for the distance of high level of sigma or standard deviation the element of risk
associated with those projects is very high. So this is the simple model theoretically I am
explaining it to you, so we can easily calculate the average returns we are calculating, expected
NPV we are calculating and we have to calculate the standard deviation of the cash flows also.

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(Refer Slide Time: 16:30)

Again you have the 2 distributions, one distribution is here that for example the cash flows is 100
then you have 200 then it is 300 so it is a correlated cash flow, 400, 500, 600 right, so you can
calculate the average return we are doing it, we are discounting it for the discount factor say for
example 12 percent and it may be the I, risk free rate of return, so we are discounting it for that
and once we are discounting it we are calculating the discounted value we are calculating the
present value.

So we are calculating the present value of all these, once that present value of the cash flows is
calculated we are summing up this present value so this plus this plus this plus this plus this is
known as the expected NPV of the project when from this present value of the cash inflows
when you are subtracting the present value of the cash outflows so the net result is going to be
the NPV and bar here it is that is expected NPV.

Similarly, from this distribution if you calculate the sigma by following the root of the variance,
first you calculate the mean and form the mean you calculate the variance and variance you
calculate and when you take the say this finally from the variance you can easily calculate the
standard deviation, so it means variance also itself is indicator of the risk mean variance. So
variance even you leave it at the variance level, so variance is also the indicator of the risk and
when you going to convert the variance into the say standard deviation you can convert that also.

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So both variance and standard deviation say communicate the element of the risk, higher the
level of standard deviation or variance because if these cash flows are highly variable then you
can understand element of risk is very high. So by calculating from this distribution of the cash
flows, future cash flows, cash inflows especially if you calculate the expected NPV and if you
calculate the sigma so you can understand what is element of risk, decision criteria as I am
repeatedly telling you that higher the NPV, lower the sigma should be our decision criteria.

If the reverse happens the project is not worth while it should be abandoned, so simple concept
of the mean variance has been applied by Professor FS Hiller and he this modeling is popularly
called as the Hillers model? So this is one technique.

(Refer Slide Time: 18:54)

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Next technique is now we move forward is with the stimulation analysis and after this we will
talk about or will discuss the say your decision tree analysis. Simulation analysis is operations
research technique basically but as now sometimes we started applying it for the project
evaluations also especially for the risk analysis in the project capital budgeting proposals, so
stimulation is basically because it is a very complex process.

It is not possible to be done manually though we do it on the systems or the computers but
manually also it can be done if the situation is very simple and there if the say total calculations
to be done are not very complex. So stimulation as the words communicate or this term
communicates stimulation means to stimulate something, to stimulate something so it means
under stimulation analysis what we do, we create an artificial model of the project.

We create the artificial model of the project where we predict everything depending upon the
DPFR information given in the Detailed Project Feasibility Report we try to put all the things at
the respective places and with the help of stimulation process which is a methodology technique
we try to create the model of the project and then we try to see whether this model looks
worthwhile or not.

So why we need the computerize analysis because many a times you have to change the figures
to means arrive at the acceptable estimates so here when you talk about the stimulation technique
or the stimulation process of say risk analysis here is a procedure given here. Number 1, point
number 1 says model the project, this point says model the project.

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You have to convert the whole project into a model and what it is written here? The model of the
project shows how the NPV is related to the parameters and exogenous variables, how the NPV
is related to the parameters and exogenous variables, what are the parameters now? Parameters
are the variables specified by the decision makers and held constant over all stimulation runs
whereas exogenous variables if you talk about these exogenous variables are inputs or the input
variables which are stochastic in nature, very volatile in nature and outside the control of the
decision makers.

So what you have to do is, you have to identify the parameters, now what are the parameters?
Parameters are like say for example which will remain constant, first of all cash outflow, then
you talk about the cash outflow means investment and then you talk about the cash inflow and
then you talk about the different parameters here that in case of the say for example let us go
back to the sensitivity analysis, if you go back to the sensitivity analysis means stimulation
analysis is sort of a technique which is advanced version of the sensitivity analysis.

Under sensitivity analysis what we have done, we change 1 variable at a time, we change
investment then we see what is the impact upon NPV? Then we change sales, what is the impact
upon NPV? Then we change the variable cost, then we can change the fixed cost, so 1 variable at
a time but the problem there we face is that we are not able to establish that how likely the
change in the sales is going to be there.

How likely the change is going to be there? How likely it is that the variable cost will be changed
and it will be this much? How likely it is that the fixed cost will be changed and it will be this,
that likelihood is not possible to be established in the sensitivity analysis but in the stimulation
analysis we remove that limitation and in that case we try to find out what are the parameters,
means what is the cash (inflow) outflow? What is the cash inflow in terms of means for
calculating the cash inflow you have to follow the sensitivity analysis and within this case you
have to determine these parameters?

These parameters are given to here to you are for example investment we have to find out, sales,
variable cost, fixed cost, depreciation, pre-tax profit and taxes. These parameters are known as
constant parameters, cash outflow will be there, sales will be there both the cost will be there,

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that is the fixed cost and the variable cost, depreciation will be there, tax will be there, all these
things which is which are going to be constant there are known as the parameters.

But what are the exogenous variables? Exogenous variables are their values, these values here.
These values are not in our control, if you go to sell certain amount of quantity in the market to
some extent we can try but largely that depends upon the market situation. Similarly, when you
talk about the investment, when you going to make investment we have pre-estimated the
investment we are going to make but they are sometimes out of the control also that when we
started building the project the prices of the steel went up.

Or when we want to say build up the project labour prices went up, so it means it is beyond your
control. So both the variables we have to identify that is the parameters and the exogenous
variables, once these variables are one are constant another are stochastic highly volatile so one
is sales are going to be there, how much sales are going to be there? That is a exogenous factor.

Similarly, variable cost is going to be there that is stable, for sure we know it but how much
variable cost is going to be there? We have estimated but it can change also, so that is called a
stimulation that we change the variable cost, change the figures time and again, if this is a
variable cost what is the result? If this is a variable cost what is the result? And then how likely
we are able to establish with the help of this technique.

So stimulation means creating a prototype of the project on system not physically on the system
and then means taking all the information into account trying to find out whether it is going to be
as far our expectations or not? If it is not going to be as per our expectations, then I think it’s
better to abandoned the proposal but it is going to be then so you can change means the
flexibility here is you can change the figures time and again and you can see the impact of the
changes.

So you have to model the project, second thing is specify the probability distribution of these
variables, probability distribution of these variables that is the likelihood this much of the sales
will be there, this much of the variable cost will be there, this much of the fixed cost will be
there, probability you have to assign depending upon different estimates either you can see the
say figure form the adjusting firms or information source is or you can take the help from other
sources but you have to assign the probability somehow.

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Then draw values at random and calculate NPV, so it means after say putting the values
whatever the values we want, say for example sales in the 1 st year will be 100 million, 2nd year
will be 150 million, then will be 200 million, so it means they are basically the say the drawing
the values at random, random we are writing here but they depend largely upon the market
random analysis and assign the probability that when we went to the people what was your
mindset when they responding to the question.

So I think people were largely serious about it because the product we are going to manufacture
it is going fulfill one of their necessities so I think they will certainly buy, so probability can be
80 percent. But if you go to non-serious respondents’ probability can be 50 percent, he may buy,
he may not buy. So like that you have to change it. Repeat 3, we can call it as repeat these steps,
repeat this point number 3 you call it as repeat point number 3, many times and plot the
distribution, this is the random draw values at random, so you can say.

When you talk the value of random so you can say it can be 100 million, it can be 150 also, it can
be 75 million also. So repeat step number 3, may times and plot the distribution. After that
applying the probability and these values, these values you have to change, so if you change
these values time and again it can be 75 million also, it can be 100 million also, it can be 150
million also and whatever the probability that we have assigned, so multiply those figures with
the probability and then the expected value can be calculated and their distribution can be
plotted.

And on the basis of that whatever the total means the relationship between the cash outflow and
inflow depending upon the level of sales, depending upon the level of fixed cost and the variable
cost comes up that can be worked out. So it means we have created a project where any kind of
changes were required we have done that and we have different kind of distributions by changing
the different say exogenous variables not parameters.

So values we have changed randomly we have applied the values, we use the word randomly but
we are say basing it upon some estimates and then multiplying it by the probability estimates
then you can easily develop that distribution and that distribution when means plotted on the
paper will give us some idea about whether the project is going to be a worthwhile proposition or
it is not going to be a worthwhile proposition right.

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So this is the stimulation analysis, I am not doing any problem here with regard to the
stimulation analysis, so for the detailed reference of this Hiller model as well as the stimulation
analysis one simple problem has been discussed in the book which I means time and again refer
to Financial Management by Prasanna Chandra if you refer to that book in the say risk analysis
in the capital budgeting proposals author has explained how the stimulation model will work but
there also the author has admitted that in fact the stimulation can be applied with the help of the
computers or with the help of the software.

But still for the sake of simplicity and understanding the stimulation analysis well the author has
done one simple example. So if you want to learn practically that how stimulation analysis can
be used in the risk reduction or the risk analysis or the capital budgeting proposals you can refer
to the book. So after these two techniques, technical say methods or mathematical approaches FS
Hiller model as well as the stimulation analysis next thing is the decision tree analysis.

This technique is very interesting technique you must have say heard about this technique
decision tree where we try to find out that yes if there is any decision to be taken we can say that
this decision may be taken may not be taken. If we take the decision what is the probability of
success? If we do not take the decision, what is the probability of say not taking or if we take the
decision what is the probability of success? What is the probability failure?

So should we make investment? Should we not make investment? So develop a tree, we try to
find out what are the possible outcomes and with the help of those outcomes we try to assign
some probabilities, so we means try to find out certain decision points and certain chance points.
In the decision points we say yes or no or we propose different options available and in the
chance point we assign the probability to those options or those decisions and then we try to
calculate again NPV of the project.

And with the help of that NPV we can decide about whether to go for this project or not, so how
this decision tree will work and what this technique is I will discuss this technique with you not
now in the next class so till then means you should read, you should try to understand what are
the other than the first 3 techniques like sensitivity analysis, scenario analysis and breakeven
analysis what is the Hillers model which is basically mean variance analysis.

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It looks a very complex model but it is a very simple and interesting model where the expected
NPV and expected sigma or the standard deviation is worked out. NPV represents return and the
sigma returns the risk in that model and stimulation is all we understand.

Stimulation is basically the say creating the project on the paper by changing the different
variables which are say you can call it as exogenous variables the values of that assigning the
probability and trying to find out that in the best possible situation how the project is going to
behave and in the worst possible situations how the project is going to respond and whether to
finally go for the project or not.

So these were the means till now we have completed the 5 techniques and the last technique that
is a decision tree analysis again most interesting most useful technique and how we can use in
the risk analysis of the capital budgeting proposals or the new investment proposals that I will
discuss with you in the next class, till then thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 45
Risk Analysis in Capital Budgeting - Part VI

Welcome all, so in the process of learning about the different techniques of risk analysis in the
capital budgeting proposals now we are going to discuss the last technique, 6 th technique and this
technique is called as the decision tree analysis. Decision tree is a very popular way of analyzing
or taking very important decisions in the business. And in the risk analysis of the capital
budgeting also we apply this concept here.

So how we talk about the, how we develop the decision tree, if we talk about that concept, so you
I will take you directly to this level, for example this is a decision tree we have developed here,
so you can say that it starts from here and it moves through this different branches of the tree.

(Refer Slide Time: 01:15)

So this is the model of the decision tree but how this tree is developed and what is the
background and how it helps in say calculating the NPV of the projects and analyzing the risk in
the say capital budgeting proposals that I will discuss with you first. So in the decision tree there
are 2 steps involved, right there are 2 steps involved. One step is first step is the, delineate the
decision tree first of all you draw the decision tree.

709
And second step is evaluating the alternatives, these are the 2 steps involved here which is given
here also in this structure, we have already written that delineate the decision tree and second
thing is evaluate the alternatives and then which alternative is the best alternative on the basis of
NPV to be calculated that alternative we are going to select, right.

(Refer Slide Time: 02:07)

So in this case delineate the decision tree means identify the decision points and the chance
point. When you develop the tree you try to find out the decision points and the chance point, so
to first of all we have to take decision, we do this thing, we do that thing, right. If we do this

710
thing what are the chances of success? What are the chances of failure? If we do that, what are
the chances of success? What are the chances of failure? So you have to take the first of all
decision and then try to find out to what extent the decision is going to be a success or is going to
be a failure and there we will use the probability estimates, right.

Chances of the success of the decision or chances of the failure of the decision, so first step is
delineating the decision tree or draw the decision tree, right. Second is evaluating the
alternatives, so it means when you have to evaluate the alternatives read these steps very
carefully, right. When you want to draw the tree you can start from here, you can start from the
left hand side but when you want to evaluate the alternatives available you have to start from this
side and this is called as the right hand side.

So left hand side and right hand side, right so in this case first is start at the right hand end of the
tree and calculate the NPV, what is written here, calculate the NPV at various chance points that
come first as one proceeds left ward. So it means what you have to do is, you have to start from
here and then you have to calculate the NPV, so these are the chance points. First chance point is
C2, right and when you talk about the C2 here so you have got the 2 chances here, C21 and C 22
right.

These two chances are there, so it means C21 is chances are of the high demand which are 60
percent and here are the chances of low demand which are 40 percent so chances there can be
two chances and both the chances we have to associate with the probability, right. Similarly
given the NPV of the chance points at the step 1 we have to then calculate the NPV. On the basis
of the values given here, we will have to calculate the NPVs by applying the say this present
value, interest factor for annuity concept.

We have to calculate the NPV and once that NPVs calculated given the NPVs of the chance
points at step 1, right here at step 1 evaluate the alternatives at the final stage of the decision that
out of the decision on the basis of the chances here this chance and this chance these are the 2
outcomes of the chances and probability assigned is 60 percent, 40 percent on the basis of the
NVP coming out here we will have to evaluate this decision which is now we are going to say
that the 2 possible decisions we can take either we can take the decision 21 or we can take the
decision say we can take the decision D21 and or we can take the decision D22.

711
So if you say go for it so means if you take this decision we go for the investment and if we take
this decision we go for stopping, we will not take make investment. But if we go for the
investment chance of the high demand are this much, chances of the low demand are this much,
right?

So we have to calculate the NPV here and then on the basis of that we have to evaluate this
particular decision which we are going to evaluate, so this is the step number 2. At each final
stage decision point select the alternative which has the highest NPV and term care the other
alternatives, each decision point is assigned a value equal to the NPV of the alternative selected
at that decision point, so it means we will have to then follow the step calculate the NPV here
and then try to find out that which one is the highest NPV out of the two.

This is going to give you the highest NPV or this is going to give you the highest NPV since this
decision is going to stop the project so no question of NPV, NPV can be expected here only so
here it will come as the present value of the cash flows and minus this investment of 100 million
rupees which we are going to 150 million rupees’ investment which we are going to make here,
so it means whatever the value comes up here that people have to calculate.

Though the value is also given here, expected market value is also given to us which is 194.2
million, how it is calculated I will explain it to you and this is outflow, so this is the present value
of the cash inflows and this is the present value of the cash outflows, so 194.2 million minus 150
so the NPV is going to be 44.2 million positive NPV, so we are going to take the decision. So
this way the whole process has to be followed.

Lastly proceed backwards, means towards left side in the same manner calculating the NPV at
chance points so selecting the decision alternatives which has the highest NPV at various
decision points truncating the inferior decision alternatives and assigning NPVs to the decision
points till the first decision point is reached, right. So you have to means sum of the decision
have to be discarded.

But some of the decision which are taken they have to be evaluated on the basis of the chances of
the success or failure and after that the decision which is going to give us the highest NPV that
has to be identified that has to be means say evaluated and if says that yes NPV is going to be

712
positive here then certainly we will take the decision or we will means make the investment or
will do the needful for making that investment, right.

So this is the these are the 4 steps involved largely first two steps, first of all draw the tree and
then evaluate the alternatives. Drawing the tree, you have to start from the left hand side but for
evaluation of the alternatives you have to start from the right hand side, starting with the chances
moving to the decision and then evaluating the first decision, similarly evaluating the second
decision and then going to the last one.

The beginning whether we should go for this investment or we should not go for this investment,
so this is a nutshell you can say the decision tree analysis and how we can apply the technique of
the decision tree analysis.

Now to understand this technique well and how this tree has been drawn here and how these
values have been calculated, we will do it ourselves here and then we will try to find out that by
using the concept of decision tree how we can say analyze the risk associated with the project
and take the decision whether to go for this investment or not to go for this investment, right.

(Refer Slide Time: 09:07)

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So now let us see this problem and then we will do the required analysis, what is the problem
here? Alpha Ltd has come up with an electric moped, new electric moped they have developed,
this is the product which they have developed is electric moped, this is the name of the company,
this is Alpha Ltd. The firm is ready for pilot production and test marketing right. Means all test
have been done and now the marketing, test marketing can be done, pilot production can be done
and test marketing can be done.

When you want to go for the pilot production and test marketing that will cost us how much? 20
million rupees and it will take a time of how much? 6 months, right and on the basis of the
results of the say your pilot production and test marketing if the results are encouraging we will
go for the commercial production otherwise, we will lose 20 million rupees and we will abandon
the project.

Management believes that there is a 70 percent, now this is a chance there is a 70 percent chance
that the pilot production and the test marketing will be successful. In case of success alpha can
build a plant costing rupees how much? Rs. 150 million, total investment requirement is Rs 150
million and for the test marketing and pilot production the investment requirements are quite low
which is 20 million rupees. Plant manager generates, plant will generate an annual cash inflow of
30 million rupees for 20 years

714
if the demand is high or an annual cash flow of the 20 million if the demand is moderate, high
demand is the probability of has a probability of 60 percent and low demand has a this is
basically 0.6 percent so this is the probability of 60 percent and this has the probability of 40
percent, 0.4 and what is the total investment? The cash inflow will be coming up as 20 million
and the time period is 20 years.

The discount rate is 12 percent, in this case now evaluating this whole information this is the
electric moped we want to say start manufacturing but final commercial production will start
only after the results of the test marketing and the pilot production and the test marketing
becomes encouraging or positive and the investment required for the test marketing as well as
pilot production is 20 million but if the results are quite encouraging then the commercial
production will start.

And for staring this commercial production will have to make a proper investment of 150 million
rupees in the plant and the sales expected are say annual sales expected from this plant of this
investment will be 30 million rupees for a period of 20 years. In case of the high demand and
minimum is 20 million in case of the moderate demand. Probability of high demand is 60 percent
and probability of low demand is 40 percent and discount factor we will use for calculating NPV
is the 12 percent.

So what is required here, conduct the decision tree analysis and advice Alpha accordingly about
the production of the moped. So now we have to go for the conduct the decision tree analysis we
have o conduct the decision tree analysis and advice Alpha Limited accordingly about the
production of the or about the commercial production of the moped. So now we have taken this
decision here and for taking this decision if you see we have found out here is that is say here
you are given the total in case of the high demand we are given the 30 million of the say sales.

In case of the moderate demand sales will be annual sales will be the 20 million or cash flow I
would say not sales, cash flow will be 20 million probabilities is 60 and 40 so we have to
calculate the NPV of these values or with the help of this investment proposal or these
investment requirements let us now evaluate it, so now we have to calculate the say we have to
develop the decision tree here and we should look at this decision tree.

715
We started with this D1 right, what decision was here? First step is delineating the decision tree,
draw the decision tree, second is evaluate the alternatives, let us discuss how it has been drawn.
We have first started with the D1 and then we said that pilot production and test marketing is
requiring how much? 20 million rupees and do nothing is no investment is required if you want
to not to go for the investment or do not want to even test the product in the market.

Now if you go for this chances of success that is C11 are going to be 70 percent and chances of
the say you can call it as failure, it is S mean success and F is a failure, chances of the failure,
failure of the test marketing will be 30 percent and if we go for means if we become successful,
if we become say as per the 70 percent chances if we become successful then we will go for the
commercial production where the decision 2 will be taken and investment of 150 million will be
required.

Or if we are means accepting this where the chances are quite bleak 30 percent we will not go
ahead, we will not go for any kind of commercial production. For example, as per the 70 percent
probability of success we go ahead and we take decision 2 where the first thing comes up is that
we will make a investment of 150 million rupees in the plant, second decision may be not to go
ahead. But we are going to decide because chances of success are quite high so we are going to
make this investment of 150 million.

So two decisions you might take, either you take D21 or you take decision D22, if you take 2 1 it
means this investment will be made, if you take D 2 2 no investment will be made. Once the
investment is made, now we go to the C2 level. C2 level says that chances of the high demand
are 60 percent and chances of the low demand are 40 percent and if there is a high demand
annual cash flow will be of 30 million and if there is a moderate demand then the annual cash
flow will be of 20 million, right.

So first this tree has been delineated or drawn has been means given the shape. Once this tree has
been given the shape now the second thin we have to do is evaluate the alternatives though the
values are also (kept) given here after the evaluation but how these values have been worked out
partly the information is given to us in the case and partly like this value we have worked out,
this value we have worked out.

716
So these values we have to work out on the basis of the present value analysis of the cash flows,
cash inflows and then same concept of the NPV we have to apply where we will subtract the say
the amount of the cash outflows from the amount or the present value of the cash inflows and try
to find out the NPV. If the NPV is positive we will take the decision, if NPV is negative we will
abandon the decision. So now second step in this decision tree that is for the evaluation of the
alternatives we are going to learn how to take that decision, right. So for taking that decision
what we have to do is.

(Refer Slide Time: 16:58)

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Now we have to calculate the say NPV at the different chance points and first step is to calculate
the NPV at what chance point? That is C2, we are starting from the right hand side, right, I am
starting from the right hand side and this is C2 so these are the 2 outcomes of the C2.

We are going to calculate the present value of these cash flows, 30 million and 20 million, so let
us calculate the present value of these cash flows, so NPV at C2 is going to be how much? The
first one is what is the probability? 60 percent and how much is going to be the cash flow? 30
millions and you are going to multiply it with something that is present value interest factor and
that is for NOT because this cash flow of 30 millions will be available for a period of how many?
20 years, right?

So means we are going to calculate it for 20 years and discount rate is given to us 12 percent, so
we are going to evaluate this part, 60 percent is the probability that your cash flow will be 30
millions plus 40 percent is the probability we are writing here plus 40 percent is the probability
of the sales or the cash flow of how much? 20 millions PVIFA and again how many years? 20
years and the discount factor is 12 percent close the bracket.

If you solve this you will come out with that the cash flows is going to be how much, rupees
194.2 millions, 194.2 millions is going to be the cash flow of this particular, so this is not the say
yeah one correction I will like to make here, this is not the NPV actually, this is going to be the
we have to call it as the in the book also it is written as NPV but this is not NPV this is basically
the present value, this is the present value of the cash flows.

So present value of the cash flows is going to be 194.2 millions, right this is the step number 1,
so first of all what is the cash flows given to you as per the chance 1 and the chance 2, chance of
success 1 and chance of success 2 and their respective probability multiplying by the probability
you calculate the present value of the cash flow and if you calculate the present value of the cash
flows then you will be able to take the decision.

So it means now to go to the step number 2, if you go to the step number 2 now what you have to
do is that you have to now calculate the NPV at the say D2, what is the decision here? we have to
now say evaluate it so if you look it at the say whatever the total information is given to us here

718
on the basis of that we will have to say try to find out that because we wanted to take this
decision D21.

So we have to take this decision on the basis of the chances of the high demand and low demand
so it means you have to evaluate now the say decision alternative D2 and for that what you have
to do is, you have to follow the step here, so put here as the alternatives, we write here
alternatives and put here as the NPV, right. Now it will be NPV this is the cash flow present
value of the cash flow and now we are going to calculate the NPV.

So what is the decision here? D21 and how much investment is required? Initial investment
required is 150 millions, right and how much is going to be the cash flow available or NVP
available? NVP is going to be rupees 194.2 minus 150, so NPV is going to be how much? 44.2
millions rupees, 44.2 millions is going to be the NPV, so this is the decision in favor of D21 and
in case of the (D2) D22 what it says?

It says stop, no investment is required to be made, so there is no question of calculating the NPV
here, so we have to go for calculating the present value of the cash flows as per the chances of
the success and less success and then to evaluate the decision on the basis of the chances of
success or failure and on the basis of that we have done this, so once you have done it so we are
going to select how which decision, decision D21 because NPV of this decision is more than
D22.

So you can all it as NPV of D21 is greater than the NPV of D2, so it means we are going to say
take the decision in favor of D1, so decision 21 is going to be the final decision which we are
going to accept and we are going to means make the investment of 150 millions because the
present value of the cash flows available is going to be 194.2 millions, so this is a first step half
of the decision we have taken here.

And now we will have to go for the next level and then we have to calculate now the NPV at C1
and what is the C1? C1 is this, C1 is about making the investment about the say this one D1, test
marketing, right. So test marketing is requiring the investment of how much? 20 millions and 70
percent chances are of success the test marketing will be successful whereas 30 percent chances
are of the failure.

719
So now we are going to evaluate the decision which is called as D1 or D11, on the basis of
chances C11, right. So for this we will have to calculate now the NPV. So nest thing is step
number, this is the step number 3 and this is a step number 4, so you can call it as present value
at C1, we have to calculate the present value at C1 not NPV but the present value at C1, so what
is the probability of chances of success? 70 percent, so it is 0.7 into how much is the cash flow
expected?

44.2 right, then plus it is how much? 30 percent chances are how much of the failure? Where the
cash flow is expected to be because if there is a failure there is no cash flow at all, we are not
considering, we are not calculating the cash flow. So it means in this case we are going to find
out that the total this cash inflow si going to be 0 because if there is a failure, there is no cash
inflow so if you calculate this, so you are going to find out that present value of the cash flow is
something like rupees 30.9 million.

44.2 is going to be the say the total cash flow available and if you calculate the present value of
that cash flow so you can say that finally the total amount which is going to be this is going to be
the expected value, at this decision C2 44.2 so it means if you say look it at the 44.2 if you see
the 70 percent of the probability of having this cash flow and 30 percent is of not having any
cash flow, 0 cash flow, so present value at the C1 is how much?

That is 30.9 million, rupees 30.9 millions, so like this now at this 5 we will evaluate now like this
alternatives and then we calculate the NPV, alternative and then we calculate the NPV, so what
is the decision here? The decision here is D11 we are going to take the decision that is your D11,
so means on the basis of these chances we are going to evaluate the decision D11 and D11 is
saying go for the pilot production.

And if you go take this decision, go for the pilot production, so how much is going to be the
investment here? 20 millions is the outflow minus how much is the NPV available 30.9 million,
so NPV is going to be how much? 10 point, rupees 10.9 million is going to be the NPV of the
project and we should go ahead with this investment or not we will have to take the decision now
on the basis of these estimates.

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So it means this is 10.9 million, right so we have taken the means we have evaluated it an if you
go further this D2, decision number D12 so it means in this case what you are going to say? Do
nothing, it says do nothing so if you do this so NPV is going to be 0, so it means the D11 which
is more important for us. If you talk about the decision here, D11 is more important for us and if
you take this decision D11 then we are going to have this NPV of the 10.9 million rupees, right.

So it means finally what can you say is your decision should be once you have to write the
decision, what you have to write here is based on the above calculations you should write like
this, based on the above calculation we find that the optimal decisions strategy is as follows, it
will depend upon what? All these calculations are available now with us, will depend upon the
following things.

Chose D11, right chose D11 because the outcomes seems to be positive here that is 10.9 million
NPV is expected to be 10.9 million so chose D11, make investment of 20 million and go for pilot
production and test marketing and wait for the outcome at the point C1 here right, so if the
outcome at the C1 is success, outcome at the point C1 is the success which we had calculated
here as at the probability of which is 70 percent.

It means because we go for the decision of D11, so as per that decision what we are going to do,
we are expecting NPV is 10.9 million positive NPV is there, it means we will go for D11 and we
will make investment of 20 million rupees, we will start the pilot production and will go for the
test marketing and if the decision is where the C1 is C11 which is the you call it as the decision
is success, if the decision is success here, so it means C11 is the success there the chances are the
70 percent then you make the investment of 150 millions.

Then you make the on the basis of this investment, on the basis of this outcome of success invest
150 millions and go for the commercial production, but if we go for the decision not C11 our
chances which are at the C12 which is of the 30 percent or these 30 percent chances are of the
failure, 70 percent chances are of the success, 30 percent chances are of the failure if the decision
C11 is upheld then go for the making investment of 150 millions go for the commercial
production and this project is viable, what if the C12 chances 1 2 are say held means you call it
as viable or acceptable or finally is going to be the outcome which is a failure and the chances
are only 30 percent but still are there then its better not to go for making this investment.

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So it means this analysis tells us that NPV are both the decision reliable, so D1 and D2 level
based upon the chances of success and failure is positive. In the first case, in case of the pilot
production NPV is going to be 10.9 million which is quite a positive NPV and at the second
stage once you make the investment of 150 millions and go for the commercial production NPV
is expected to be again very high 44.2 millions and that is again positive, right.

So since at both the levels NPV is expected to be positive so I think we should go for making the
decision in favor of making this investment initially at the smaller level as a pilot project and test
marketing by simply investing 20 million rupees, once the say outcome is success C11 is upheld
decisions of C11 is upheld where the chances are 70 percent then we take the final decision,
invest 150 million rupees.

So it means the risk analysis can be done in a way that rather than straightway investing 150
million and losing the entire amount in case of the failure of the project is always better to spread
the lesser amount, to shell out the lesser amount of money lesser amount of investment as in this
case it is only 20 million for the pilot production and test marketing.

If the outcome is positive go for the commercial production otherwise don’t go, so how it helps
in lessening the risk or minimizing the risk or analyzing the risk is in terms of dividing the total
investment of this 150 million into 2 stages. One stage is making the smaller investment where
we have made a proper analysis and chances of the test marketing are also of the success, but in
any case if the second alternative proves good or say holds good and the project becomes a
failure then you can say the remaining amount of the 150 million.

So 2 step investment when we are doing though the results are expected to be positive but still
we have to cautious in making the investment and it has to be made one after the another, so if
we are successful it is a win-win situation but because of some reason if the project fails even in
that case we not going to lose the entire amount only the amount which is invested for the pilot
production that we are going to lose.

So this is the entire way or the process how the decision tree has a analytical tool in the risk
management or the risk analysis of the capital budgeting proposals or the new investment

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proposals can be used, right. So these are the 6 techniques, first 3 are the most popular
techniques, sensitivity analysis, scenario analysis and the breakeven analysis.

Other techniques are used in some cases or in many cases provided the investment is quite large,
so there we use the multiple techniques. So sensitivity analysis is always used like payback
period and other techniques we have a choice either we can go for the simulation or we can go
for the decision tree or we can use the say you can call it as the 2-3 techniques together and try to
evaluate the risk or analyze the risk associated with the project from different angles.

So regarding the different techniques of the risk analysis and the capital budgeting proposals I
could discuss these proposals with you to some extent or may be mean say means the sensitivity
analysis we did in detail, scenario analysis also we tried to understand in detail only two
techniques that is the Hillers model and stimulation model I discuss with you in abstract and
decision tree also we discuss in detail.

And for the further reference, if, you want to learn further more about these techniques then you
can again refer to any good book on financial management. The book which I am also referring
here in this discussion or which is a very good book again I am saying it is the book Financial
Management by Prasanna Chandra. So detailed discussion about all these 6 techniques is
available in that book, or in any other book of the financial management. For the moment I will
stop here and some other important concepts with regard to the say risk analysis in the capital
budgeting proposals I will discuss with you in the next class, till then thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 46
Risk Analysis in Capital Budgeting - Part 7

Welcome all. So in the process of learning about the say risk analysis in the capital budgeting
proposals, now I am going to take the last class on this topic – Risk Analysis. And in this class,
we are going to learn about that after learning about the different methods of risk analysis in the
capital budgeting proposals of the new investment proposals we will be learned about the say
sensitivity analysis, scenario analysis, benefit cost, means you call it as break-even point, not
benefit costs but the break-even point.

And then we learned about the say some advanced techniques, mathematical models like Hiller's
model and then we learned about the say some other techniques like your stimulation analysis
and the decision tree. Now, the question arises that how to go for the say corporate analysis or
maybe the analysis of the project as a whole. So, in this case, because when you talk about the
different techniques, so we can say that those techniques help us to learn that how to measure the
risk or how to go for this kind of analysis.

But in the practical sense, how to do it and say depending upon the risk profile of the project or
the say new investment opportunity or the new investment proposal, it depends upon whether it
say first time a proposal or maybe the firm which is going to take up this investment proposal is
the new firm and there only have this project in their mind or they have some other projects also
or this is an existing firm and in the existing series of investments, they are going to make a new
investment.

So, if it is a existing firm and in the series of existing investments, they are going to make a new
investment then we call it as a corporate risk analysis. But if it is a standalone project, maybe the
only project or the first project of any new entrepreneur or the new say group of the people who
have established maybe a partnership organization or a joint stock company or may be a private
limited company, not joint stock company directly but a private limited company.

So, in that case means the two different approaches we have to follow. In case of the stand alone,
if it is a new firm for the first time they are into the business, they are new entrepreneurs or
maybe it is a startup. In that case the say risk analysis been largely depend upon these

724
techniques. Say sensitivity analysis, scenario analysis, because other say projects are not in say
existence. The firm is already not in existence. It is going to be a new firm.

So we have to make use of these methods maybe the sensitivity and scenario analysis, which are
very commonly used. And then we can say there means the use the break-even point also and in
the new businesses, breakeven point plays a very-very important role because there you have to
recover the fixed cost. Once that total cost, fixed and variable stands recovered then after that
whatever the production and sales we make, that is going to give us the profit.

So in the new businesses, for the new entrepreneurs, the challenge is that to arrive at or reach at
the breakeven point as early as possible. Venture capitalists also when they accept the proposals,
they also expect that in the not in the first year, it may be a loss in the first year; second year will
be a loss, third year at least the business should reach at the breakeven point. So, that fourth year
onwards now the firm or that project or the business start earnings the profit.

If any business is not expected to reach at the break-even point even after say four years, what to
talk of three. But even after the four years, then a venture capital is not liked generally. This kind
of the proposals or this kind of the investment opportunities. So, in case of the stand-alone any of
these methods can be used or say jointly we can use not one method is sufficient. You can use
the break even analysis and we can use the sensitivity analysis or we can create different kind of
scenarios and then we can decide about whether to go for this investment or not.

But in case of the corporate risk analysis, the caution is say, very serious caution is required
because what is going to happen, that it is going to say add up a new activity, a new investment
proposal, and that new investment proposal may be the riskier proposal or maybe say less risky
proposal, riskier proposal. So definitely it is going to impact upon the existing risk say
complexion or the profile of the business.

So, if it is a riskier proposal, then it is going to increase the overall risk of the firm. And if it is a
less risky, then it is going to have the less impact. So, it means in the corporate risk analysis we
will have to think about in terms of that the new project is going to create what kind of the
situation for the existing firm. Say, for example, when I talked to you in the beginning about the
anchor fruit beer project. So in that case, you see that when they lost 350 corers by adding up a
new activity into the business, say it was a very riskier project for them and they lost almost a
very high sum out of the reserve surplus or maybe from the funds raised from other sources.

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So, corporate risk analysis requires that a new investment proposal is going to change or impact
upon the existing risk profile of the firm in what manner? How right. And here we could have
the say two important points in mind.

(Refer Slide Time: 6:01)

First point given here is the project; project corporate risk is its contribution to the overall risk of
the firm. Already we have the say different say you can call it as an investment. The projects we
are already working on these are, the three projects of firm already have or they might have the
different say different three products they are manufacturing and selling now they want to add
the fourth one in the say row. So it means this is means this, these three projects, this plus this
are going to means say give or they are giving some returns as well as the risk.

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But when they are going to adopt the fourth one also, so this is going to impact the performance
of all the three existing projects also. And overall risk profile or the complexion of the firm is
going to be impacted. So, if this is going to be the situation, if this is going to be the case, then
we have to see here that say, second point, on standalone basis or project may be very risky, but
if its returns are not highly correlated. If its project returns are not highly correlated or even
better, negatively correlated.

If they are not highly correlated or even better, negatively correlated with the returns of the other
projects of the firm, its corporate risk tends to be low. So, you must have heard about, for
example, if you have say gone through some concepts of the investment finance. So there we
used the say a portfolio theory for making investment in the market. We follow the portfolio
theory for making investment in the market and there we make the say mean variance analysis.

In the mean variance analysis in the portfolio theory suggested by or given by the Harry
Markowitz long back ask for that say there should be complete diversification of the say
different investment options which we have, and we should not put all of our eggs into one
basket. We should not put all our eggs into one basket. So it means what we are going to do here,
when this firm is going to have four projects. One, this is two, this is three and this is four so it is
means going to be the one which is going to say have the philosophy.

They are not going to put all their eggs into one basket. They had the first project in the
beginning when it was successful. Then they went for the second. Then they went for the third.
And then they went for the fourth. Now, in this case, what is written there in the point, if we have
properly read that ‘returns of the projects must not be positively correlated rather they should be
less correlated or it would be much more better if they are negatively correlated’. It is not the
case of the new projects. It is case of the existing projects also.

So, it means if the especially for the new project, the fourth opportunity, if the returns of this
fourth project are negatively correlated. So, it is going to reduce the risk profile of the firm.
Normally what happens, the diversification we do is because normally there are two kinds of risk
involved in any kind of investment opportunity, in the stock market investment when we use the
portfolio theory which I am just talking to you about, is that just given by the Harry Markowitz,
we used this concept of diversification.

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So what we do is slip the stocks, maybe the individual investor. They do not make investment in
one company's shares only. They make investment partly the investment into this, into this, into
this and into this. So they diversify. And what they do is these four stocks belong to four
different companies which might be belonging to the four different sectors. One must be
belonging to the consumer sector. One is belonging to the consumer durable. One is belonging to
the infrastructure sector and one is belonging to that say you call it as a say, oil and gas or maybe
the telecommunications or any other company.

So four different companies say they have chosen into the stocks of the four different companies
the investment is going to be made. So what is there? There are two kinds of risks involved in
any investment opportunity, whether that is a project investment or whether that is a stock
investment. So, in both the investments, say possibilities or opportunities two kinds of risk are
there; Firm level risk and the say industry level risk or you can call it as economy level risk, not
industry level, but the economy level risk.

So the firm level risk can be managed. You can say, look at that say the profitability position of
the firm or you can look at the financial position of the firm. You can see how the stocks of the
say firm are being say, traded or what is the price people are paying for. So firm level risk
managing the firm level risk there is not a difficulty at all because after proper analysis of the
financial statements of any company, you can make out that for the past three four years, after
analyzing the financial statements if you come to know that this company is performing well so
maybe in the years to come also this company will be doing very well in the market.

So, means in any way you can understand the firm level risk and that can be managed also. But
with the risk, which is the economy wide risk, which is called as the systemic risk, which is a
risk caused by the system that can be in terms of the inflation say rate that can be in terms of the
interest rate so for say a hedging the systemic risk, we have to use a strategy which is called as
diversification, proper diversification.

So, in this case, what we are doing, these are the projects, which are the bigger the project
investment, is being made by the same business entities and these are the stocks where the
investment is being made by the individuals. And in both these say projects as well as the stock
investments if you want to minimize the risk, what you have to do is you have to use the strategy

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of the diversification. And if you properly go for the proper diversification, so you are going to
minimize your risk.

What is now the diversification means that what we are doing it? We are not putting all our eggs
into one basket. It means partly the investment it made here, partly the investment is made here,
partly the investment is made here and partly the investment is made here. Why we are doing it
because we want to go for the diversification of the total investment so it may be possible that
the returns from the different investment options may behave like this. It is like this. It is like
this. It is like this. And it is like this.

Returns of one stock are going up, one is going down one are going up, one are going down. So
what is going to happen that if there is going to be any loss in any project that will be offset by
the profit from the other project? Similarly, if there is going to be a loss in one stock investment,
then it may be offset by the profit or gain in the, another stock price because the price of another
stock may go up right. So, in this case means because I have as I am saying what is written here
that with the returns means on a standalone basis the project may be very risky, but if its returns
are not highly correlated or even better negatively correlated.

So this is called as a negative correlation. Highly correlated means all four are going like this or
all four are going like this. This can be like this if they are a highly correlated. So what is
happening? All the four investment options are going to be either the loss or the profit. And that
is a very bad situation. So for managing the corporate risk, like as we manage the individual's
level risk that is by say diversifying our investment into different kinds of stocks. The firms also
have to diversify the say investments.

And you might have seen the bigger companies like say, for example, Hindustan Unilever; they
make investment into different type of the products. Some of the investments they are making
into the say your consumer products some are; some investment means their total portfolio if you
look at even in the consumer products also the total investment is not into one product into the
different products. So, because of the change in the taste of the people requirement of the people
demand for the one product may go down, but the demand for the other product may go up.

So they have a property portfolio and same is the case with the other say investors also, bigger
companies, for example, you talk about the reliance, not the reliance is the different activities
they have investment into the say distribution, also reliance stores are there, they are into the

729
petroleum and chemicals. They are into the textiles also; they are into the telecommunication
also. So why this all they are doing to minimize the risk, the corporate risk so that if the one
sector is not doing well.

The other sector will do well. And there is a very say standard saying that a firm will stand better
of means like a balance firm in the market if it has minimum three legs, if it has minimum three
legs for example, we have the say black board. So how many legs it has? It has three legs. If it
has only two legs, what will happen, it will fall down if it has only one leg. It is not possible for
the firm to stand. If it is the three legs, minimum three legs and I am saying if it has more legs
then there is no problem.

But minimum if it is three legs are there it is better for the firm to keep on standing rather than
having the lesser than three, because that will create a very difficult situation. So what we can do
is we can use the strategy of the diversification and proper diversification so that that the loss and
profit situation into different products ultimately means either means it takes us to a no loss
situation or maybe lesser loss in the one project may be compensated by the more profit in the
other projects. So ultimately the firm keeps on going.

So corporate risk requires the proper diversification strategy and apart from following this
sensitivity analysis, scenario analysis, breakeven analysis, we should go for the proper
diversification. So, that means if one sector is giving a loss, other is giving the profit and firm is
going on. It is continuing its properly functioning in the market. So this is a corporate risk
analysis. Then managing the risk, how could we manage the risk?

(Refer Slide Time: 16:18)

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We have the different options available here and for managing the different options available
here, say you can use any of the strategies here. For example, you can manage the cost, you can
manage the price you can to manage the investment like a sequential investment. We can take
care of the financial leverage, insurances and other way out then long term arrangements are
there, strategic alliances are there and derivate are there. So, I will discuss them these important
things nutshell, not in detail because of the shortage of time and for the detailed discussion and
detailed reference.

Again, you can refer to the book, any book on financial management. Now, for example,
managing risk by say managing the cost both fixed and the variable cost. Normally what happens
that when the fixed cost of any firm is very high, so it is very difficult for the firm to reach at the

731
breakeven point at the earliest? Because when you calculate the break-even point, first of all, we
calculate the contribution and after a contribution, what we talk about here is a break-even point,
can be calculated by a fixed cost divided by the contribution margin ratio CMR.

And after this fixed cost ends are recovered we arrive at the profit right. So, break-even point is
this and then the same I would say that is equal to this. You can do one thing here is that is the,
for calculating the profit once this fixed cost is recovered, it means we are at the state of no
profit, no loss. And in this case, the say for calculating the profit what you have to do is
contribution margin ratio or maybe not contribution margin ratio but the contribution margin
here you would say contribution margin minus fixed cost. So that is going to give you the profit.

So, it means if you are say manufacturing everything yourself for the firm is going to
manufacture everything by themselves it means in that case they have to create the fixed assets
or maybe the plant building and machinery. And if they are going to make huge investment into
the fixed assets, it means they have to recover that fixed investment also. And in the process of
recovery of the fixed investment, their break-even point will go very high. So, it will take means
larger amount of time for the fund to reach at the say profitable stage.

So in this case, sometimes what happens the firms may adopt the strategy that whatever the total
number of products they want to say sell in the market under their brand name part of the
products they can manufacture themselves, part of the product they may acquire from the market,
from the small manufacturers. Those small manufacturers can be asked that you manufacture for
us and then manufactured under the proper quality control. The manufactured products can be
bought from the small manufacturers and they can be sold under the company's own brand name.

And many say consumer products manufacturing like Hindustani Unilever, Dabur, Parley's, even
Patanjali also, Patanjali whatever the products they are selling in the market under their own
brand name, they are not manufacturing all the products. They have outsourced the
manufacturing. So in that case, what happens, we do not have to say shell out the larger amount
of investment for making investment into the fixed assets also. So we are avoiding investment
into fixed assets and then only by incurring the variable cost.

We have to recover only the variable costs so lesser the amount the fixed cost, higher the amount
of the variable costs it is easier to reach at the profitable stage rather than having the higher
amount of the fixed cost. So means arriving at the fixed cost will create the problem. And I think

732
that the break-even point will create a problem. So it means we can manage the fixed cost. It
happens many a times. For example, a long back you must have heard about the company's name
Onida. Onida was a leader in the consumer durables market.

They were manufacturing electronics products like color TVs and say other things like air
conditioners and washing machines. So, till I think 2000, ‘99 - 2000, they were the leader in the
market. But after that, because of the multi-nationals’ influx in this economy, they started losing
the market and today the Onida's overall say the market share is not very high. So in 2001 or ‘02
they adopted a strategy that if they keep on manufacturing all the product they are selling under
the brand name, brand name of Onida then it will be very difficult for the company to meet the
fixed cost because their sales got negatively hit.

So, then they adopted the strategy their part of the product they manufacturer themselves and
part of the products they outsource and then they bought the manufactured products and then
sold the products under their own brand name. So that happened the company two, 2 means, to
take care of the fixed cost so that way you can minimize the fixed cost and simply by incurring
the variable cost and recovering that we can increase the profitability of the firm that can be the
one strategy.

Then pricing strategy, so sometimes if we are say feeling that we will be able to gain the larger
market share by reducing the price of the product so it will be a better strategy, but if you reduce
the price of the product so risk comes up here is again reaching the break-even point creates the
problem. So, we have to be very careful looking at the total market dynamics that say what price
should be charged. There the two kinds of the marketing policies.

One is a market penetration policy another is the market skimming policy, under the market
penetration policy to earn a desirable amount of the profit we reduce the price and increase the
number of units we are going to sell in the market. So what happens? Per unit profit is lesser but
when we sell large number of units in the market, so it means multiplied by the large number of
units, the per unit profit which we are earning ultimately the profit volume or the amount of the
profit comes up as we want to earn.

But under the market schemed policy or the market skimming policy, what we do is we keep the
price of the product relatively high and the target that by keeping the relatively high price for our
product will not be able to sell the large number of units in the market rather lesser number of

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unit is in the market, but since the profit per unit is very high. So, it means ultimately we will be
able to reach at the point of profitability where we want to reach.

So, depending upon the risk profile, market dynamics, customer preferences, consumer
preferences, we can follow the marketing policy and we can price the product by following either
the market penetration policy or the market skimming policy. So risk can be managed.
Sequential investments do not make all their investment together. We can follow the decision
tree. So we are not going to make a say for example, all the investment together. You see that we
are going to do like this.

And then we are going to do like this so we can create a decision tree means decision tree
analysis is very, very important in sequential investments. If you make all the investments
together and if for example it does not work, then huge risk is involved so sequential means, for
example in 1982 when Nirma came up to a came up in the market by Karsanbhai. So, he started
the say production at a very small level. He distributed initially had free of cost. Then he say
when the response was very good he started the commercial production.

But the commercial production was also means carefully done and producing that all other
investments, whether they are into the education sector or whether they are into the cosmetics or
they are into the detergents means first was the detergent. Then they moved to the cosmetics,
then they moved to the education sector. So sequentially, investments are made in the market and
that can also help to manage the risk.

Financial leverage keep the level of borrowings debt amount as low as possible because debt
brings the risk in the firm, because debts always has a fixed charge and if you are paying the
fixed charge means if we are borrowing more funds especially when we are the new in the
business, it is the advice to the new entrepreneurs that if they want to move into the business or
maybe you want to have a startup, always avoid to borrow money in the form of the debt capital
and debt is known as basically the financial leverage.

The technical name of the debt capital is called as the leverage. So, keep your leverage as low as
possible, because if the more funds come as a borrowed capital, as a debt capital and the firm
start incurring the losses so you will not have the say liquidity, or the funds surplus funds
available to service the debt and to repay the principal. And that will means immediately create a
situation for the firm where the firm has to be to be liquidated because it will become bankrupt.

734
So always means the financial sources should come largely from the internal sources more in the
form of the equity capital or investment from the entrepreneurs.

Similarly, if it is an existing firm they want to make investment into the new project, even in that
case also borrowings should be as low as possible. The component of the financial leverage in
the capital structure has to be as low as possible, so that the fixed charge, fixed financial charge,
creation of the fixed financial charge is as low as possible and it is within the manageable limits.
So financial leverage has to be managed to keep the risk low.

Insurance we can get our all fixed assets, our people insured, even our stock insured, so that in
the event of any loss we can say, we can means take advantage of the claims to be paid by the
insurance companies and business is ultimately safe. Long term arrangements – Long term
arrangements are in many terms. For example, we can enter into the long term arrangements with
the suppliers that you will keep on supplying at this particular price per unit for the next 5 years,
that means you will not change the price.

Normally because of inflation we have to change the price of the raw material. But if you are
entering into 3 to 5-years long term arrangement, then I think we are at the means in a better
position, we can enter into the long term say agreement with the labor, with the workforce, with
the employees, that you will be paid this much an annual increase for the next 5 years will be this
much. So, it means firm is safe they are they know in advance that supply of the material for the
next five years is assured.

The availability of the human resource is best human resources is assured for the next 5 years.
Similarly, we can have the long term say contracts with the say buyers of the finished product.
This is one classical case here. Steel Authority of India Limited when it became a sick company
means when they lost their sale in favor of the private sector players after the liberalization of
say Indian economy and opening up of the steel sector for the private sector participation, so they
now how to think about the sales which they lost in India. They had to make the sales good by
looking for the say markets in the other countries.

It was suggested to the sale that if you want to continue selling the same amount which you were
selling earlier, then the economy was a closed economy and you were the largely the sole player
in the steel market. So in that case, you have to look for the markets now in the say countries
outside India. So, they suggested McKinsey as a consulting adviser. They suggested SAIL that

735
Middle East could be a market where you can look for the say, for the customers for the lost
market and they can help you to regain the market and company did, SAIL did like this.

They opened up a say, you can call it as a nodal office in Dubai, and that nodal office facility the
facility to the long term say contract with the buyers in the Middle East countries that for the
next say three years or four years or five years, the buyers in those countries will keep on buying
the finished steel from SAIL. So means long term contract in terms of raw materials, in terms of
labor, in terms of selling the finished product can be entered into, so that risk of input and selling
of the output in the market can be avoided.

Strategic alliances – We can form the joint venture to deal with the risk and you would say, find
it interesting that multinational companies when they move from one market to another market,
they enter into a joint venture or they enter into a strategic alliance with the local player in the
host country. For example, in India when the multinationals came in the different sectors. For
example, you must have heard about the company Hero Honda.

Now the Hero Honda was a joint venture, but say long back it is now say broken away and now
these two companies are independently operating in the market. But Honda when they had to
enter the Indian market they entered into a strategic alliance. They formed the joint venture with
the Hero cycles and Hero and Honda jointly then performed in the market for many years. Later
on when they, Honda thought that now independently they can sustain in the market then they
broke away the say joint venture of the strategic alliance.

Now, these two companies are independently working in the market. Honda is working
independently and Hero Moto Corp. is working independently. So, it is a very good strategy to
minimize the risk because when any multinational company goes into the new market, they do
not know the say taste of the people, the distribution channels, the government strategies, the
government rules and regulations. So, it is always better to form the strategic alliances to take
care of all of those risks, once you are aware of the market, say regulations and changes, then no
issue.

You can start operating independently. So, it is done. Recently you might have seen that the risk
which was posed by the Jio's entry in the telecommunications sector. There the two adjusting big
players Idea and Vodafone, they enter into a strategic alliance. They formed a joint venture
because they knew it that the risk which is going to be posed by the Reliance Jio, that is going to

736
be very-very difficult for them to fight. So, they entered into that joint venture strategic alliance
and largely that was to deal with the say lost or the market share to be lost in favor of Jio. So that
was done largely to deal with the risk of the loss of the market share.

So, strategic alliances are very-very useful. Then we can take the help of derivative products. We
have the very popular derivative products available in the Indian market, also stock exchanges
are regulating these say products they have that say largely two products, futures and options. So
with the help of futures, we can say secure or we can mitigate the risk of rise in the price of any
kind of the particular input. For example, oil refineries, they can buy the long term oil futures
from the suppliers of the crude oil that for the next 5 years, or maybe the crude oil in this year or
in this date or in this particular period will be supplied to the refinery at this price.

So if we are entering into a future contract for the supply of the crude oil from the supplier, so
our supply of input is secured and risk of increasing the price in the market is taken care of.
Similarly, we can use options, where the call options and put options are there. Call option gives
the right to buy something at a predetermined price and say put option give the right to the buyer
of the option to sell a one particular product at a predetermined price. So, it means these
derivative products are available in the market and they can be made use of for mitigation of the
risk.

(Refer Slide Time: 32:02)

So, project selection under the risk. So there are the different methods, different say options
available here with us for the project selection under the risk and the four methods are available

737
here, quickly, let us go through these. Judgmental values – We can judge experts, means experts
can judge and they can find out how much risk is involved and that can be taken care of. Payback
period Method is the one which helps us to understand that how or in how much period the
investment is going to be paid back so that can be one way.

Risk adjusted discount rates we can use and there is a one method called as the certainty
equivalent method. So, we can make sure with the help of the certainty equivalent method that
how much say return is available from the project, because certainty equivalent index or the say
you can call it as coefficient we have to work out. And when we work out the certainty
equivalent coefficient, then we make sure that my rate of return is this much and how much
return is available from the project.

So say required rate for return and expected rate for return on the basis of that we work out a say
certainty equivalent coefficient and then we multiply the cash flows with that coefficient and
calculated the NPV. So, detailed discussion you can refer through the books, particularly The
Financial Management by Prasanna Chandra, the method is very nicely explained there. So
please, I request you buy the book and then you would be more clear about all the concepts we
are discussing say here in this class.

738
(Refer Slide Time: 33:42)

Then we talk about lastly, the last leg of discussion is just quickly for 2 minutes Risk Analysis in
practice. Largely what the people do, what the corporates do when they go for the risk analysis?
Number one, conservative estimates of revenue, safety margins in the cost figures, flexible
investment yardsticks, acceptable overall certainty index, and then the judgmental, judgment of
the three point estimates. All these five methods not all alone, but to jointly are being used in the
practice.

So, conservative estimates of the revenue, because ultimately cash flows depend up on the
revenue. So, when you are going to say, on the basis of the market and demand analysis, when
you are going to estimate for that revenue, always be conservative. We know that we are going
to sell 1000 unit per month but always say assume that we are going to sell 800 units in the
market so that if your revenue estimates are conservative and despite that, the project is going to
be the profitable proposition then certainly to a larger extent that risk is managed.

Similarly safety margin in the cost – When you estimates for, estimate for the cost like the fixed
cost of the variable cost always keep some contingencies so that we are planning that our plant
and machinery investment requirement is 100 crores or maybe the 100 lacs, 1 crore rupees, but
we will assume that it will not be available for 1 crore, it will be available for say 1.20 crore. So
we have already kept so means lowering down the revenue, expected revenue and increasing the
expected cost still of the projects NPV is becoming positive it means to a larger extent you have
taken care of the risk.

739
Flexible investment yardsticks always mean keep on changing your investment yardsticks
always, do not say that I always want this much rate of return. Depending upon that my cost of
capital goes down my rate of return can go down also. So always it has to be a you can call it as a
multiplier effect means you should not always stick to one thing that I would like to borrow, buy
raw material from this source only or my rate of return is this much only or my cost of capital is
going to be this much only.

No, we have to change so many variables at a time so that we can find out that in the best
possible situation what is going to happen. And acceptable overall certainty index, when we are
going to calculate the say acceptable overall certainty index or the coefficient, we should mean
that say required amount of the return that should be means optimally determined. So
comparison between them required and expected returns from the project should be means
carefully worked out.

And then when you calculate the NPV by multiplying the cash flows with the certainty
equivalent coefficient, then we will be able to find out that whether it is a workable project or
not. And lastly, judgment on the three point estimates. Like when we follow the sensitivity
analysis of the scenario analysis we create three estimates, three scenarios. You call it as most
likely scenario or most expected scenario, pessimistic scenario and the optimistic scenario.

So, by creating these three scenarios firms normally take care of the risk. So, in practice, all these
techniques are there in practice and not one technique is going to be a foolproof or going to be
the say give us the best results. We have to use the say 2 - 3 techniques together so that overall
means the risk profile of the project, which we work out, we are able to find out to a larger extent
in advance how risky this investment is going to be and whether we are in a position to take care
of that risk or not.

So, if we are clear about how much risk is involved, how much return is involved still we find
that the project is a worthwhile, say proposition. We should make investment into this
investment opportunity. Then there is no point not making investment. We should go ahead,
make investment because almost all possible negative and positives have been say visualized in
advance. So with this discussion I close the discussion on the risk analysis in the capital
budgeting proposals to some extent because of the say time shortage.

740
Whatever the time was available or I could give it for this topic I tried to discuss the different
methods, different techniques and some other concepts associated to this particular topic. And
for the detailed reference, say especially the certainty equivalent index I wanted to discuss with
you, but because of the shortage of time I could not. So for the say a detailed reference of this
kind of things which we could not discuss in this class here you can refer to any good book on
the financial management.

And the one which I am following The Financial Management by Prasanna Chandra, if you buy
that book, use that book. It is certainly going to means remove all your doubts, if there is any
after means listening to these lectures. So, with this I stop here and in the next class I will move
up with the next topic and that will be the say cost of capital. Till then thank you very much.

741
 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 47
Cost of Capital – Part 1

Welcome all. So, now as a next part of discussion or the next topic, which we are going to take
up in this subject of the Financial Management for the Managers is the cost of capital. Cost of
capital is very important topic for the financial management students, because it plays a very
important role in many ways or in many senses. That if you want to say know about any
investment opportunity, if you want to evaluate any investment opportunity especially what we
discussed in the capital budgeting. That is a new investment proposal or the new investment
opportunities, in that case, cost of capital plays a very important role.

Normally, we use the concept of the weighted average cost of capital in the corporates or in the
corporate life, because the capital in the corporate life comes from the different sources. And
when it is coming from different sources, the different sources have the different cost of that
capital. Equity capital, preference capital and debt capital these are the 3 important sources.
There are the other sources also but largely these are the 3 sources which is called as the equity
capital, preference capital and the borrowed capital or the debt capital.

And all these 3 capitals have the different rates or different costs, which the borrower has to pay.
So, largely the cost pertaining to the preference share, preference capital or the preference shares
and the debt is fixed, you have to pay that cost in any case whether the firm earns the profit or
incurs the losses. Whereas the cost of equity only can be managed in a way that, if there is a
profit, you pay the dividend and if there is no profit you can avoid the dividend. But, all the 3
sources have the cost, equity is called the internal source of funds and preference capital though
it is also the capital.

But, we normally consider it as part of the debt and it is considered as an external source of fund
largely for the purpose of categorizing it though it is capital, you can call it is as a share capital.
Like equity capital, the preference capital is also the share capital but because all the properties
of the preference capital are as same as that of the debt, so it means we consider it is or we treat
it like a borrowed capital because it comes for a limited period of time.

742
And the amount of dividend has to be paid for certain, whether the firm is into the profit or the
firm is not into the profit. So, same is the case same are the properties associated with the debt.
So these are the 3 sources, when the capital is coming from the, these 3 different sources and
having different rates or the cost associated to them. Then naturally, for calculating the average
cost of capital we will employ the concept of the weighted average cost of capital.

(Refer Slide Time: 3:38)

So, WACC is more important, here we call it as the cost of capital means we use the concept of
the WACC – Weighted Average Cost of Capital. Because weightage of the different sources is
different. So, for calculating the cost of capital we multiple the weight or the proportion of the
capital by the rate of interest or the rate of dividend and we add up all these 3 and then the,
whatever the capital comes up is called it as the weighted average cost of capital, so it is a very
important concept.

In the capital budgeting you might have seen that we worked out the cash flows and then we
discounted the cash flows to arrive at the present value especially of the cash inflows. And in
case of the cash outflows also when the investment is made in the subsequent years also those
outflows also have to be discounted to calculate their present value. So, there we were using
something in the denominator, we were writing if you call it as that is the CF cash flow in the
year T or you call it as a cash flow in the year T.

743
So, we will write it as if you recall it is a CF for the year T and it was discounted by something
called as 1 plus r. So, what is this r, r is the discount rate and that discount rate is anonymous to
the cost of capital that depends upon the cost of capital. What is the cost of capital? We have to
discount. Because the cost of capital already gets adjusted for the inflation. If the inflation goes
up cost of capital will increase, if the inflation goes down cost of capital will go down.

And inflation is the one which largely impacts the time value of the money or because of which
the time value of money changes, if it is already embedded in this R which is the discount rate
and discount rate depends basically upon the cost of capital. Without the cost of capital
evaluating any new investment proposal will not be possible. So, it is a very important concept
cost of capital, we used it for the capital budgeting proposals, we used it even in case of the
sensitivity analysis.

While talking about the risk analysis in the capital budgeting proposals, but now we are going to
learn about it what basically the cost of capital is and how it impacts the overall performance of
the firm. So, cost of capital is important in many cases whether it is an evaluation of the new
investment proposals, cost of capital is important because without that you cannot discount the
cash flows. It is very important in determining the capital structure.

Capital structure is the next topic we will be discussing after the cost of capital in detail that is
why I am moving in the sequential form that once the previous thing is cleared to you so in the
next thing we are going to use it we know it already in advance. So, in the capital structure also
the cost of capital is going to play a very important role. In the say capital structure, we have the
2 kind of sources, equity and debt and both these have the cost.

Equity cost is different, debt cost is different and depending upon the weighted average cost of
capital, because in the capital structure, we determine the capital structure of any firm in such a
way where the expected cost of capital remains as low as possible. Weighted average cost of
capital remains as low as possible. So, in the determination of the capital structure also we take
care of or we make use of cost of capital.

Similarly, for assessing the leasing proposals, for assessing the leasing proposals we make use of
the cost of capital and many a times many companies who generate electricity, who even

744
distribute the water because these days you have to spend money on the treatment or processing
of the water also for generation of the electricity. So, when we make investment in generation of
these facilities and finally we have to distribute it to the people.

So, it means we have to use the cost of capital so as to determine the price, at what price per unit
of electricity or the power should be sold to the people, per unit of the water should be sold to the
people. There the investment takes places, means whatever the investment has taken place that
has to be properly evaluated with the help of the cost of capital. And then finally, the pricing of
the final product has to be done.

So, in many cases any capital budgeting proposal is not possible to be undertaken without the
cost of capital or may be the capital structure of the firm cannot be decided without considering
the cost of the capital, so it is a very important concept and now we are going to learn in detail
how to determine the weighted average cost of capital and for determining the weighted average
cost of capital, how to determine the cost of the individual sources of the capital.

There we will learn about how to determine the cost of debt, how to determine the cost of equity,
how to determine the cost of preference capital. And what important factors that play the role in
determining. Because if the cost of the individual sources can be walked out, then calculating the
weighted average cost of capital is not a difficult process, it can very easily be done. So, now let
us go to the formal discussion in this case and what is we have written here, what do we mean by
the cost of capital actually.

745
(Refer Slide Time: 09:09)

It can be understood from these 2 – 3 lines given here. The cost of capital of any investment
project, cost of capital of any investment project, business or company, is the rate of return the
suppliers of capital would be basically the rate of return, the suppliers of the capital would expect
to receive if the capital were invested elsewhere in an investment project, business or company
of the comparable risk. Basically, it is synonymous to the rate of return required.

746
Normally, when we have the surplus savings available with us, we depending upon the risk
profile or the risk taking capacity of we individuals. We decide the investment avenue, if we had
totally risk hours, we deposit our savings in the bank because their minimum rate of interest will
be given by the bank without any kind of risk. But if are not satisfied by that return then we have
number of other options.

We can invest that into the bonds, market, we can invest that into to the stock market, we can
invest our savings into the real estate market. So, number of options are available but the
moment you want to increase your returns you tend to increase the risk also. So, depending upon
the risk profile or the risk complexion of any individual or any organization, the cost of capital
means in a way the rate of return depends. More the risk you are ready to take more rate of
return, more cost of capital will be your capital will have the higher cost of capital.

But if you are not ready to take the higher amount of risk then certainly your rate of return or
cost of your capital will be treated or considered as low. So, the rate of return and the cost of
capital are considered as the same thing. But here the question arises, do you feel that the rate of
return or cost of capital are just interest rates? They are not interest rates, they are more than
interest rates because they are two kind of returns, one return is the risk free return. So, when
there is a risk return which we call it as the RFR – Risk Free Return.

Risk free return is available from the investment opportunities or into the investment products
where the risk level is almost negligible or 0. For example, bank deposits, when you go to the
bank and give your funds whatever the rate of interest they give it to you, whether it is 3.5
percent on savings and 6.6 percent on the fixed deposits that rate of interest is the risk free rate of
interest. If you are satisfied with that, it means the element or the level of risk in that case is 0.

But if you want to increase it that I am not satisfied with this, I do not want 6 percent, I want 10
percent rate of interest, it means you want to add up how much 4 percent here and when you
want to add 4 percent the risk will not become 0, it may become 1, 2 or 3 units. So, it will also
increase, as the return increase, risk will also increase, so I can say, when I am saying I want a
return of 10 percent, it means in a way I am saying the cost of my capital is 10 percent.

747
It is not less than 10 percent, so I want minimum that much of the return, if that much of the
return is not available I will not make investment. But if I am asking 4 percent more return as
against the risk free rate of return I have to take more risk. So, level of the risk is 0 here, level of
the risk is 2 here, it means the moment you increase your cost of capital or rate of return, you
increase the, or you automatically tend to increase the risk also.

So, it means, the cost of capital is basically the rate of return and that is why when you discount
the say cash flows here with the r, the capital in the capital budgeting proposals, when we are
discounting the cash flows with 1 plus r. So, it means r is basically the rate of return that is why
we call it as r. And rate of return is synonymous to the cost of capital, it depends upon the cost of
capital, higher the cost of capital higher will be the percentage of r.

Lower the cost of capital lower will be the percentage of r. So, it means r is basically the required
rate of return and that depends upon the cost of capital. So, cost of capital reflects, expected
return and second thing is it represents the opportunity cost. Expected return from any
investment proposal, so that is the, if I am satisfied with that means I am making investment in
the bank I am satisfied with the 6 percent, so it means my expected return is 6 percent and I am
satisfied with that 6 percent. So my opportunity cost or the cost of my capital is also 6 percent.

Second thing we are talking about here is opportunity cost. Opportunity cost means the cost or
the return, which is expected from the other projects, other investment options at the comparable
risk. So, it means when the amount of risk is same, when the amount of returns is going to be
same, so it means the opportunity cost of my capital is 10 percent, so I will not make investment
at 6 percent if I make investment in the bank I am going to get 6 percent.

If I go to stock market, I am going to get 10 percent because I am risk pro I am risk neutral when
I am ready to risk then I am expecting the higher rate of return so cost of return on my
investment or cost of my capital will be 10 percent and not 6 percent. So, it is a very important
concept. When you talk about the weighted average cost of capital you talk about something this
kind of the model.

748
(Refer Slide Time: 14:58)

Here is the weighted average cost of capital and we have the 3 components here. This is 1
component, this is the second component, this is the third component. First component is that,
wErE. WE is basically the proportion or weight of the equity. In the total, if you call it as, if the
total investment required in the company is 100 percent. So, what is the percentage of equity, say
50 percent. What is the proportion of the preference capital, is 10 percent, and what is the
proportion of debt is 40 percent? So this 50 percent, 10 percent, 40 percent is the W, is the
weight. And this has to be multiplied by the cost.

749
So cost of equity might be 20 percent. Cost of the preference capital might be 12 percent and the
cost of debt we normally take as the after tax. Because the cost of debt, which is the beauty of
this particular source, that whatever the cost on that borrowed capital of the debt you pay, that
you debit in the profit and loss account and by that amount your profit goes down, so it means if
you are not debiting by that amount, the profit and loss account, your profit will increase and you
tend to pay the tax.

So this cost is calculated as cost of capital on the debt, but after tax. For example, it is 10 percent.
So it means with this weight and this cost, this and this, this and this, this and this, if you
calculate the cost and then sum these up, this plus this, this plus this, so it will be called as the
weighted average cost of capital and this is what this model is saying. W is the weight of equity;
r is the cost of equity. Written here, proportion of equity and the cost of equity.

Proportion of the preference capital that is a wP, and cost of the preference capital is the rP, and
proportion of the debt here it is proportion of the debt and the cost of debt multiplied by 1 minus
tax, it means that is tax deductible because it helps us to minimize the tax burden, the cost which
we pay. Only then trust which you pay on the borrowed capital, you debit with that interest the
profit and loss account, but the dividend which you pay on the equity capital, you do not debit
that dividend in the profit and loss account, so that is a major difference.

That is why we call it as, debt capital is cheaper as compare to the equity capital, but debt capital
being a fix obligation is a riskier also, because in every case you have to pay the interest back to
the bank or to the source. Plus the principle amount on the regular intervals. Whereas this is not
the case in case of equity. So it is less costly, but being a fix charge riskier. And then we talk
about the rD pre-tax cost of the debt, but when you are factoring it with the corporate tax so it
becomes a post-tax cost of the debt.

750
(Refer Slide Time: 18:20)

It means cost of equity, proportion of equity plus cost of preference capital and cost of debt and
proportion of debt, and the post-tax cost of the debt. So, for example, how we can calculate it,
assume it here like this, then for example in any firm, the proportion of equity is 50 percent, so
we call it as 0.5 and the cost of equity is 16 percent. Then the proportion of the preference capital
is 0.10, 10 percent and the cost of the preference capital is 12 percent plus the debt is remaining
amount 40 percent, 0.40 and the cost of the debt we assume post-tax cost of the debt is 8 percent.

So you can calculate if you solve this, you will be able to find out that the, we put this also in the
bracket. So this means, 50 percent is coming from the equity at the cost of 16 percent, 10 percent
is coming from the preference capital which is at the cost of 12 percent and 40 percent is coming
as a borrowed capital as a financial average and the post-tax cost of debt that is 8 percent. So
weighted average, cost of capital if you calculate here that works out as 12.4 percent that works
out as 12.4 percent.

So, it means you have to be very carefully working it out, that weighted average cost of capital
has to be under the control. So, we can say that if the cost of equity is very high, if the cost of
equity is very high as compared to the cost of the debt, then we have to look for how risky the
project proposal is or the investment proposal is. And depending upon the risk associated to the

751
proposal, we have to decide the amount of the risk we can take or we are going to take. If it is
risky proposal more funds should come from the internal sources from the equity capital, though
it is expensive.

But if it is less risky then we can depend more upon the preference capital and the borrowed
capital, because net result available to the equity shareholders because of borrowing more funds
from the market will be very high. This is the model which is helping us to understand the
concept of the weighted average cost of capital. And this we will be using for further reference
whatever the discussion we are going to make that is called as a weighted average cost of capital.
And as a r, the discount rate which we used in the capital budgeting or in the risk analysis of the
capital budgeting was also the weighted average cost of capital, not the simple cost of capital.

(Refer Slide Time: 20:43)

So, now the important points to be bought in mind are here. Only 3 types of the capital, equity
capital, and preference capital and in the preference capital also non-convertible and non-callable
we are going to use and the debt also is going to be the third component which is also non-
convertible and non-callable. So, in the broader sense, you can say that only 3 type of the sources
we largely used, we use the capital from other sources also, but bonds also, debentures also we
use.

752
But we are, means for our discussion here, we assume that the capital in the businesses is going
to come from the 3 sources, that is equity capital, preference capital and borrowed capital in the
form of debt from the financial institutions. Number 2, Debt includes long term debt as well as
short term debt. In certain cases, for calculating the weighted average cost of capital we do not
include the short term debt but this is not a right approach.

Total debt has to be taken into account and the cost has to be calculated accordingly, whether it
is a short term borrowing or long term borrowing, both the borrowings had the cost and it should
be taken into account for calculating the WACC. Number 3, non-interest bearing liabilities, such
as trade creditors or expense creditors. Trade creditors are basically the suppliers of raw material
on credit and expense creditors are basically employees of the company, who work for 30 days
and they do not ask for the salaries before 30 days.

The suppliers of the electricity, water, and these utilities supply companies they are expense
creditors. They supply all these inputs for a period of 30 days or sometimes 60 days also they do
not ask for the payment before that period of time. So, these are known as the expense credits.
Trade creditors, expense creditors they are called as the spontaneous sources of the finance. So,
we have 3 sources of finance, short term sources or other way round long term sources, finance
or the spontaneous sources of finance.

For our discussion, we will take into account the long term finance, short term finance but not
the spontaneous sources of finance. Fourth, rationale, if the firms rate of return on its investments
exceeds its cost of capital, if the firms rate of return on its investments exceeds its cost of capital
equity shareholders benefit, means why we are going to talk about the cost of capital because
ultimately who are owners of the business. Equity share holders are considered as the promoters
and the real owners of the business and ultimate purpose of every business is to maximize a
return to the equity shareholders, to the owners of the business.

And there the cost of capital plays very important role. Because if the cost of the external sources
that is debt capital and preference capital, if it is under control or minimized, then whatever the
returns are available from the project that will be available to the equity shareholders. So, what is
written here, that if the rationale of understanding the cost of capital carefully is, if the firms rate
of return on its investments exceeds its cost of capital equity shareholders benefit.

753
That the total returns available from any investment proposal, if they are more than the cost of
capital average cost of capital then whatever the remaining amount is that is the benefit to the
equity shareholders. More generally, when a firm earns a rate of return in excess of its cost of
capital, it creates economic profits or value for its investors or basically the shareholders or
basically the equity shareholders. Investors here means the equity shareholders or the owners of
the business.

Now, how we talk about, we understand this rationale that the expected return from the project
and the cost of capital of the project. What I am saying here is that if the expected returns from
the projects are more than, if they exceed the cost of capital, so it means it is going to get or
provide the larger economic value, larger economic benefit to the equity shareholders the real
investors and that should be ultimate objective that the capital structure should be decided in
such way that the cost of weighted average cost of capital is as low as possible.

Or especially, the cost of capital with regard to the external sources, preference capital and debt
capital is as low as possible. So that the total returns minus the cost of external sources, means
the difference is going to be the larger one and that is going to provide the larger benefit to the
equity shareholders.

(Refer Slide Time: 25:54)

754
We can understand this concept with the help of a small calculation. For example, there is a
project where the weighted average cost of capital of the firm works out as10 percent. How it is
worked as 10 percent? For example, they used the debt equity in the equal proportion. So in this
case, what we are going to do is, 50 percent of capital is going to come from equity and the cost
of equity, because equity is costlier, considered as costlier than debt. So we assume the cost of
equity is 14 percent and the cost of debt is say, we call it as6 percent, cost of debt is, post-tax
cost of debt is 6 percent.

So it means, what is the weighted average cost of capital in this case? It is going to be equal to 10
percent. This weighted average cost of capital of the company is going to be 10 percent. Because
we have calculated this, this multiplied by this, this multiplied by this, summing up both, so this
comes up as 10 percent. And same company now, for example, employees or invest how much?
100 million rupees. They invest 100 million rupees and the project earns the returns at the rate of
12 percent.

What will be the benefit to the equity shareholders? Means the benefit or the returnable to the
equity shareholders can be calculated with the help of this formula – Total returns on the project,
total returns on the project minus interest on debt, minus interest on the debt, we write here this
is minus interest on the debt, minus interest on the debt divided by say equity funds, divided by
equity capital, divided by equity capital.

So, now on the basis of this if you calculate the total returns from the project. What are the total
returns from the project? How much investment we are making? 100 million. And what is the
returns available from this? That is 12 percent. What is the cost of debt capital? 6 percent, and
how much is the proportion 50 percent, total investment is 100 million. So, 50 million has come
from the debt capital and the cost of the debt capital is how much? Only 6 percent.

And remaining funds have come from? Equity capital. If you solve this, it works as it how
much? 18 percent, and this 18 percent is the return available to whom? This is the return
available to this source of capital which is basically the equity capital or suppliers of the equity
capital, why? Because from the total returns of the project the cost of the debt has already been
subtracted. Under 100 million are invested, 50 million is the borrowed capital, 50 million is the
equity capital and earnings of the project are 12 percent.

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So, it means 100 into 12 percent minus the cost of the borrowed capital, debt capital if you
subtract then whatever the return is now available is a remaining return that is the return
available is 18 percent and that belongs to the equity shareholders. So, what is the cost of capital
equity shareholders? 14 percent. So it means the net benefit to equity shareholder is of the 4
percent.

And in this cases, in this situation, value of the firm stands maximized, in this case value of the
firm stands maximized, so it means they wanted to earn 14 percent, but actually project is giving
to the equity shareholders to the owners of the business. How much? 18 percent. So, it is very
good situation where they are going to earn the very good rate of return or the high rate of return
or more than the expected rate of return which is larger than the cost of the capital of the firm.

This is just the initial discussion on the cost of capital or the concept of the cost of the capital
which I wanted to introduce you with. So, I have started with what is the cost of capital? How we
largely calculate the cost of capital and what are the important sources from where the capital
comes?

(Refer Slide Time: 30:42)

So, further discussion on this particular topic that is about the cost of capital, company cost of
capital and the project cost of capital and then the cost of capital of the different sources like
equity capital, then the preference capital, debt capital all these individual sources. What is the

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cost of these individual sources? How to calculate the cost of individual sources and then finally
how to calculate the summed up cost or the average cost which is called as WACC? All these
concepts I will discuss with you one by one in the subsequent lectures.

Till then thank you very much

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies, IIT
Indian Institute of Technology, Roorkee
Lecture 48
Cost of capital 2

Welcome all. Now, we are in the process of learning about the Cost of Capital Concept, I
initiated this discussion in the previous class and it was just beginning at that time. So,
now will be, we will be proceeding further with the remaining discussion on this concept
of the cost of capital. As I told you in the previous class that is a very important concept
and everything means with regard to the overall evaluation of any project or any say
investment proposal, largely depends upon the cost of capital.

And we use this cost of capital as a, say a discount rate also for calculating the present
value of the cash flows. So, since, it is a very important requirement of the financial
management as a whole, so we are learning about the cost of capital. So, in the previous
discussion, in the introductory discussion or in the initial discussion, we discussed some
just basic points of that what is the cost of capital and then see how we calculate it.

And the concept of the cost of capital which we use in the process is called as the WACC
– Weighted Average Cost of Capital. So, we learned about the beginning of or just initial
discussion about the Weighted Average Cost of Capital. And now, we will take up the
further issues and then we will learn about how to calculate the cost of the different
instruments of the capital or the different instruments of finance or different sources of
finance, which is largely you can say, 2, internal and external sources of finance.

So, in case of the internal we talk about the cost, means the equity not the cost but the
equity funds, even the preference capital is also there, but for calculating the cost of
capital we treat the preference capital like the debt capital. So, we have the two kinds of
the capitals equity capital and preference capital. And then we have the external sources
of finance which is a debt capital, borrowed capital.

So, for all these 3 different sources, there are 2 internal and 1 external we will learn about
how to calculate the cost of capital for these individual sources and then how to arrive at

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that WACC – Weighted Average Cost of Capital and there we will apply the concept of
the flotation cost also. So, before we move forward into the different other important
concepts of the cost of capital, I would like to discuss one important concept here.

And that important concept here is the company cost of capital and the project cost of
capital. So, we discuss here that for example, the firm is already into existence, they are
already into the business and they are manufacturing different products or their say into
the different business activities already. Now, they want to introduce a new product or
maybe the new service or maybe the new business activity, they want to add, maybe in
the same line of the business or into the different line of the business, which you call it as
a diversified line of the business.

So, that investment proposal or that investment opportunity will be treated as a

independent project or a new project, which is owned by or which is going to be
established by the existing firm. So, here we will learn about or the question arises, which
costs of capital will be important for considering it as a discount rate or the cost of
capital?

Because it may be different that the cost of capital or the average cost of capital for the
existing firm is different and the cost of the capital with regard to the sources of the
funds, which we are going to use for the new project they are different. So, which cost of
capital we will have to talk about and we will have to say or sometime it may be possible
that there is a mix of the sources of the funds.

Partly they are coming from the internal sources, partly they are coming from the external
sources for the new project also and the funds mix or the financial mix is largely same.
So, which cost of capital we should be applying for the new project, for the new
investment proposal, whether the cost of capital of the new project or the cost of capital
of the existing firm. So, here it is a very important clarification I think we should be clear
about that.

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(Refer Slide Time: 4:47)

So, when you talk about the company cost of capital, it is basically the rate of return
expected by the existing shareholders. It is basically the rate of return expected by the
existing shareholder or the capital providers. This is the company cost of capital. And
when you talk about the project costs of capital, it is basically the rate of return expected
by the capital providers for the new project, for this new proposal, the company proposes
to undertake, it will depend on business risk and the debt capacity of the new project,
debt capacity of the new project.

So, it means, it may be a different situation, that the sources which we have been using
for the existing firm or for the existing operations of the firm they are different and the
sources which we are going to use for this project. Because sometimes what happens that,
when the new project or the new investment proposal is undertaken, it may be possible
that, IPO or the FPO may not be possible, followed on say public issue or the public offer
may not be possible because people are not sure about the success of the new project.

People are not sure about the success of the new venture. So, largely it may be possible
that for the new project or for the new venture, the capital is coming largely as a
investment from the existing firms maybe from their reserves and surpluses or from their
retained earnings and partly we are going to borrow the funds from the market. Whereas,

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in case of the existing firm, the capital is coming or it has already come from IPO –
Initial Public Offer by way of selling the equity shares in the market and very lesser
amount of the dividend we have, sorry, very lesser amount of the debt we have issued or
maybe that raise the funds by way of the debt instruments from the market.

So, this all depends upon that, what are the sources of the funds for the existing firm and
for the new project? If the source of the funds is same for the new firm, new project as
well as for the existing firm, then it is always better advisable to use the existing
company cost of capital as the cost of capital for the new project. So, we are writing here
third point, the company cost of capital, which is the weighted average cost of capital is
the right discount rate for an investment, which is a carbon copy of the existing firm.

If now, the two things must be, means the two assumptions must be verified in case of the
new proposal that you can use the company costs of capital, existing cost of capital of the
company as the cost of capital for the new project also provided the sources of the funds
are same as we are using for the existing operations of the firm or existing processes of
the firm. And second important requirement is risk profile or risk complexion of the new
project is also as same as of that of the existing firm.

So, it means if the risk profile is same and the capital structure is same, second
requirement is the capital structure. So, this is the first requirement and this is the second
requirement. If the risk profile is the same of the new project, if the new project is very-
very risky, then I think we should use a different cost of capital or different discount rate
for discounting the cash flows, cash inflows especially for arriving at the NPV of the new
project.

But if the risk profile is same as that of the existing operations of the firm and capital
structure is also largely same, then in that case, the existing cost of capital as a discount
rate for discounting the cash flows for the new project can be used. So, we will have to be
now careful in this case that what cost of capital or which weighted average cost of
capital we have to use and how to use that as a discount rate will largely depend upon
from where the funds are coming and what is the risk profile of the proposal.

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For example, I talked to you about that fruit beer project of the Anchor industries. So, in
that case, probably you cannot use the existing cost of capital, because the product is
totally new in the market and it carries as compared to the existing products of the firm,
the larger amount of risk and so, if the risk involved is high, so, in that case, you can
think about that the higher discount rate can be used or the higher cost of capital can be
used, because in that case means say, risk profile is higher.

And we always understand it, that largely the rate of return say goes along with the risk
associated with any investment proposal. So, risk and the return, they have to be
coexistent. So, depends upon what kind of the proposal is this, the new proposal is this
and how it is different from the existing operations of the firm. If it is same in terms of
risk as well as the capital structure, then in that case, I think the existing cost of capital
can be used as a discount rate.

But if the risk is high and the cost of, sorry if the risk is high and the capital structure is
also different and largely it happens that for the new projects the capital structure
normally remains not as same as that of the existing firm. So, it depends upon that from
where the additional capital is coming, it is coming as a borrowing or it is coming as a the
investment by the existing firm. If it is coming up as a investment by the existing firms
from the reserve and surpluses or from retained earnings, then fine, you can say the risk
profile is low because largely the capital is from the internal sources.

But risk profile has to be checked from the product profile, product profile angle also, the
product which we are going to manufacture or the service which we are going to generate
and their acceptability in the market, their salability in the market, all these factors have
to be kept in mind. So, normally I would conclude this particular component that
normally we should use the existing cost of capital, which is the existing weighted
average cost of capital of the firm, if the risk and the capital structure profiles are same.

But if the risk is more, then you can use the higher discount rate or the higher cost of
capital. And if the capital structure is also different, then certainly it must be risky, then
again we should use comparatively the higher cost of capital as a discount rate for the
new project, otherwise, the existing cost of capital or the weighted average cost of capital

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of the firm can be used. Now, we talk about as I told you that we will have to now learn
about calculating the cost of the different sources of the funds.

Because, ultimately we are going to end up for say, this concept or learning of this
concept of the cost of capital that is in the form of the weighted average cost of capital,
and weighted average cost of capital it will be possible to be calculated, if you know the
cost of capital of the individual sources of the capital, and I told you in the beginning of
this lecture, that normally the capital comes from three sources, 2 are internal, 1 is
external. In the external also there can be multiple sources.

But, if you call it as one source as a whole, then it is called as the debt, external source of
the funds is the debt, it can be the long term debt, it can be the short term debt and in the
internal sources, it is largely the equity capital and partly it is the preference capital, but
for calculating the cost of capital, for the purpose of calculating the cost of capital, we
treat the preference capital also as same as the debt capital. So, process of calculating the
cost of the preference capital is also same as the process of calculating the cost of
borrowed capital or debt capital.

There is a process of calculating the equity capital is different? Calculating the cost of
equity capital is more complex, because there is the issue of the payment of dividend and
the dividend is always unstable, dividend is always unstable. So, if we have the profits,
but we require those profits within the firm for the reinvestment purpose, then we will not
declare the dividend. So, the entire amount of the profit will be reinvested back into the
business. So, what is the cost of equity in that case?

Sometimes, if we the high profitability and we do not require the funds internally, the
firms tend to pay the higher amount of dividend whereas in case of the low profitability,
still the firm's want to pay the dividend, dividend level comes down. So, means the cost
of capital will be associated directly with the dividend being paid by the firm to the
equity shareholders. And since that amount of the dividend is not pre decided, it is not
certain. So, the calculation of the cost of equity becomes a complex job.

763
Which is not the case in case of the borrowed capital, in case of the borrowed capital, the
cost of capital is basically the interest cost at which we have borrowed the funds from the
different sources, whether it is a short term source or it is a long term source, we know
we are going to pay a fixed charge on that borrowed capital and that fixed charge is
basically the interest and we are say, in all the situations, whether the firm is earning the
profits or the firm is incurring losses, firm has to pay that cost of capital in all situations,
in every circumstance.

And say, in the situation or in the event of profitability, the cost of debt will remain same,
in the event of loss making situation the cost of debt will remain the same. So, cost of
debt is going to remain the same, it is stable, it is prefixed. So, it is largely easy to
calculate the cost of the debt, whereas, it is not the case in the equity. Similarly, for
calculating the cost of the preference capital, when you calculate that cost of preference
capital that is also associated to the dividend we are paying back, but see the dividend on
the preference shares is largely pre-decided or prefixed.

(Refer Slide Time: 15:17)

When the preference shares are issued in the market what we write here, we write
normally 12 percent, preference shares at the rate of rupees 1000 per share, this way we
write, this is a normal standard language, 12 percent preference shares at the rate of
rupees 1000 per share. So, it means, in this case this, what it is written here is that is the,

764
what is this 12 percent? This rate is already decided; this is the rate of the dividend which
will be paid or returned back on the preference shares.

So, we write it like this 12 percent preference shares at the rate of return is 1000 per year.
It means this is the 12 percent rate of dividend we are going to and it is prefixed and
largely in India we issue the say cumulative preference shares, cumulative preference
shares. So, what happens, that in the one year, in the first year of the business, for
example, if there is no profit available or sufficient profit is not there, so this dividend
cannot be paid by the company or a company want to postpone this dividend.

So, in the next year, in the second year dividend has to be paid as the double of the rate
12 percent for the first year and 12 percent for the current year. So, it has to be paid at the
rate of 24 percent so it will keep on accumulating. So, it means cumulative preference
shares when we issue, largely we issue the community preference shares because if it is a
non-cumulative preference shares, then in the event of non-profitability or non-sufficient
profitability, the preference shareholders will not get any return.

So, to protect their interest, government insist for, regulatory agencies insist for that the
firms must issue the cumulative preference shares, so that the subscriber to the preference
shareholders are entitled to the dividend in every circumstance, though the payment of
dividend can be postponed from the year of the less profit or the loss to the year of
sufficient profit or more profit. So, that means the firm is also running, so operations and
the providers of the capital are also getting the good return.

So, that keep on accumulating and the cumulative dividend has to be paid in the year of
the profit and in that year the dividend for the previous years also has to be paid. So,
since this rate is pre decided, and in case of the debt capital what happens? In case of
debt, we normally borrow from the bank, for example, we are borrowing some amount of
100 crores. We are borrowing from the financial institutions. So, what we are doing here
that rate of interest is already decided.

For example, it is at the rate of 18 percent per annum. So, this 18 percent per annum is
what? Basically it is a cost of the debt or we are going to borrow the short term debt or

765
the short term borrowing we are going to have and that is for the 10 crores, so that rate of
interest is at the rate of how much? 12 percent. So, it means, this cost of the capital is also
known, in case of the long term debt we are borrowing from the financial institutions 18
percent is our interest.

For the short term debt, we are borrowing from the banks 12 percent is the interest and
for the preference capital we are issuing the preference shares at 12 percent, it is prefixed,
the percentage is prefixed with the share that is a 12 percent preference shares at the rate
of 1000 per share. It means, in these all three sources, the cost of capital is very easy to
determine, because already it is given. So, it is the rate of interest which we pay back to
the source from where the funds are borrowed, and to the preference shareholders who
subscribed to the preference shares of the company.

So, it is very easy to calculate the cost of these three sources, but as far as the cost of
equity is concerned, cost of equity is concerned. So, it is very difficult because I discuss
with you the reason of volatility or uncertainty, because whatever the return we pay to the
shareholders, that return is the dividend and dividend is not certain, you all agree with me
that dividend is not the right of the equity shareholders, it depends upon the state of the
profitability of the company.

If the company's earning the sufficient amount of the profits, then board of directors, is
the right of the board of directors to decide whether to pay the dividend in any particular
year or not. If the board of directors decide that sufficient profits are not there, or
whatever the profits we are earning that needs to be reinvested back in the business also.
So, no dividends will be paid. So, and the flexibility in the hands of the equity
shareholders is that if they're not satisfied with the performance of the company.

Or the dividend being paid or not being paid because of one or the other reasons, so, and
if the company shares are listed in the stock market, are being traded in the stock market,
then they are at the liberty of selling the shares in the market, in the secondary market and
getting rid of this investment. So, both ways it is the flexibility to the company also, to
the company management also, to company’s boards also as well as to the shareholders is
available, especially in case of the listed companies.

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But, yes, the companies who shares are not listed in the stock markets and that does not
happen, it happens only in case of the Private Limited companies. So, Private Limited
company’ management is basically very close knit, but in case of the public limited
companies the issue of dividend arises. So, their shares are being publicly traded in the
market. So, if they are not satisfied with the policy of the company or the policy of the
board of directors, they can get rid of this investment and they can sell it off in the, their
shares in the market because they are not getting the dividend.

So, that depends upon what is our requirement? Whether our requirement is a regular
income requirement or it is a long term investment requirement? If it is the regular
income requirement, then you should look for that kind of the shares, where the regular
dividends are being paid, but if you are looking for the long term investment, then you
are indifferent whether you are paid the dividend or you are not paid the dividend.

Because ultimately, even if the dividend is not paid, it is going to be reinvested into the
business and that is going to increase the value of the firm or the overall equity of the
overall capital base of the company. So, ultimately the proportion of the shareholders
wealth is going to increase. But there comes a problem for estimating the cost of equity,
because of the not certainty of the dividend to be paid by the company to its shareholders.
So, there will be the problem which we will discuss when we will reach other equity
capital.

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(Refer Slide Time: 21:54)

Now, we will start with the first capital, source of the capital and here we call it as that
the first source of the capital is the debt capital and cost of the debt capital can be
calculated very easily, very simply, because largely it is given to us. So, in this case, for
example, this model is given to us, these are the components of the model where you are
given here as P 0 is equal to sigma n, t is equal to 1 and then it is I divided by 1 plus r d
power t plus F that is the F divided by the 1 plus r d power n.

Now, what this model stands for? With the help of this model, you can easily calculate
the cost of the debt. So, what are the components of this model first is a P 0, what is this
P 0? Current price of the debenture or the bond at which that bond is selling in the market
or that debenture is selling in the market. And I is the annual interest payment, this I is
the annual interest payment and that is for the number of years that is a t that for how
many number of years this interest will be payable that depends upon the duration of the
loan or the duration of the bond or duration of the debenture.

n is a number of years left for the maturity, that is a total, this is the current year and then
is the number of years for which that debenture is purchased or the loan is borrowed from
the market and F is the maturity value, this is the maturity value. So, means you get two
components back, one you get the interest and second you get the maturity value. So, it

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all depends upon that if the interest is being paid by that bond issuer or the company who
has issued the bonds in the market or the debentures in the market.

If they are paying the interest periodically, regularly, maybe 5 monthly or annually, then
at the time of the maturity of the bond, only the principal amount will be returned. And if
they are reinvesting back, if you have opted for the option that I do not want the interest
periodically, even my interest should be reinvested back in that case, in the majority sum,
it will be returned with the principal amount and the interest on that.

So, it means in this case, what is the case? We are now with the help of all these
components, we are going to calculate the cost of the debt or the cost of the debt
instrument, it can be bond, it can be debenture, it can be loan also, for the loan it is little
different, but for the debenture and bonds we are talking here like this. So, you can say
that your P 0 is equal to, P 0 is basically the current price of the debentures.

And in this whole case now, for example, current price of the bond we are knowing and
that interest which is payable that is also explained, that every year this much interest will
be paid by the bond issuer in the market and this much amount will be available as
maturity value. So, in this case, we may not be able to find out what is this rd, rd is
basically the interest available on this, basically you call it as 1 plus rd basically it is a
discount rate you can say, which makes your investment which you are going to make in
the market is a P0.

Because ultimately in every investment instrument what happens? That whatever the
interest we get back and the maturity values we get back after the period of that bond or
the loan or maybe that debenture that should be at least equal to the amount which we are
investing today. And this is basically the process of calculating the NPV of the
investment in which we are making to subscribe the bond and then we are getting the
inflows back.

So, inflows come in the form of interest and the maturity value and we have to discount it
at certain rate and that discount rate is called as the interest available on that this debt
instrument or in the bond of the debenture. So, this rd is basically the bone of contention

769
here, which we have to calculate, if normally when we buy the bonds or debentures we
are given that, we will be given this much of the annual interest and will be given this
much of the maturity value.

But sometime they remain silent on telling what is the rate of return in terms of the
percentage and that is the basically the rd that is a cost of the debt and for calculating the
cost of the debt, what you have to do is? Now, in this case, because we are making this
investment P 0 in the market for buying one bond and then this side, the right hand side
will be available as the return in the form of interest and in the form of the maturity
value. So, this P should be equal to the discounted value of I and F.

So, it means both the sides should be equal so, that minimum your NPV is 0, you want
that that minimum your requirement or minimum requirement is NPV from this
investment should be 0, so that whatever I am investing in the market over the number of
years in the form of interest and maturity value, this amount comes back to me. So, this
needs to be discounted, this interest in flow as well as the maturity value in flow needs to
be discounted at a certain rate and that is written here as rD.

And rD is basically the interest available or the expected rate of interest, which is
available from that investment or maybe the subscription to that bond of the debenture
that is basically a debt instrument. Now, rD is computed through the trial and error all the
times because, in case of the for example, in case of the say you remember that is IRR
internal rate of return available from any capital investment proposal, there are also we
were using that trial and error and here also, we have to use the trial and error.

We know the absolute values; we know how much annual interest I am going to get. We
know that how much maturity value we are going to get for this investment into one bond
or one debenture, but what is the rate of interest can be easily calculated and for that you
have to follow this approach, which is called as the trial and error approach. So, it means
that discount rate at which the discounted value of all the interest inflows and the
maturity inflows becomes equal minimum to this, the purchase price of that debt
instrument is called as the discount rate or the interest rate available from that investment
opportunity or from that investment instrument.

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Now, sometimes what happens, this trial and error process becomes a little complex, this
process becomes a little complex. So, we have the shortcut also, if you do not want to
follow this method of the trial and error, so, what can you do is, you can use this method
which is called as the approximation method. This is called as the approximation method
where you can use this I plus F minus P0 divided by n. And then, here in the
denominator, we use a 60 percent of the purchase price which is P 0and 40 percent of the
maturity value, which is F.

So, I is the interest, F is the maturity value, P0 is the purchase, price of the debenture, n is
the number of years for which the debenture is being purchased or the maturity period of
that debenture is n, number of years left to maturity, 60 percent of the purchase price plus
40 percent of the maturity value, if you use this model, then directly without using the
trial and error method, you can calculate this rate which is called as rd or the cost of the
debt, which is called as the cost of debt.

(Refer Slide Time: 29:41)

So, how it is to be applied? We have used an illustration here. Now, look at this
illustration. For example, the face value of any bond or debenture is 1000. Coupon rate
which is being said that this much of the interest will be paid, coupon rate is 12 percent.
Maturity period is 4 years and current market price is, current market price is the 1040. A

771
bond which is having the face value of the 1000 rupees is being sold by the issuer in the
market as the rate of 1040 means, that bond is being sold at a premium in the market.

Coupon rate being promised is 12 percent and your maturity period is 4 years. So, it
means, when you use the approximation method, you can see that rate of return available
from this investment proposal is how much? 10.7 percent, 10.7 percent so, this rate of
interest is 10.7 percent, coupon rate is 12 percent. So, it means what we are writing here
is, the approximate yield to maturity of this debenture is how much? That is 10.7 percent.

So, it means, in this case, when you are saying the coupon rate is 12 percent, coupon rate
is 12 percent means when you are reinvesting the interest back so total yield available
from the total investment will be 12 percent. But if you want to talk about here the yield
or the interest rate available, so interest rate is 10.7 percent which will become the
coupon rate of 12 percent.

So, we are using here simply means, you call it as the coupon rate, we are saying 120 is
the coupon rate that is basically the interest available and then we have this the face value
and maturity value. Sorry, this is our P0 is the face value, this is the maturity, this P0 is
the current price, F is a face value, then is the 60 percent of the purchase price, market
price and then 40 percent of the your face value.

So, if you use this approximation method, you can say that discount rate of this cash
inflow is 10.7 percent or the interest available from this project is or this particular bond
instrument is the 10.7 percent. So, you should not get disguised by the 12 percent as a
coupon rate. Actual return, actual rate of interest available from this investment proposal
is 10.7 percent, this will become 12 percent, when, on the cumulative basis, the interest
being earned annually will be reinvested back then it will become the 12 percent.

But otherwise, this is basically the rate of return available or the rate of interest available
from this particular debt instrument is 10.7 percent. So, this is the way we can calculate
the cost of debt. Now, in case of the bank loan. How to calculate the cost of the bank loan
particularly in case of the banks? Because we use the multiple sources, we use the bonds
and debentures, we use the bank loans, we use the commercial paper also. So, different

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multiple instruments are used for raising the debt from the market, both the long term
debt and the short term debt from the market.

So, in case of the debentures we have seen that what is a model available, or if you do not
want to use a trial and error method, we can use the approximation method. But in case of
the bank loan, what interest or the, what cost of that capital should be considered as a cost
of capital. So, there in that case means, bank loan means the current rate of interest will
be the cost of capital, it may be possible that the firm has borrowed the loan, existing firm
who is going to start the new investment process or the new project they are going to
undertake their existing borrowings rate of interest is 13 percent.

But currently the interest to be asked or to be charged by the bank on the borrowing is 12
percent. So, it means the cost of capital, for existing cost of capital on the bank borrowing
to the form is 13 percent but on the new borrowing from the bank is 12 percent. So for us
the current rate of interest to be charged by the bank is important and that we are going to
consider as the cost of the bank borrowings that we are going to consider the costs of the
bank borrowings.

(Refer Slide Time: 34:15)

Similarly, we have the other instruments like commercial paper and other short term
instruments. So, how to calculate the cost of commercial papers? When you talk about

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the cost of commercial paper, commercial paper is basically that short term debt
instrument which is sold in the market. And in the commercial paper how it is different
from the normal debt instruments is that the normal debt instruments, we make
investment and the avenue where we make the investment in those, in those debt
instruments they pay the interest back to the investor.

If we are subscribing to the bonds of any company, then we make that investment and in
return company gives us the interest on our investment. And at the end of the period of
that bond or the life of the bond, they return the principal amount but in case of the
commercial paper no interest is paid rather commercial papers are sold at a discount and
redeemed at par, they are sold at discount and redeemed at par. What does it mean?

(Refer Slide Time: 35:12)

Now, for example, a commercial paper of 1000 rupees will be sold at a discount of 10
percent. So, it means 10 percent on this will be 100. So, it means 1000 rupees’ maturity
value commercial paper will be sold in the market for 900 rupees. So, you are investing
900 rupees for buying one commercial paper and on the maturity you will get back 1000
rupees. So, it means we do not pay the interest on the commercial paper or the issuers
never paid any interest on the commercial paper.

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Rather they issued at discount redeem at par. And that difference between the purchase
price and that maturity price is known as the interest or the return available on the
commercial paper. So, it may be the commercial paper or it may be the bank loan or it
may be the short term borrowings, all these different sources have the different costs of
capital and how to calculate the cost of bond, we have seen how to calculate the cost of
the debenture, we have seen.

The bank in case of the bank loan, the current interest rate to be charged by the bank will
be the cost of capital and in case of that instrument like commercial paper, which is
largely used for the short term borrowing in India, the commercial paper can be issued for
minimum for the seven days and maximum for the one year not for more than one year’s
maturity, the commercial paper can be sold in the market and second thing is the
minimum investment requirement in the commercial paper is 500,000 rupees, 5 lakh
rupees and subsequently investment in the multiple of the 5 lakh rupees has to be there.

So, I can say it is also not again a retail investment instrument, it is not for every
individual. It is normally for the companies, banks, financial institutions. So, minimum
maturity period is one week, maximum is one year that is the commercial paper and the
minimum subscription or the investment is 5 lakh rupees and subsequent investment in
the multiple of the 5 lakh rupees. So, since the maximum maturity period is one year, so
you can agree with me that it is a short term investment instrument for the investor and it
is a short term borrowing instrument for the borrower or for the company.

And largely commercial paper is used as the source of funding the working capital
requirements. So, different sources different costs of capital, but finally, on all the debt
instruments long term and short term, we can easily calculate the average cost of debt or
average cost of borrowings. So, how to calculate the average cost of debt or average cost
of borrowing that I will discuss with you in the next class. Thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 49
Cost of Capital -Part 3

Welcome students, so in the previous class we were talking about the different sources of
the debt, the long term as well as the short term. In the long term we talked about the
debentures or bonds and then the bank borrowings or the borrowings from the financial
institutions. And we learned about that how to calculate the interest or the cost of capital
for the debt that is the debentures as well as the say borrowing from the financial
institutions.

At the same time, we talked about the one short term instrument which was a commercial
paper, and I told you that commercial paper is different from the normal borrowing
instruments because on the commercial paper, no interest is paid rather the commercial
paper is sold at discount in the market to the investor and redeemed by the firm, the
borrowing firm at par. So, the difference is called as the coupon rate or the interest rate or
the say you can call it as the differential amount is called it as the return on that
investment on the commercial paper.

So, finally, what we can do is, if the firm is using the multiple instruments, then we can
calculate the average cost of capital and for calculating the average cost of capital, we
will have to now learn about or with the help of some example, we can learn that how we
can calculate the average cost of capital. So, I am taking here the different debt
instruments and then we will learn about how to calculate the average cost of capital.

Because normally for all that debt instruments, we show the interest cost in the profit and
loss account and that interest which we debit in the profit and loss account or be debit the
profit and loss account with is this sum total of the interest on the or the average cost on
both long term and the short term sources. So, that is basically called as the average cost
of that debt capital.

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So, how to calculate that average cost of the borrowed capital or debt capital that we will
learn here. So, you can say that how to do that, we will do with the help of this particular
calculation or this particular table.

(Refer Slide Time: 02:26)

For example, we take here as a debt instrument right, we write here as the debt instrument
and then we write here as the face value. We write here as the face value and then we
write here as the market value.

This is the market value, this is called as a coupon rate and lastly this is called as the
YTM Yield to Maturity or you call it as the current rate, current borrowing rate, yield to
maturity is basically the current borrowing rate. So, we will take here as the debentures,
first is the debentures or bonds right, in case of the debentures the amount is how much
we are going to raise? 100 million, this is the 100 million.

So, we are going to raise this 100 million and the 100 million the face value of 100
million and the market value of that which we are going to sell because as I told you that
against the face value sometimes the bonds and debentures are sold at premium. So, the
market value here we assume is 104 million right, coupon rate is that is the 12 percent
and yield to maturity we have already calculated, learned how to calculate it and that is
10.7 percent.

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Second we talk about the bank loan or borrowing from the bank or financial institutions.
So, as I told you, that we are going to consider the current borrowing rate, not the
previous borrowing rate. So, previously the firm must have borrowed at the rate of 13
percent or 14 percent, but the current borrowing rate is at the rate of 12 percent. So, the
12 percent is important for us not the previous one.

Because we talk the marginal cost of capital in terms of marginal cost of capital not in
terms of the historical costs of capital. So, marginal cost of capital is means the
subsequent borrowings which you are going to make in the market at what rate of interest
we are going to borrow. So, that is more important is the current rate and here also we are
taking into account the current rate in case of the debt instrument right.

So, we are assuming here that this is say 200 million. We are going to raise from this
market this amount 200 millions we are going to raise from the market, again loan is
going to be same, so it means rupees this is 200 millions is going to be this value and the
rate of interest, current rate of interest we are assuming is 13 percent right, sorry the
previous rate of interest was 13 percent at which the firm has borrowed, coupon rate is
the 13 percent at which the firm has borrowed the funds and the current rate of interest is
the 12 percent, it is 12 percent and then third one we are going to talk about is the
commercial paper CP.

And in case of the commercial paper, we are going to raise how much? 50 million rupees
and say the market price because I told you the commercial paper is sold at a discount.
So, the market price for this is 48 point we are considering it as 48.25 millions right and
coupon is not there because it is sold at discount. So, no historical cost is there and we
assume that the say as per the discount rate given, the yield to maturity is 7.39 percent,
right.

So, in this case now, we have to calculate the average, these are the three sources from
where this total amount is coming and the total borrowing which we are going to have is
how much? 350 millions, but the market value which is more important for us is the
market value is how much? That is 352.25 millions right, this is more important for us.

778
So, before calculating the average cost of capital we take into account the market value of
any borrowing, not as the face value of the borrowing. So, in this case, because here we
are talking about 48.25 because when we are issuing the commercial paper worth rupees
50 millions in the market, actually the firm is getting the cash flowing back to the firm is
after discount is 48.25 millions against a bank loan 200 is 200 million same.

And against the debentures against the debentures of face value of 100 rupees, we are
going to raise 104 million rupees, because we are going to sell the debentures at
premium. So, it means total market value of this debt which we are going to raise from
the market with the help of different instruments, both long term and short term is 352.25
millions. So, now, for calculating the average cost of capital, we will have to take the sum
of all these three and in this case for calculating the average cost of capital, average cost
of capital.

Now, we will calculate that we are not calling it as a weighted average cost of capital,
weighted average cost of capital will be the one when the capital to the firm will come
from different sources both internal and external. So, there we will try to find out what is
the component of equity, what is a component of preference capital, what is a component
of the debt capital, there will be we will be talking about the weightages.

Here we are going to talk about the total simple average of the say total debt coming from
the different sources depending upon the different rate of interest being charged by the
financial institutions and the investors. So, average cost of capital has to be calculated
average cost of debt, average cost of debt has to be calculated here. And for calculating
this average cost of debt, we have to take now, the market value as I told you is important
for us.

So, we will take this market value and then we have the, already we have got this current
rates they are important for us 10.7, 12 percent and 7.39 percent. So, for calculating this
how to do it, 10.7 into right what is the first in this total amount? 104, divided by total
amount is how much? 352.25, 352.25 is the first component we are going to raise from
the market, then is a second plus next is a 12 percent, into 12 percent into how much we
are going to raise, 200 million.

779
So 200 divided by 352.25 million and close the bracket and then third one is how much?
That is 7.39 percent into how much is the total amount we are going to raise? 48.25
divided by 352.25. So, you close the bracket here, if you try to find out the average cost
of capital after solving this equation, you will find out that the average cost of capital
here works out as 10.98 percent, 10.98 percent is the average cost of this capital, right.

So, it means, we are and we are calculating the average cost of capital because it makes a
sense also because finally, at this rate we are debiting the profit and loss account. So, you
can say that one source or the long term sources, because in India now, we have the term
structure of interest rates. So, long term borrowing sources charge higher rate of interest
short term borrowing is charge a lesser rate of interest.

So, average cost of capital works out on the all the debt instruments both long term and
short term in the one for example, it is 12 percent or maybe in this case 10.7 percent in 12
percent and then it is 7.39. So, average cost works out as a 10.98 percent. This is the
average cost of the total debt we are raising from different sources, both long term debt
and the short term debt right. But here one important adjustment now has to be made
also, and that is with regard to the tax.

The main advantage of the debt as a source of funding is that it is basically tax
deductible. So, overall effective cost of the debt comes a seriously down as compared to
the cost of equity, this advantage is not available in case of the equity capital neither in
case of the preference capital right because in the equity capital also in the preference
capital also no interest is paid back to the investor rather we paid back them the dividend.

And dividend is not something which is tax deductible, you cannot means show the
dividend payable or paid as a cost of the funds in the profit and loss account. It is not the
financial cost, it is not the part of the financial costs, it is not the component of the
financial cost. So, this only, this liberty this feature, this important feature is only
associated to the borrowed capital.

So, if there is a negative feature with the borrowed capital that it is a fixed charge and in
every situation, you have to pay back the interest as well as the principal back to the

780
source or to the lender. So, the another positive feature or maybe the positive feature of
this instrument is that it is tax deductible, whatever the financial cost we pay to the
different sources, from where the funds are being borrowed, that cost is subject to the
deduction from the tax liability.

So finally, we are going to call it as this average cost of capital we have calculated is
basically this is pre-tax cost. This is the pre-tax cost, and we have to calculate now the
post-tax cost of debt, post-tax cost of debt or average cost of debt is that you can
calculate, how can you calculate that post-tax cost is that is pre-tax cost, you write here,
pre-tax cost into 1 minus tax rate.

1 minus tax rate so what is a pre-tax cost here? Pre-tax cost is 10 point we have
calculated it is 10.98 percent, right, this is a pre-tax cost and multiplied by 1 minus tax
rate. We assume here that tax rate is for example 35 percent, corporate taxes are largely
more than the individual taxes or the personal taxes. So, it is we assume in this case is 35
percent. So 1 minus 0.35, so it becomes how much?

If you solve this, this becomes as 7.14 percent, this is 7.14 percent, so post tax cost of the
debt, post tax average costs of the debt is 7.14 percent. So, this is the main reason, this is
a bone of contention, which creates a problem that in the capital structure of the firms
which is the next topic we will discuss after completing the discussion on the cost of
capital is that should the firm raise more funds from the debt or from the equity.

And here is the main difference, point of difference between the debt and equity that
though the debt is basically the risky source of funds because in every situation you have
to return back its financial charged that is the, means the interest cost and the principle
amount, you have to service the debt in the form of interest and then you have to pay it on
the maturity value of the loan or that debt you have to pay on the at the time of maturity
in every situation you have to pay it back.

Otherwise the lender will get the firm declared insolvent or liquidated. So, that risk is
there but if the firm has the assured profitability, then it is always better and advisable to
raise more funds from the debt because it is number 1, fixed charge against the profits of

781
the firm or from the against the revenues of the firm not profit, against the revenues of the
firm. And second thing is effective cost of debt is much less as against the cost of equity,
because it is number one fixed and secondary it is tax deductible.

This feature is not embedded with the cost of equity both whether it is a cost of equity
capital or it is a preference capital. Their dividend is not tax deductible. So because of
this basic difference between the debt capital and the equity capital, the capital structure
becomes a very serious issue and firms are even today are not able to decide whether they
should have higher amount of debt or higher amount of equity in their capital structure.
right.

So, you have seen that how we calculate the average cost of capital in case of the external
source of funding largely in case of the debt instruments, whether it is a debenture,
whether it is a bank loan or whether it is any short term instrument like commercial paper
and finally, by calculating the individual cost and yield to maturity, we calculate the
average cost of capital and that average cost of capital is calculated as the post-tax cost of
debt or the cost of borrowed capital.

Now, we talk about the next part and the next part is preference capital, how to calculate
the cost of the preference capital?

782
(Refer Slide Time: 15:58)

Here it is written that given the fixed nature of preferences dividend and the principle
repayment commitment, given the fixed nature of preference dividend and principle
repayment commitment, and the absence of tax deductibility, the cost of preferences
simply equal to its yield, because the feature as I told you this tax deductibility feature is
not there with the preference capital.

You cannot deduct the tax payment, because dividend is not subject to the tax deduction,
it is only the interest. So, because of the absence of this feature, finally, the cost of
preference capital is simply equal to its yield, that how much yield is available to the
preference shareholder, who is making the investment in any company's preference
shares is becoming or is called as a cost of preference capital.

783
(Refer Slide Time: 16:51)

We have taken the illustration here, for example, the face value is 100 rupees of any
preference share, dividend rate is which is 11 percent. So, on that say share certificate, it
will be written as 11 percent preference share at the face value of 100 rupees. So, face
value is 100 rupees, dividend rate is 11 percent, maturity period is 5 years and the market
price is 95.

In this case we are assuming a preference share having the face value of 100 rupees or the
maturity value of 100 rupees is being sold in the market at a discount and discount is 5
percent or 5 rupees. So, 100 rupees face value share, preference share is selling in the
market for 95 rupees it means 5 percent discount is there. So, for calculating the yield,
same approximation formula or the method can be used here also and same all the
components will be same.

We have got the market price also, we have got the face value also, we have got the
maturity period also and we have got the coupon rate also. So, it means finally if we use
this approximation method, not the trial and error method. So, if you use the
approximation method then you would say that approximate yield on this investment is
12.37 percent, right.

784
So, against the dividend rate of 11 percent we are getting the and this is largely the
cumulative you can call it as a preference share, because in this case in the cumulative
preference shares, we are investing the dividend back and finally, at the end of the say 5
years when we are getting the total return back, that is the principal amount along with
the cumulative dividend, so that yield works out as 12.37 percent.

So, against the standard dividend rate of 11 percent, the yield on that investment works
out as 12.37 percent. So, this is how we can calculate the cost of the preference capital.
So, almost as same as the debt capital only difference is that this cost is not tax
deductible. So, you have to pay the dividend but you cannot take the advantage of the
reducing the tax liability by paying any kind of the dividend on the preference capital. So,
this is the discussion about the preference capital and the debt capital.

And now, we will move forward with the next and the most important part and the most
complex part also with regard to the cost of equity and for calculating this cost of equity,
we have to now learn it in detail that how we can calculate the cost of equity, what are the
different methods, what are the different ways we can use for calculating the cost of
equity. In this case, for example, cost of equity as I told you, it creates a problem because
the dividend amount is not fixed.

Sometime you pay very high amount of dividend, it may be possible that sometimes
equity shareholders are getting 50 percent dividend right against the investment of 100
rupee their annual return is 50 rupees on one share. If the one share if they have bought
from 100 rupees, so, they may get back 50 rupees. So, it means the return is 50 percent
which is totally you call it as unexpected return from the market.

And there could be situation they do not they get anything back as the return means they
get the zero return, they get back the 0 return. So, in both cases means ultimately they
have to face the music whether say not I would say it or not to face the music, music they
are going to face only in case of when they are not getting any dividend. But in that case
also if the firm is profitable, and they are not getting the dividend back, the total profit is
being reinvested back into the business.

785
So, that way the overall market value of the firm is going to increase because the capital
base of the firm is going to go up, right. So, cost of equity as I told you dividend
remaining the main deciding point and it is uncertain. So it is very difficult to calculate
the cost of equity, but still we have number of ways to learn about that how to calculate
the cost of equity and different ways different methods of calculating the cost of equity
are.

First of all, let us read these points, before reading these points, I will discuss 1 or 2 more
points, that when you talk about the equity, now you understand from where the equity
comes, what are the sources of equity capital. There are two sources of equity capital, one
is directly by issuing the stock in the market before you call it as through IPO, initial
public offer or through FPO followed on public offer in the market.

So, directly when we issue any equity shares in the market, people subscribed to that. So,
we get the equity capital right, this is the one source. Second sources that when I am
saying the company has a profit, but they do not pay the dividend or you can call it as
dividend payout ratio is very very small and larger part of the say earning of the business
are going to be reinvested back. So you call them as their retained earnings. So, equity
also comes from the retained earnings also, when you are investing.

786
(Refer Slide Time: 22:11)

For example, we have got the say 100 rupees, one share of the 100 rupees is there right,
we have sold it in the market and total base of the company is going to be how much? 1
lakh rupees, if we assume that number of shares we have sold in the market and for one
share of 100 rupees so total number of shares are how much? 1000 shares are issued in
the market.

So, it means the total base of the company in the first year is 100000 rupees and in the
first year the company earns a profit of say 10000 rupees, profit of 10000 rupees, but the
firm means the management of the company, the board of directors decide that we are not
going to pay the dividend because of our capital requirements are high. So these 10,000
rupees which we have earned the profit at the end of the first year are going to be
reinvested back into the business.

So this 10,000 we are going to invest, so this at the end of the next year or in the
beginning of the second year, this base of the firm, capital base of the firm becomes
1,10,000 rupees, right. So, in this case also if you divide it by 100 or maybe 1,000 shares,
because number of shares are going to remain the same 1000 shares. So, it means a face
value of the share which was of 100 rupees, now it has become you call it is a book value
of the share has become 110 rupees, right.

787
So, similarly when the book value of the share is increasing, the market value of the share
is also increasing in the market. So, if any shareholder who is not satisfied with non-
dividend paying policy of the firm, he can easily sell off his share in the market, in the
secondary market and very easily he will recover for this dividend amount of 10 rupees
rather he would be able to sell his share which is purchased for 100 rupees, 1 year back.

Maybe easily for 130 you call it as 30 rupees or 140 rupees or minimum 120 rupees, so
he has recovered for the face value also, he has recovered for the dividend also and he has
made some profit also on that investment, maybe by just a meager amount of 10 rupees.
So, both ways it is possible.

(Refer Slide Time: 24:13)

So, when you talk about the sources of equity, it is written here, equity finance comes by
way of number 1, retention of earnings, this is one and this second is issue of the
additional capital. So, first time when any company when it is converted from the private
limited company to a public limited company, the company converted into the public
limited company start raising the capital from the market that is done with the help of
IPO Initial Public offer, right. And once that amount is raised and companies start making
use of that amount sufficiently or maybe very efficiently in the market, so, they start
earning the profits.

788
And maybe as I told you that they may decide that we will not declare dividend or maybe
we will pay only 10 percent profit as dividend, 90 percent will be reinvested back. So that
90 percent will becomes the source as the retention of earnings and one source is the
capital raised through IPO. And when that capital which is raised through IPO is a fully
exhausted, we can go with the further issues of the capital also and they are called as FPO
Followed on Public Offers also.

So, two sources are there, from where this capital comes in the business and that is from
the equity sources or the equity capital. Here now, the one important thing is the
opportunity cost of the say retained earnings. That is a very important concept. While
talking about the retention of earnings we should be taking care of the opportunity costs
of the retained earnings.

And if you talk about the opportunity costs of retained earnings because it creates a
problem. For example, we are investing that profit into the business and business is
returning 10 percent back average return for the business is 10 percent whereas if it is
invested in the market in open market, the return available from the market is 12 percent.
So, it means opportunity cost of that investment is high. But in a way, we have to look at
from the other angle also.

That will be borrow the capital from the market it will come at 12 percent but it if we say
reinvest our own profits back it will be available at the rate of 10 percent. So, it means
when the cost of borrowing or investment is lower and the return start increasing, that
differential can be easily made up, but we should be say keeping into consideration all the
times that the retained earnings always had the opportunity cost and we should be
worried about this component.

It may be possible that for example, if the funds are easily available in the market, and in
the market, the rate of interest or the borrowing rate or the cost of equity capital, maybe
the boring rate is 8 percent. There are other opportunity costs of capital is 10 percent so it
may be possible that we can invest our own funds out in the market and we can borrow
from the market at the rate of 8 percent. So, overall cost of capital will go down.

789
So, all these, these evaluations should be done but largely when you talk about the equity
cost or the cost of equity, first of all be clear equity comes from two sources. One is the
retention of earnings. Second is from the IPO and the FPO. Next point, irrespective of
whether a firm raises equity finance, by retaining earnings or issuing additional equity
shares, the cost of equity is the same, we treat it as the cost of equities is same.

In both the cases the cost of equity is the same. Though we evaluate it against opportunity
costs of capital, but we do not provide two cost, we take the total sum, how much is the
total equity investment, that is the paid up capital as well as the free reserves that
becomes the total equity capital and the only difference is the flotation cost, it is written
here only difference is the flotation cost that in case of the retained earnings, no flotation
cost has to be paid.

Whereas, in case of the equity capital, fresh issue of the equity capital, maybe IPO or
FPO we have to pay the flotation costs. So, what is a concept of the floatation cost? I will
discuss with you in the subsequent lectures, floatation cost is basically preparing the cost
of preparing the prospectors, then the fee is to be deposited with the registrar of
companies and printing expenses, advertising expenses, because for the advertisement of
selling the equity shares in the market.

You have to give the advertisement into the print and electronic media. So, all these costs
are associated which are not there with the retained earnings. So, means barring that
flotation cost which is specifically going to take place in case of the IPO and FPO other
costs are going to be same. So other than the flotation costs, cost of retained earnings and
the cost of equity is going to be treated as the same cost.

And next point is cost of equity is a little difficult to calculate due to dividend, due to
dividend it is little difficult to calculate due to dividend right from the beginning of the
discussion, I am means emphasizing upon that dividend is the bone of contention,
because it is not fixed and it is the only reason which makes the calculation of the cost of
equity little difficult right.

790
(Refer Slide Time: 29:30)

So, for calculating the cost of equity, we have the different approaches. First approach is
the security market line approach, second is the bond yield plus risk premium approach.
Third approach is the dividend growth model approach. And fourth is the earning price
ratio approach. These four approaches are there, which we normally use, these four
methods are there, which we normally use for calculating the costs of the equity and first
is the most important which you call it as the CAPM approach also Capital Asset Pricing
Model approach also.

Security market line basically, we draw with the help of the CAPM capital asset pricing
model. And if you want to use it most objective method we call it as, if you want to use
the most objective method of calculating the cost of equity, then the first method is the
most important that is the calculating the cost of equity with the help of capital asset
pricing model or the security market line approach.

Otherwise, we can use the other subjective approaches also, which is maybe the bond
yield plus risk premium approach, dividend growth model and then it is the earning price
ratio approach right. So, what are these four different approaches which are normally
used to calculate the cost of equity to take care of the dividend issue, I will discuss with
you at length one by one.

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All the four approaches, all the four models but that too in the next class, for the moment,
I will stop here and remaining discussion about the calculation of the cost of equity I will
discuss with you in the next class. Thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 50
Cost of Capital-Part 4

Welcome all, so now we will learn about the different approaches to calculate the cost of
equity. The one important source of finance, we call it as generally the internal source of
finance, for financing the investment projects or the investment proposals by the firms.
So, out of the two broad sources internal and external sources equity capital is the main
internal source because preference capital provides the say only a fractional amount, a
larger part of the finance comes from the equity capital.

In case of any form of the business organizations I would share with you that whether it
is a sole proprietorship or a partnership firm or even a private limited company and
public limited company, larger component has to come from the internal sources because,
first if the owner is ready to make investment in the business, then only the outsiders will
believe or the outsiders will trust the business.

But if the owner is not investing anything from the pocket and largely depending upon
the external sources, that does not happen, right. So, certainly more in case of the sole
proprietorship, more funds come from the internal sources, internal equity is very high. In
case of the partnership firms, yes, the internal funds are very high and Private Limited
companies, largely more funds come from the internal sources.

Once the efficacy of the internal funds is proved, then the external sources or maybe the
borrowing from the external sources will be allowed or they will be inclined to make
investment in any company otherwise not and same is the case with the public limited
companies that normally we call it as that debt-equity ratio is 2:1, standard debt equity
ratio is that 2:1 in the say capital structure issues.

So, what does it mean, that if we invest minimum 1 rupee from our own pocket, then we
can borrow 2 rupees from the market, right. So, minimum investment has to come or

793
sometime it becomes a maximum investment also, if the overall profitability profile is not
up to the mark or the volatility of earnings is very high then sometimes what happens
more funds come from the internal sources which we call it as the equity capital.

So, as I told you in the previous class that because of the and non-fixed nature of the
dividend, which is the return on the equity paid to the equity shareholders or investors
into the equity shares, because that is not fixed that is uncertain, sometime it is more,
sometime it is less, sometime it is zero. So, it makes very difficult for us to calculate the
cost of equity.

(Refer Slide Time: 03:06)

So, I told you that before the 4 approaches here, one is the CAPM approach, Capital
Asset Pricing Model approach, then is we have the bond yield plus risk premium
approach, then it is the dividend growth model which is given to by the Gordon,
Professor Gordon and then it is we have the fourth approaches as the earnings price ratio
approach.

So, if you look at these 4 approaches, the major difference is only first approach here it is
this is the most objective approach, security market line approach. Whereas, other 3
approaches to some extent or maybe to a significant extent they involve the element of
subjectivity. And when the element of subjectivity comes, then sometimes trusting that

794
particular method or component becomes difficult or that estimate becomes doubtful that
what is that you can call it as the acceptability of those subjective estimates that is a
million-dollar question, right.

So, let us discuss these approaches one by one and then we will say conclude which one
is going to be the best one, which normally firms use in practice in the market. And even
as a new entrepreneur or any manager of any or any financial manager of any company,
we should suggest to the company that which approach is more prone to use or likely to
use or going to give us the best results. So, first is the security market line approach.

(Refer Slide Time: 04:33)

Security market line approach is basically you call it as I told you, that it is based upon
something which is called as the capital asset pricing model, capital asset pricing model
and the capital asset pricing model CAPM model is this model basically you call it as the
equation of the CAPM is this one, and with the help of this model, you can calculate the
cost of equity.

So, here what is it included in this model, r E that is on the left hand side cost of equity or
the rate of return on the equity right, but how to calculate that depends upon the
components in the right hand side, which is R f plus beta E into E R M minus Rf right. So,
what is this Rf, let us see all these components one by one they are given here. So, it

795
means now, if you want to see that rE is basically the required return on equity of the
company.

And Rf is, Rf is basically the risk free rate, risk free rate is that rate on which the element
of risk is almost negligible, you can assume that if you are making investment into any
say avenue of investment, where the rate of return being provided is a risk free rate. So, it
means you can assume that at the end of that investment period or investment horizon,
that much of the return will be certainly available from that investment avenue.

For example, you talk about the investment into the government securities, government
bonds, government issue two kinds of bonds, treasury bonds which has the short term
investment instruments, and the long term bonds, which are long term investment
instruments. And whatever the rate of interest government promises that is normally paid
on the maturity that is why they are called as that guilt edged securities.

Because the element of the security associated to those bonds is called as the guilt edge
securities. So, guilt edge securities are going to give us the certain return which is a
promised return and at the end of that maturity period, come what may that much of the
return is available, simply you talk about the bank rate.

When we give our funds to banks or we make our investment in the bank in the form of
the fixed deposits or maybe in case of the recurring deposits. So, whatever the rate of
return banks promises to us, it is a guilt edge deposit, it is a guilt edge security and that
much of the return is available from the bank. So, that rate of interest is called as or that
rate of return is called as risk free rate, this is called as R f plus beta of equity, beta of the
stock, individual stock I am talking about.

Because we are going to talk about the cost of individual’s security, we are not going to
talk about the costs of the entire market stocks. So individual security means it is called
as the beta of the individual security. And with the beta you are multiplying the
difference between the expected market return minus the risk free rate, expected market
return minus the risk free rate.

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So beta is basically, the beta of the equity of the company, beta of the equity of the
company is the beta E, now what is beta, how do you define beta? Beta is basically the
measure of riskiness of an individual security as against the riskiness of the whole
market, element of the risk involved in the risk of say individual security or the security
or the stock an individual company as against the market in the risk, element of the risk in
the market as a whole.

So, this is a relationship which is exhibited by beta for example, you say the beta is 1,
beta value is 1, it ranges from 1 to more than 1 or sometime less than 1. So, for example,
the beta 1, beta 1 means the security of the company or the stock of the company is as
much as risky as there is a total market risk, it means what is the average market risk is
there, the security of this company is also that much risky and the individual security is
not less risky or riskier as compared to the market risk.

So, beta explains about the relationship of the risk between the individual security and the
market risk or the risk edge in the individual security and the market risk. For example,
beta is 1.2 right, so you can see that individual company whose stocks you are going to
evaluate or the cost of the equity you are going to calculate is riskier as against the total
average risk available in the market.

Because beta 1.2 but for example, beta 0.8. So, in that case, you can say the security of
the company, the stock of the company in question of which the cost we are going to
calculate is less risky as compared to the total market risk, it means, if you calculate the
total risk in the market of all the securities being traded in the stock exchange, they are
more risky, average risk of all those securities is more as compared to the risk associated
with the individual security.

So, beta is basically the indicator of the risk associated to the individual security as
against the market risk. Expected RM is, E(RM) is basically expected return on the market
portfolio, expected return on the market portfolio that total market return means much?
Because this is the difference and this is a difference is basically why, because if you
want to have the risk free rate of return, then why should you go to stock market.

797
You should not go to stock market then it means that much of the return is available from
the government, say bonds, short term or the long term depending upon the investment
horizon. It is available in the bank deposits. So, if we are going out in search of the higher
rate of interest or the higher rate of return that is why we are into the stock market.

And when you are expecting the higher rate of return by going to the stock market, you
are prone to the higher amount of the risk also. So, this basically you call it as a risk
premium, expected market return minus risk free rate of return is the reward for that
particular risk which the person, the investor is going to take by investing his surplus
savings, not in the risk free rate of return, but in the stock market.

So, he is ready to take the higher amount of risk and for that he needs to be compensated
by that higher amount of return. So, expected market return means expected return from
that security minus in the market minus the risk free rate of return is called as the E R M.
Basically it is talking about the risk premium that is a E R M minus R f is basically the
risk premium, which will largely depend upon the element of the risk associated to that
security. If the element of risk associated to that individual security is high, then the risk
this premium will be affected accordingly.

And if the risk or the beta is low, then certainly the risk will be much less as because
individual securities are less risky as against the market risk. So, we are multiplying the
risk premium that is the E(RM) with the Rf with the beta and ultimately we are going to
decide about the riskiness of the security, by taking into consideration or calculating the
beta or beta in the same way you call it as basically the variance of return available from
the companies or the investment in the companys stocks.

Now, for example, we have taken a simple illustration here, R f we are assuming risk free
rate of return is 7 percent, beta of the security is 1.2, 1.2 means security is 20 percent
riskier as compared to the market risk, average market risk, this security in question of
this company is 20 percent riskier as compared to the general market risk and E(R M) is
expected market return available in the stock market is 15 percent.

798
And rE if you want to calculate by using this then it works out as 16.6 percent. This
security is going to give you the higher returns as against the market returns by 1.6
percent. Because beta is higher, because the riskiness of the security is higher. So, the
volatility is higher, volatility of the return in the security is higher, but since you are
going to take the more amount of risk, that is why the return also is higher as compared to
the market return because the risk and return are directly correlated.

So, in this case, you can easily calculate the cost of equity that is basically the required
return on the equity of the company rE can be calculated by taking into consideration the
risk free rate of return beta of the security and the risk premium, which is available and
that can be calculated by subtracting the risk free rate of return from the market return
and rE is equal to 16.6 percent in this case.

(Refer Slide Time: 13:44)

799
Now, for calculating this model or means using this model or calculating the cost under
this model, the cost of equity under this model, we need certain inputs and from where
the inputs come? That is, we are going to talk about in this slide or this particular say
presentation here. Different inputs can come from the different sources or different
estimates are there and there is a complete disagreement in the market between the,
among us the financial practitioners.

But important finally we arrived at the best estimates which are acceptable to all. So,
despite the significant disagreement existing in the market amongst the finance
practitioners, there are some common points which are of the quite helpful or reasonable
help and we follow these points then certainly we can find out all the input variables
required for the security line model or the CAPM model, right.

So, first thing is the risk free rate may be estimated as the yield on the long term bonds
that have a maturity of 10 years or more, means the question here is that when you are
talking about the risk free rate of return the 7 percent, from where this has come? Why
should you take it as a 7 percent, currently for example, it is 6.25 percent right? And
previously it was maybe sometime 8 percent in the future also it is expected it may go up
or it may come down.

800
So, how can you say that risk free rate of return is always 7 percent. How to arrive at this
risk free rate of return, this is a point regarding this that the risk free rate may be
estimated as the yield on long term bonds that have been maturity period of 10 years or
more. So, you can calculate the average of this yield on the long term bond for the period
of 10 years. So, that if you predict about the next year on the basis of the yield on any
bond for the period of the past 10 years.

So, it means a larger you have adjusted for all ups and downs and you can say that
whatever we are expecting the rate of interest for the coming year will be means rightly
anticipated, or will be able to calculate it correctly. Second point is the market risk
premium may be estimated as a difference between the average return on the market
portfolio and the average risk free rate over the past 10 to 30 years.

You can find out because market portfolio is easily available for example, you can take
the Sensex value right, how the Sensex is changing. So, market index is easily available,
you have the different indices are there, different market indices are there and for say you
can take the Sensex value, you can take the Nifty value. So, that can be considered as the
representative of the market return.

And for the individual security or for calculating the risk free rate of return you can take
the average risk free rate over the past 10 to 30 years. So, you have to subtract from the
market returns the risk free rate of return and the time period is so large 10 to 30 years we
are talking about. So, that difference between the market return, market return can be say
used means the market index can be used as a proxy of the market return.

And the risk free rate can be used from the long term bonds for a period of the past 10 to
30 years, maybe 10 years, 15 years or 20 years or maybe 30 also depending upon the
information available. So, if you are taking such a long period and you are getting two
proxies easily available, the market index as well as the say the risk free rate of return so
premium can be satisfactorily worked out.

The beta of the stock may be calculated by regressing the monthly returns on the stock
over the monthly returns on the market index over the past 60 month or so. It is basically

801
the regression equation means, if the market return is this much, how much will be the
return from the individual security? So, it is the basically the regression analysis we do it
by calculated by regressing the monthly returns on the stock.

Individual security whose costs we are going to calculate over the monthly returns on the
market index, over the past 60 months or so. And next thing we talk about the systematic
risk and the unsystematic risk, these two risks are very important risk to be taken care of,
as far as the say unsystematic risk is concerned, unsystematic risk is basically the
company level risk you call it as.

The company level risk, which can be largely taken care of with the help of
diversification of the investment right. Say, for example, if we are investing into the
stocks, maybe we have the, as an individual also or as an institution, if you have to invest
a certain sum of money, it is always advisable that do not put all your eggs into one
basket.

So, what should we do? For example, if somebody want to make investment of 1,00,000
rupees into the stocks or in the stock market, he should choose a different security, he
should make a good portfolio of the 3-4 securities 3-4 stocks of the 3-4 companies. So,
that if the stock of any company or the return on the stock of any company goes up and
on the other goes down.

So, ultimately net results remain the same, he has not lost anything and if the proportion
of the growth and the proportion of decline is equally same, so, at least you are at the
state of the no profit no loss or sometimes if the proportion of the growth is higher and
the proportion of declining other securities lesser ultimately you end up making some
profits.

So, with the help of I mean to say diversification, the unsystematic, the company level
risk can be taken care of. But the other risk which you call it as the systemic risk and the
risk which you say may come because of the industry risk or the market risk. So, we have
the 3 kinds of analysis, EIC analysis we call it as, we call it as the say EIC analysis.

802
(Refer Slide Time: 19:37)

EIC analysis means, this is EIC analysis. It is economy, it is industry and it is company as
far as a company level of the risk is concerned by analyzing the companys stocks over a
number of years, the product type, the companys background, you can easily take care of
that what is the riskiness involved. So, with the help of diversification, this risk which is
called as largely the unsystematic risk can be taken care of and for taking care of the
systematic risk, you have to then use the different strategies.

803
And for say this systematic risk means because largely the market premium depends
upon, expected return from the market depends upon the systematic risk and for that
systematic risk we have to know the different things given here and for that what you
have to do is, you have to calculate the beta, because individual security, the risk
associated you have already nullified by going for diversification.

Systematic risk, which is represented by beta needs to be taken care of because it comes
from the factors which are beyond the control of any individual, any company also. They
are caused by the industry as a whole, they are caused by the economy as a whole,
economic system, industrial situation, recessionary situations, inflation rates in the
market or maybe the demand supply situation, world economic scenario.

So, all these factors, which are going to create the problems and going to affect the
returns of the stocks of individual companies, which is calculated in the form of the beta,
we have to now say calculate the beta and with the help of beta, you can try to find out if
the amount of the beta is high, then certainly we want the higher premium for the
compensation against the systematic risk.

So, with the help of beta the systematic risk can be measured and for handling of non-
systematic risk, we can use the concept of diversification and people can use both means
the prediction of the systematic and the unsystematic risk involved in the riskiness of the
security and if you look at the model.

We have taken care of both the things that if we want to increase that return from the
market, sorry, return into the individual security. Then you first you talk about the
unsystematic risk. So, there we use a diversification and for the systematic risk, you can
use the beta and with the help of beta you can understand how much riskiness is there or
how risky the security is.

And depending upon that, you can assign the premium expected from the that investment
and finally we can decide the say the cost of capital by applying this model of the CAPM.
There are some limitations in the CAPM also that for example, the beta of the individual

804
companies does not remain same over the number of years, there can be the one
important reason.

Even sometime the unsystematic risk is not also completely possible to be reduced by
simply diversification. So, we need some premium for unsystematic risk also. So, despite
all these limitations, 80 percent of the companies in the world use this method, this model
for calculating the cost of equity, despite the beta is not going to remain stable, which is
reflector of the systematic risk.

Despite the fact that unsystematic risk cannot be fully handled by the diversification, still
this model is most objective and most useful model and you call it as because of the
element of objectivity associated in this model, largely the companies in the world use
this model for calculating the cost of equity. right.

So, this is the most objective technique and you have understood how to calculate the
cost of equity, that is by using the equation or the model given, that is the cost of equity is
equal to that depend upon this RE is equal to Rf plus beta of the individual security into
expected market return minus risk free rate and this is basically the risk premium
associated for taking the risk while going to the stock market.

So, it means if you are taking the additional risk, we need the additional premium also for
getting compensated for the risk we are taking. So, this can be measured by using this
model, which is largely called as the security market line approach, which depends upon
the model called as the capital asset pricing model CAPM given to us by the noble
laureate, William Sharpe.

805
(Refer Slide Time: 24:22)

Now, we go to the next this approach, which is quite subjective approach, Bond Yield
Plus Risk Premium Approach and the cost of equity can be calculated with the help of
this approach. So, if you want to use this approach, what we do here is, as the say this
formula says cost of equity can be calculated with the help of yield on the long term
bonds, yield on that long term bonds plus risk premium.

So, yield on the long term bonds of the firm plus risk premium, so, yield on the long term
bonds can easily be calculated, you call it as a risk free rate of return right which is being
used in the security market line approach also that is R f that is the yield on the long term
bonds right, that is easily available from the market, since it is a risk free rate of return.

So, with certainty that you can say this much of the return is available plus, because we
are going to stock market for making investment into the equity of the companies. So, we
are going to take additional risk. So, we need to be compensated by the risk premium for
the risk we are taking, and here this factor of the risk under this approach is added to the
say risk free rate of return on the basis of subjectivity or experiences of the market
experts.

So, should the risk premium be 2 percent, 4 percent or n percent? How much should it be,
2 percent, 4 percent, n, how much we should add here? Because, that will depend upon

806
the risk in the market and how much risk is going to be there in the market. For example,
if the economy is growing at a very faster rate and the growth rate is very high. Sensex is
growing, Nifty is also growing all the companies are stock stocks are doing very well in
the market, market return is very high.

So, in that case risk is very low, but the situation can be reversed also, situation can be in
between also, it can be means volatile also right. So, what percentage we should add here,
there is no standard formula, no standard mathematical model or approach only
subjective approach depending upon the past experiences and the understanding of the
financial experts in the market.

You can add some premium here and it is clearly written here. There seems to be no
objective way of determining it. In practice it normally ranges between 2 and 6 percent.
In practice normally depending upon because what has been seen in the market
practically it ranges between 2 and 6 percent depending upon the operating and the
financial risk of the business, depending upon the operating and the final financial risk of
the business.

If the operating and financial risk of the business is high, then we assign high amount of
premium, but if these two risks are lesser or lower than minimum premium which has to
be added in the risk free rate of return is 2 percent, for example, risk free rate of return is
7 percent then the cost of equity will be adding 2 percent is 9 percent or maximum it can
go up to 13 percent, if it is 6 percent premium we are adding right, but that depends upon
the riskiness of the individual company and their stocks.

So, operating and the financial structure or the risk associated, which is called is
operating and the financial risk are going to play the part. But the limitation of this
approach is that risk premium to be added here has to be based upon the subjectivity and
largely upon the estimates, best estimates of the financial experts, though we are going to
supplement this information with the operating and the financial structure of the firm or
the operating and the financial risk associated with that security but still this approach
remains largely subjective approach.

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(Refer Slide Time: 28:09)

Next is dividend growth model which is given to us by Gordon. This one you can call it
as mathematician, means a person, you call it as a person not mathematician, I would
correct myself. He is the Myron J. Gordon. He is a financial expert. So Professor Gordon,
he is basically the say professor of financial economics.

So, Professor Gordon has given this model and this model is basically called as, how it is
explained it is given here and this model is called as the dividend growth model. And
Gordon says that cost of equity largely depends upon the growth rate of the dividend,
largely depends upon the growth rate of the dividend that at what rate the dividend of the
company grows, that is going to decide the cost of the capital of the company.

So, here it is written clearly, that is the price of equity stocks depends ultimately on the
dividend expected from it, higher the amount of a dividend, higher the price you are
ready to pay, lesser the amount of dividend lowers the price you are going to pay for the
stock of that particular company and if the dividend per share grows at a constant rate of
g percent right.

So, it means this is again a bone of contention constant rate of growth, which is called as
g percent right. So, it means, you have to now find out that constant rate of growth. So,
this is a major limitation of this model that can you expect that the dividend will be

808
growing at a constant rate over a period of time? It is very-very important, we will be
having the question of this constant rate of growth, we can try to find out how to means
find out the handler to find out g that is also discussed in the next slide.

But for example, if you assume that this model will be followed for calculating the cost
of equity, then this model says that depending upon the dividend being paid on the
investment, the costs of equity can be decided and in this case, how it is being done P 0
depends upon D1, dividend given in any year divided by rE minus say the g, that is the
cost of the, return from the equity minus growth rate right.

So, it means this dividend it will depend upon that is the return on the equity minus g, this
is a growth rate. So, it means for calculating the r E, rE will depend upon what? That is rE is
basically the return from the security or the say rate of return of the security. So, in this
case, if you talk about the expected return from the security, it will depend upon how you
calculate it D1 divided by P0 plus g.

P0 is the price of the security in the current year, P 0 is the price of their stock in the
current year, D1 is the dividend expected at the end of the year and plus the growth rate is
the g. So, here it is the growth rate here, that at what rate the dividend is growing over the
number of years, the price in the current year and the dividend in the current year and
plus at what rate the dividend is expected to grow, with the help of that you are going to
decide this value of rE.

So, from this rate of return from the equity r E if you subtract the g and say this dividend
is divided by the r E minus g, then you will be able to find out the price of the stock or
the price of the equity capital or the equity stock. So, in this case, does the expected
return of equity shareholders, which in equilibrium is also required return is equal to the
dividend plus the expected growth rate right.

So, the expected, this basically, when you are talking about this r E this is expected return
of the equity shareholders. And this expected return of the equity shareholders will
depend upon what? This depend upon which is equal to the dividend, which is equal to

809
the dividend plus the expected growth rate. So, it means, at what rate that dividend of this
companys growing in the subsequent years, P0 will depend upon this.

So, P0 is largely depending upon what? This is depending upon the dividend being paid
on that stock by the company and that will depend upon the growth rate over the number
of years. So, it is written clearly here, if the dividend per share grows as a constant rate of
g, then the cost of equity, that is P 0 price of the share, equity shares can be calculated by
this model, and this largely depends upon the growth of the dividend. Now, the million-
dollar question here is how to calculate g? How to calculate g?

(Refer Slide Time: 33:04)

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Getting a handler over g this is the question because growth rate, at what rate the
dividend will grow, we have to find it out. So, first thing is written here, for publicly
traded companies it is easy to determine the dividend yield. However, it is difficult to
estimate g right.

So, in this case, because for the Private Limited Company it is very difficult because cost
of equity problem comes normally in case of the public limited companies, there also we
have to calculate the cost of equity. So, the dividend is easily available right, is easily
available that it is easy to determine the dividend yield.

However, it is difficult to estimate g, so for estimating g, what we have to do is, number

one, relying on the analysts forecast of the growth rate. Different companies, different
secondary estimates are available in the market, from the different research agencies who
keep on forecasting depending upon the previous number of years 10, 15 years, they
predict that what will be the growth rate of the dividend, in case of the different stocks, so
we can make use of that.

Average annual growth rate in the preceding 5 to 10 years can also be used right, if you
do not want to depend upon any secondary estimates, then we can take the, we can
calculate it ourselves, retention growth rate, that is the retention rate means we can easily

811
try to find out with the help of the retention growth rate also, which can be calculated by
the retention rate into the return on equity.

Retention rate and the return on equity it can also be done like that. So, it means if you
want to follow that, if you want to use the retention growth rate, how can you calculate
the retention growth rate? Retention growth rate can be calculated easily by say retention
rate is basically, how can you calculate the retention ratio? That depends upon the
dividend payout ratio right.

So, if you want to see the dividend payout ratio, so it means a retention rate, how to
calculate the retention rate? That depends upon the say 1 minus dividend payout ratio,
that depends upon the dividend 1 minus dividend payout ratio that depends upon the
retention rate right. So, in this case for example, the dividend payout ratio is 40 percent,
that 40 percent of the profit is being paid.

So, it means your retention rate is going to be how much? 60 percent, right? So, retention
rate is going to be 60 percent and if you want to find out the say retention rate is 60
percent and the return on equity is for example 15 percent, this is 15 percent in that case,
sorry we will have not to us here this percentage because we are using it otherwise in the
fractional form. So, you have to call it as this particular part that is 0.6 into 15 percent.

So, if you call it as, so, what is the g? g will be 9 percent here. So, you can use the
retention rate also with the help of the retention rate, you can calculate the g, either you
depend upon the analyst or the secondary sources in the market or we can calculate g our
self by taking the growth rate for the preceding 5 to 10 years or we can use the retention
growth rate which is basically the retention rate into return on equity, right.

How to calculate I have explained it to you and the companies that do not pay the
dividends or the companies that are not listed in the market, dividend growth rate is not
sure. So, return on equity is also not sure, so there comes a problem. So, it means, here
we are going to talk about is that in case of the listed companies in the market, either you
use the analysts forecast or you use the annual growth rate or you use the retention
growth rate.

812
Either way, the g can be calculated and if you are able to calculate g, so, it means, if the
dividend per share means, the cost of capital will be calculated as the price of equity
stock depends upon ultimately on the dividend expected from it. And if the dividend per
share grows as a constant rate of g, then the cost can be calculated this way. So, for
calculating g, 3 estimates can be used, problem only comes in case of the companies
which are not listed in the market.

For example, the companies they are not listed in the market or sometimes the companies
who do not pay dividend, the company is listed in the market, but they are not paying
dividend then there comes a problem. So their means cost cannot be easily found out so,
there we have to be very careful, because growth rate will not be possible to be known.
And the return also the also will not be possible to be known.

Where the companies which are listed in the market or which are, whose shares are being
traded in the market, in those companies’ cases, finding out the cost of capital will not be
difficult by following this method that is called as the dividend growth model given to us
by the financial economics expert, Professor Myron J. Gordon. So, this model can be
used which is called as a dividend growth model or dividend growth approach.

So, these two approaches which are called as a subjective approach we have discussed
apart from the say your this CAPM approach which is the most objective approach.

813
(Refer Slide Time: 38:49)

And last approach I am going to discuss here quickly in the say next 2 minutes is, earning
price ratio approach right, earning price ratio approach is the, with the help of this, you
can calculate the cost of equity, that with the help of this particular model that is E 1
divided by P0, E1 is expected earnings per share.

So, it means earning price ratio approach, earning to price ratio approach, it means, what
is the base price in the current year and what is earning expected by on the basis of that
you use this say ratio and with the help of this ratio, the cost of equity can be calculated
where E1 is expected earnings per share for the next year. And now, you can easily
calculate the earnings per share for the next year is current earnings per share into 1 plus
growth rate of earnings per share.

Again now, the problem will come for assessing the growth rate. But depending upon the
past number of year growth rates we can estimate this also and P0 is the current market
price. So, current market price will be dividing the expected return which can be
calculated on the basis of the current earnings per share into 1 plus growth rate of the
earnings per share. So, with the help of this model you can calculate this approach is
called as the earning price ratio approach.

814
So, you can use this also, this is the third approach, subjective approach third, in total it is
a fourth approach and point of caution here it is, if you look at this line, point of caution
here is this approach provides an accurate measure in the following 2 cases, number 1
when the EPS is constant and the dividend payout ratio is 100 percent, which is quite
unlikely in the market.

Second is when the retained earnings earn a rate of return equal to the cost of equity. That
is the rate expected by the shareholders, when retained earnings earn a rate of return
equal to the cost of, equal to the cost of equity that is the rate expected by the
shareholders. So, in these two situations, if these two situations are held good, then means
when the dividend payout ratio is 100 percent, whatever the profit we are earning, we are
distributing as dividend which is quite unlikely.

And second thing is retained earnings earn the same rate as expected by the equity
shareholders or which is equal to the cost of the capital, which is also again going to be
very difficult. So, since these two conditions say do not hold good in case of this
application of this approach, so this approach is not used in practical sense.

So, in case of the subjective approaches either you use the second approach or you use
the third approach means second approach is basically the bond yield plus risk premium
approach. There if you know this risk premium, you can easily apply because the first
part is stable, we can easily find out which is a risk free rate of return. Whereas, in this
case, if you look at the risk premium, you can if you are able to find out the risk premium
easily, then we can easily means use this model which is again the subjective approach,
but still usable.

Or we can use if you know the growth rate of the dividend over the number of years, then
the dividend growth model can be used, but earning to price ratio approach is not possible
to be used. So, as I told you 80 percent of the companies use the CAPM, the security
market line approach, which is most objective for calculating the cost of equity, but if
other approaches have to be used, then you can use either the bond yield plus risk
premium approach or the dividend growth model approach given to us by the Gordon.

815
So, these two approaches can be used or the most objective CAPM can be used. So
means because of the dividend problem or the dividend issue, this calculation of the cost
of equity becomes complex, but ultimately we have to calculate it because we want to
calculate the weighted average cost of capital. So, till now, what I could discuss with you
is that how to calculate the cost of capital of the different sources.

First, we discuss the cost of capital of the borrowed capital, that is a debt, then the
preference capital and then the cost of equity by following the say or by using either of
the four approaches, in these approaches, one is the most objective approach and three are
the subjective approaches.

So, depending upon the resources available and the information available, any of these
four approaches can be used. So, this is how we calculate the cost of can you call it as the
cost of individual sources of the capital. But now, next part will be that how to decide the
proportions and then on the basis of these proportions, how to calculate the WACC
weighted average cost of capital and how to deal with the problem of the flotation cost
that all I will be talking to you but in the subsequent classes, in the next classes.

So, in the next class we will learn about how to determine the different proportions that is
largely dealing with the problem of the capital structure and then say the flotation cost.
And then finally calculating the weighted average cost of capital that I will discuss with
you in the next subsequent classes, till then thank you very much.

816
 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 51
Cost of Capital –Part 5

Welcome all, so in the process of learning about the cost of capital, now we will move forward
with some more relevant concepts, which are equally important in learning about the say the
entire process of determining the cost of capital or the weighted average cost of capital. So when
we talk about the weighted average cost of capital we need two say broad components or the
information about the two broad components.

Number 1, is the cost of individual sources of the funds and second one is the say deciding the
proportions of these different sources into the capital structure of the firm. So till now in the
previous classes we discussed that how to calculate or maybe what are the different sources of
the funds from where the capital can be arranged and how to determine the cost of these
individual sources.

After determining the cost of these individual sources now we can learn how the weights can be
assigned or how the weights can be determined with regard to the different sources. So what
should be the proportion of which source because we have learnt till now that largely there are
three sources equity capital, preference capital and the borrowed capital or the debt capital. So
means in these three sources or out of these three sources how to decide the weights or
proportions that is now the second important question to learn or to answer here. So some
important points I have noted down here they are with regard to the determining the proportions
or weights.

817
(Refer Slide Time 1:59)

So first point says the appropriate weights are the target capital structure weights stated in the
market value terms, right? So we have the two capital structures as I have talked to you
sometime in the past also, one is the current target. Current capital structure of the firm who is
proposing to take the new investment proposal.

If it is an existing firm and want to take up the new investment proposal then they have the two
capital structures kind of, one is the existing capital structure of the firm in which they are
working, they are operating and second one is the target capital structure which they want to
make for the new project or which they want to have for the investment proposal or the new
project.

So while determining the weights we should not means look at the existing capital structure of
the firm or the current capital structure of the firm rather we should look at the target market
structure of the firm or the proposed market structure or the capital structure of the firm. Because
we are going to talk something relating to the future, right, the project is going to come up in
future. So when in future we are going to say set up any investment say process then what kind
of the different sources of the funds are available at that time.

And say looking at the risk factor as well as the cost of capital associated to them as well as
availability of the funds from these different sources we should more focus upon the target
capital structure and on the basis of that we should assign the proportions and the weights, right?

818
So this is one thing and second thing is that which value we should take? We should take the
book value of that investment we are going to make or the market value.

So we have to always take the market value of the firm because always when you want to
determine the say a return on investment to be given to the different stakeholders or to the
different sources from where the capital will be raised. They would like to have the return on the
market value of their investment not on the book value of the investment. So the target capital
structure has to be the.

So the basis of determining the weights or the proportions and that to the value of these different
sources of the funds has to be taken as per the market value and not as per the book value. This is
the first point, so means it is very clear that the weight should be decided on the basis of the
future capital structure and not on the basis of the current capital structure. And for example if
the firm is in new, they are coming up for the first time into existence and they want to directly
start it up as a public limited company.

So in that case means normally does not happen because creating a public limited company in
the first go it is a little difficult but if for example if we assume the situation that any how it is
going to happen in that case the current or you can call it as the proposed market structure will be
important the say even in that case also not current. But the target market structure will be
important that how they look forward that the funds will be available, which sources the funds
will be available from and how they have to bring these funds in the venture.

And say what should we the proportion of those different sources which will be forming the
capital structure of the new proposal or the new project or the new investment opportunity, right.
So always focus upon the target capital structure. The new capital structure and the value of the
funds will be in terms of the market value not in terms of the book value. This is the first point;
second point is the primary reason for using the target capital structure is that the current capital
structure may not reflect the capital structure expected in future.

As I told you that in the future things are going to change, it may be possible that supply of the
funds from different sources is going to change and second thing is that riskiness of the new
project may be different. So maybe say the different funds or different sources of the funds who

819
are otherwise interested to make investment in the company may not be a means say interested in
the new project.

Because it is the untested opportunity and the risk factor is very high, so it may be possible that
the external equity may not be available. So you have to arrange the funds largely from the
retained earnings and from the borrowed capital by paying a higher amount of the say cost of the
debt. So that may be possible. So looking at the risk profile, looking at the potential market
situation of the new investment proposal we always have to focus upon the target capital
structure.

The proposed capital structure and not upon the existing capital structure. Third important point
is market values are superior to the book values because in order to justify its valuation the firm
must earn competitive returns of shareholder, for shareholders and debt holders on the current
that is the market value of their investments. So whatever the ROI you want to provide, whatever
the required rate of return will be means expected by those say different sources of the funds.
That will be based upon the market value not upon the book value.

And if the market value is always higher as compared to the book value then certainly the ROI
will also be higher in the absolute terms not in the percentage terms. So it means for example if
we make investment of 250 crores and or means you look back that for example we made an
investment of the 250 crores.

Sometime back write the book value of the investment is 250 crores or in a way you can think
like or you can plan this say proposal like that initially when we set up the project we say invest
in 100 crores or 100 million rupees, 100 crores or 100 million rupees and over a period of time
the book value of that investment increase to 250 million or 250 crores, right?

So there is a book value but the market value of that investment, market value of the total capital
structure of the firm is 450 million, right? So whatever the say your capital structure is going to
talk about or we are going to determine the cost of capital that will be in terms of because cost of
capital is otherwise a required rate of return by the investors. So investors would like to have the
required rate of return on the market value of their investment not on the book value of the
investment.

820
So initially 100 million were invested, the book value rose to 250 million but the market value
has gone up to 450 million. So the investors would like to have the return on 450 million market
value not on the 250 million of the book value of the investment. So always we talk in terms of
the market value of the investment and not in terms of the book value of the investment. So cost
of capital means the proportions have to be as per the target markets capital structure not as per
the current capital structure.

And the values of the different say sources of the funds will be say will be means useful for us as
per the market value of those funds not as per the book value of those different sources of the
funds. So that we provide the higher return to the sources from where the capital has been
arranged. So proportion of the weights or the different say proportion deciding the proportion or
different weights that would depend upon that say what is the target structure of the new project.

Target capital structure of the new project and second thing is what is the market value of those
sources? If there is no difference in the book value on the market value because initially it does
not remain for the first time. When any investment we are making book value and the market
value will be same but over a period of time when the project starts working its performance
becomes visible in the market and people come to know about that this is a very good investment
opportunity the stocks or thus say shares of this particular project or this company are selling at a
very high price.

So what happens because of the say high volume of the trading or the frequency of trading in the
market the market value of that investment becomes high as compared to the book value. So we
always have to treat them the weights in terms of the market value not in terms of the book
value.

821
(Refer Slide Time 10:20)

Now we talk here as the weighted average cost of capital, if you look at this the weighted
average cost of capital. So we are taking here something as that is the different sources of the
capital are given here means we have this way we have explained this the process of determining
the weighted average cost of capital where we have calculated here is that is the weighted
average cost of capital is 13.4 percent.

And this all depends upon the process of determining the weighted average cost of capital. So if
you talk about determining the weighted average cost of capital.

822
(Refer Slide Time 10:53)

So let us recall the process WACC and for this if you recall it if you take this into account. So
WACC can be calculated how? We all understand it that it has to be like wE weight of the say
equity capital. So it has to be something like weight of equity capital and multiplied by a return
on the equity capital, cost of r is the w is the weight of the equity capital r is the say cost of
equity capital plus wP is the proportion of the preference capital and say your rP not wP, rP is the
cost of preference capital rP is the cost of reference capital.

And then we have to take the third component here that is that W D is the proportion of the or
the weight of the debt capital and rD is the cost of the debt capital but here this cost we calculate
by adjusting it for the tax benefit. So it is 1 minus the tax rate. So it means 1 minus tc we have to
take this as the 1 minus tc. So this becomes the process to determine the 1 minus tc. So it means
the tax rate.

So it is the W is the proportion of the equity that is a internal funds equity capital and then is the
cost of equity capital rE then it is a proportion of the preference capital cost of the preference
capital. This is the proportion or the weight of the debt capital borrowed capital and this is a cost
of the debt capital but the cost of debt capital has to be say considered after-tax not pre-tax. So
when you are multiplying it by 1 minus the tax rate, so it means you can understand that this cost
actually will be lesser than what we are going to pay.

823
Because there is a tax advantage available on the debt capital and so whatever the financial cost
we pay on the borrowed capital that is say subject to the tax deductions or maybe tax benefit is
available there on that because we debit the profit and loss account with the interest cost, the
financial cost and when you subtract it from the revenues in the profit and loss account by
debiting the profit and loss account with the interest cost.

So that much of the tax savings are there which benefit is not there on the equity capital as well
as on the preference capital. Because in the equity capital and the preference capital we pay the
dividends which are not tax deductible. So this benefit is there, so for determining the weighted
average cost of capital. For example, we assume here that the there is a company called it as the
XYZ Limited.

We assume this, this is a company XYZ Limited and they are going to make a new investment
here. And say the cost of the new investment is say new investment is say requirement is going
to be fulfilled from three different sources of the funds. The investment requirement of this new
investment proposal is going to be fulfilled from three different sources, one is the equity capital,
second is the preference capital and third is the borrowed capital or debt capital.

And the cost of capital is given to us, here rE that is equal to 16 percent and when you call upon
the rP cost of the preference capital that is given to us is the 14 percent and if you talk about the
cost of rD, that is a cost of debt that is equal to 12 percent, right? So these are the three different
sources from where the funds can be arranged for this new investment proposal by XYZ Limited.
And this information is available with regard to the say the cost of capital coming from the
different three sources and we are given here as the different proportions also.

So it means W E is also given which is going to be how much? That is going to be 60 percent
and WP is also given and that is going to be somewhere how much, that is 0 point we can call it
as 5 percent only, only 5 percent and then the proportion of the D is or the debt is going to be
remaining amount and this is 35 percent, right. So these are the proportions, this is the cost of the
three sources, these are the weights of the three different sources.

60 percent coming from equity, 5 percent coming from the preference capital and 35 percent
coming from the debt capital, additional information given to us here is that the corporate tax
rate is 30 percent, right, corporate tax rate is 30 percent, so if the corporate tax rate is that 30

824
percent so rD which is equal to 12 percent at the moment will be finally coming down to 1 minus
how much? You have to multiply 12 percent into 1 minus, this is 30 percent. So if you multiply
it this actually works out as effectively this comes up as 8.4 percent. So the cost of equity is
going to remain as 16 percent, cost of reference capital is going to remain as 14 percent but the
cost of debt, effective cost of debt which will be included here in this particular component is
going to come down which is we are going to play the 12 percent.

But effectively it is going to come down to 8.4 percent because of the tax deductible advantage
of the debt capital. So this is the situation with regard to the different sources of the funds being
used in the new project by the XYZ Limited, their cost of capital is also given and their
proportions or weights are also given. So finally on the basis of this information we have
calculated here the weighted average cost of capital, right.

We have calculated here the weighted average cost of capital. So if you look at this weighted
average cost of capital here, so what is this, source of capital here we have taken, proportion we
have taken and then the cost we have taken here and the weighted cost has been calculated here.
So in this case of the equity capital our proportion is 60 percent, cost is 16 percent. So mind it,
the cost for the equity and the preference capital is the same original cost, no tax deductible
advantages there.

So the weighted cost is this much, preference is this much is the proportion 5 percent, this is a
cost means the dividend we are going to pay and this is going to be the weighted cost and debt is
the 35 percent is the proportion as we have seen and effective cost has come down from the 12
percent to 8.4 percent because of the tax advantage of 30 percent. So the weighted cost is this
much, so finally the weighted average cost of capital is 13.24 percent.

Means the cost of equity is very high, always normally the cost of equity is very high. So cost of
equity is very high 16 percent, preference is also comparatively high, debt is cheaper and debt
has further become cheaper from the 12 percent to 8.4 percent. Because it has the feature of
being tax deductible or whatever the cost we pay to service that debt in the form of the interest
that is debited in the profit and loss account as an expense and by that amount your profit goes
down. And when the profit goes down your tax component also goes down.

825
So this advantage is there with the debt capital. So there must be a means a question a
misconception which I will discuss at the end of the say discussion on the cost of capital, there is
a misconception that since the debt capital is very cheap, so every firm must increase this
component of capital in their capital structure because overall say weighted average cost of
capital will go down but this conception is not true.

This is a misconception because the moment you increase the amount of debt in the firm, the
riskiness of the overall firm increases and the movement the riskiness of the overall firm
increases. The equity shareholders also increase their required rate of return. So overall weighted
average cost of capital almost remains the same or unaffected. Because the moment you increase
the debt, the borrowed capital in the concern your riskiness increases.

Because it has the positive feature that yes it is tax-deductible as a source of fund the cost of
capital on the debt is or with regard to debt is tax-deductible. But it is s very-very risky also in a
particular situation when the cash flows of the firm are not very sure and in the initial years or a
beginning of any say of the project years beginning years of any project when the cash flows are
not up to the mark, the project is incurring the losses and even it has not reached up to break-
even point.

You even at that time you have to service the debt. And you need the free cash flow for that or
may be sufficient cash flow for that for servicing the debt. And if the funds are not available then
the debt has a capacity to take the firm or the project to the say the at the brink of this bankruptcy
and that may be a difficult situation. So if it is cheaper as compared to equity it is equally risky
also. So riskiness makes it difficult to employ in the firm in the desired amount or in the desired
proportion, right.

So this is how we can decide that or we can work out the weighted average cost of capital
WACC proportion. These now the question here is how we have decided these proportions, 60
percent, 5 percent and 35 percent? These proportions depend upon the target capital structure of
the new investment proposal, target capital structure. It may be possible that for example out of
the information available in the market or the information which we have generated from the
different say financial experts or maybe by preparing the DPFR Detailed Project Feasibility
Report.

826
We have come out that the new project should be means requiring the total capital whatever the
amount it is requiring for example 200 or the 300 million rupees. For example, it is requiring, so
we can say it will be very easy for us to raise equity from the market. So 60 percent will come
from the equity preference capital also we can issue but only very nominal amount 5 percent and
then the remaining amount will come in the debt. So this is a proposed capital structure of the
new project not as per the existing capital structure of the firm.

So there is a difference between the target capital structure and the current capital structure. So if
the new project is coming up new capital structure should be decided and that should be as per
the target or the expected situation in the market. And then the cost of capital as per the, say the
cost of individual sources has to be worked out and then the weighted average cost of capital has
to be calculated.

So this is how we calculate or learn about that how to calculate the cost of individual sources of
funds and second thing is how to determine the weights to be given or the say the different
sources from where the funds will come, how much proportion of those sources has to be there
or how much weightage to these different sources has to be there that we are going to means
make use of in this particular concept of say deciding about the weighted average cost of capital.

(Refer Slide Time 22:17)

Now we talk about some best global practices in estimating the cost of capital, best global
practices in estimating the cost of capital. First important point here is weighted average is the

827
dominant discount rate used in the DCF analysis, discounted cash flow analysis DCF analysis is
the discounted cash flow analysis. So you always require weighted average cost of a capital
without WACC it is very difficult to discount the cash flows because total investment we are
making in any project is that is coming from different sources that is coming from equity also,
that is coming from preference capital also and that is coming from the debt capital also.

So it means the discount rate which we want to use if you remember that the cash flow CF
divided by 1 plus R. So that R is the basically the say discount rate and that is based upon that
WACC weighted average cost of capital and that is also the required rate of return also by the
suppliers of different sources of funds. So this is very important that for using or calculating the
discounted cash flows we will have to use the weighted average cost of capital and all the firms
in this world are using the WACC as the say discount factor.

Second is weights are based upon market not book value mixes of debt and equity, weights are
based on market not book value mixes of the debt and equity. So market value of the debt we
have to means. For example, in case of debt the market value is same as compared to the maybe
as there is a book value. So there is no difference in the book value and the market value of the
debt because how much we are borrowing same amount we have to pay back the interest cost is
separate but there is no difference as far as the debt is concerned in the market value and in the
book value.

But in case of the equity it happens that the market value is different as compared to the book
value. The companies who are well-managed companies who are operating in the market you
would agree with me that there is a lot of difference in their market capitalization and in the book
value of their say equity capital. So market capitalization is more important the market value of
that say capital is more important for this.

So weights have to be decided as per the market value not as per the say book value of that
investment to be brought into the project. Third important point is the after-tax cost of debt is
predominantly based on marginal pretext cost and marginal or statutory tax rates. The after-tax
cost of the debt is predominantly based on the marginal pre-tax cost.

So first we have the marginal pre-tax cost because pre marginal pre-tax cost is a cost which we
pay to the banks, right? So we are going to pay to the banks for example the cost of the debt is 12

828
percent we are going to pay to the bank 12 percent the financial cost we are going to show in the
profit and loss account as the interest cost that will be 12 percent. That will not be minus tax but
the real effect of that we have to calculate while calculating the cash flows that the tax advantage
will be there and that cost which we are paying as the cost of servicing the debt that will be
means taken to the profit and loss account will be treated as a financial expense.

And by that amount your profit will go down and certainly your tax component, tax liability will
also go down. So you need to, to calculate the post-tax cost of the debt you need to have the pre-
tax cost of the debt and the tax rate. So both the things if are available to us then we will be able
to calculate them post tax cost of the debt which will be relevant cost for any kind of the decision
making as well as for calculating the weighted average cost of capital.

And fourth important point is that the CAPM is the dominant model for estimating the cost of
equity, it is a worldwide practice that largely cost of equity is determined on the basis of CAPM.
There the other techniques also book building techniques is also there or some other techniques
are also there for determining the cost of equity but in the practical sense the most objective
model, most objective method is the CAPM Capital Asset Pricing Model with the help of which
we determine the cost of equity.

And any cost of equity determined with the help of CAPM will be considered as the reliable cost
of the equity. So these are some of the best global practices which are being used in estimating
the cost of capital or we call it as in a way the weighted average cost of capital.

829
(Refer Slide Time 27:15)

Now we talk something about the save on a more relevant concept which is equally important
here equally relevant here that is the weighted marginal cost of capital schedule and weighted
marginal cost of capital schedule means what we mean by weighted marginal cost of capital?
Marginal cost of capital is important here to be known about. Say when we make the investment
we make in the sequential form, right.

First we make investment in the one project and if we are very successful or successful to the
desired extent in that investment process then we go for the next one then we go for next one and
then we go for next one, right?

But there is a means upper limit to the extent we can make investment in the market depending
upon the whole say spectrum of the firm capital structure of the firm there is a upper limit that to
what extent in this given say the overall performance of the firm, existing firm the capability of
the existing management, the capability of the existing shareholders there is the upper limit of
deciding about that to what extent maximum you can take the size of this firm?

Or maximum you can talk about is that when the investment proposals are different, we are
having not one single project, we are having the multiple projects. For example, we first has the
project A we invested some amount and the ROI was very good. So we were very successful
then we went for the BCDE, so like that there is a say upper limit that to what extent maximum
we can expand the business of the firm so that will be deciding.

830
The maximum upper limit of expansion of the business or the proposed expansion of the
business will be deciding the marginal cost of capital because after making investment in the one
project how much marginal investment you want to make in the market? So the moment you
want to you think of increasing the investment in the market same way the marginal cost of
capital will come in the picture, right?

So in this case say what is written here, the procedure for determining the weighted marginal
cost of capital involves the following steps. The procedure for determining the weighted
marginal cost of capital involves the following steps. Number 1 estimate the cost of each source
of financing for various level of its use through an analysis of the current market conditions and
an assessment of the expectations of the investors and the lenders, right.

Estimate the cost of each source of financing for the various level of its use through an analysis
of the current market condition, how much funds are normally available from the market, right?
And what is the cost of individual source of funds in the market? Because ultimately the
borrowing funds from the market or raising funds from the market also depends upon the say
internal rate of return available from any investment opportunity, right.

Accordingly, we can decide about that if the say expected return or the internal rate of return
from the project is going to be very high then we think of that yes after successful completion of
the one project. We will go for the second project we will go for the third project but then comes
the saturation the upper limit beyond which we do not want to say make investment in the
market.

So that the capital availability will also be saturated accordingly and the subscriber to the shares
of the different projects of the company same firm, same company as well as the cost to be
charged or asked by the sources of the debt or the lenders of the debt will also have their own say
means you call it as the stipulations, limitations and restrictions.

So number one is that how much maximum you can borrow will depend upon the lending
capacity or the stock subscribing capacity of the potential shareholders as well as the say
borrowing capacity of the firm depending upon the internal rate of return available from the
different investment proposals and the cost of capital to be paid to the different sources from
where the funds will be arranged.

831
Second point is identify the levels of the total new financing at which the cost of new component
would change as means identify the levels of total new financing at which the cost of new
components would change given the capital structure policy of the firm these levels called
breaking points this is a very important concept in the marginal cost of capital schedule breaking
points can be established using the following relationship can be used say can be established
using the following relationship.

(Refer Slide Time: 31:59)

So weighted marginal cost of capital schedule will depend upon these breaking points, so BP is
equal to TFj, BPj is equal to TFj divide by Wj right, where BPj is the breaking point, this is a
breaking point on account of financing source j means breaking point on account of the financing
source j means financing source can be largely we have seen there the 3. One is the internal
capital that is an equity capital, I am talking about the equity capital may be by selling the
additional shares in the market or maybe through retained earnings.

Second is the preference capital, third is the borrowed capital. So in every source or with regard
to every source of capital, means one source of capital will be called as j we have to determine
the breaking points. Breaking points are basically the upper limits of raising the funds depending
upon the borrowing capacity of the firm right. Because there is a maximum limit for example
you talk about say that the NIRMA industries.

832
Initially they started means this entire process, business process long back in the beginning of
80s by the single product that is the NIRMA washing powder in the market. Now they are
expanding, they have diversified, they are expanding but now they have stopped at some place
they are into the say detergents, they are into the cosmetics. They are into the education sector or
they may be into one or two more sectors but that is I think the upper limit of the group.

And this is you call it as the breaking point, we have to decide the breaking point that how much
maximum investment we can make in the different projects of the company accordingly the
marginal requirements of the capital will be decided and in that total requirement of the capital
how much will come from the equity. So j means equity is 1 j, one source of financing and the
breaking point of the maximum equity raising capacity have to be worked out.

Similarly, the breaking point for maximum say a preference capital has to be worked out and
similarly the breaking point for the debt capital has to be worked out. So it means breaking point
for that particular source of financing which we have assumed there is j will depend upon the
total financing coming from that source and Wj is the proportion of financing source, j in the
capital structure.

Means total financing TFj is the total new financing from the source j at the breaking point from
the source j total capital coming from the source j in the new capital structure. And Wj is the
proportion, the weightage of that particular source j in the say new capital structure of the firm or
in the say proposed capital section of the firm. So it means you have to determine the breaking
points how much upper limit or the maximum capital we can raise for different kind of the
projects and there also the breaking points with regard to equity, with regard to preference
capital, with regard to debt capital we have to work out.

And then with regard to those breaking points we have to say determine the range of raising the
capital and the respective cost of paying. The cost of that capital, so it means the marginal cost
of capital will depend upon that because you do not borrow the huge amount in one go that is not
available. Also from the market first you borrow the first set of amount you make investment in
one project.

If you give very say you can call it as an encouraging result then you go for second, third, fourth
but then the saturation comes. So there we have to try to find out that saturation level maximum

833
borrowing limit and in that within that maximum borrowing limit the breaking point for equity
maximum say raising the funds through equity, breaking point for preference capital and
breaking point for the debt capital we have to work out.

And then for calculating this BP the breaking point for example the equity capital in one
proposed capital structure or the total proposed capital structure of all the projects put together
you have to find out in this totally investment in all the projects we have made what is the
proportion of total financing coming from equity and what is the in terms of the weightage of
equity in the total capital structure of all the projects.

So you have to determine the breaking points. Number 3, calculate the weighted average cost of
capital for various ranges of that total financing between the breaking point. So range I am
telling 0 to for example 75 million you can raise for from equity or 0 to 100 million you can raise
from debt or 0 to 30 million you can raise from the preference capital. So those ranges have to be
decided and then we have to calculate the WACC for individual range.

Fourth, prepare the weighted marginal cost of capital schedule which reflects the WACC for
each level of total new financing. So total schedule we have to prepare and we have to find out
that from the different sources how much capital can be say generate and what will be the say
weighted average cost of capital coming from different sources and what is the maximum
borrowing limit of all the projects put together and the source wise how much maximum funds
we can raise?

For example, from equity, debt and the preference capital and on the basis of those breaking
points and range is decided, rang is of raising the capital decided. You can work out the breaking
points and on the basis of these breaking points the say marginal cost of capital can be worked
out. So here because of the lack of time I am not able to explain it to you with the help of an
example or with the help of solving a problem but further detailed discussion and reference you
can refer to the book on financial management by Prasanna Chandra.

Where this concept of the weighted marginal cost of the capital schedule has been discussed has
been explained largely this conceptual thing I have taken from there and then it is explained in
the book, how this marginal cost of capital can be calculated? What is the concept of the
breaking points? So further detailed reference you can refer to the book but here as per the

834
importance or the relevance of this concept I could means introduce you with the concept of the
marginal cost of capital and the moment we keep on say increasing our requirements of raising
the funds from the market.

We have to say accordingly calculate the weighted average cost of capital and theoretically this
is the process conceptually this is a process how we can calculate the weighted marginal cost of
capital or how we can prepare the weighted marginal cost of capital schedule, right. So after this
we will be talking about say something that is with regard to the determining the optimal capital
budget.

(Refer Slide Time 38:57)

So determining the optimal capital budget if you look at this structure, so in this case what we
are going to talk about here is, we have on the one side in this structure the return or the cost
given here. And then on this side we are given the amount in the millions of rupees and there is
some curves coming up here.

So we are going to drive out of it the say the optimal capital budget, so what this say process of
determining the say optimal capital budget. And how we mean arrive at this particular situation
and how we mean arrive at that budget, the total capital investment budget which is called as the
optimal budget. This all means we will discuss in detail but in the next class. So that we can
understand in detail that or say what are the different sources of the funds from where the capital
can be arranged.

835
How we have to decide the proportions of the capital coming from the different sources. What is
the importance of the return associated to those sources? What is the cost of capital importance
of the cost of capital associated to those sources and how to decide the optimal capital budget
this I will discuss with you in the next class. Till then thank you very much.

836
 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee

Lecture 52
Cost of Capital - Part VI

Welcome all. Now, we will take up the next concept which we started talking in the previous
class also, but I stopped at just a means say initiating the discussion on this particular concept
and this concept is a say determining the optimal capital budget, optimal capital budget for any
project or maybe the number of different investment proposals if you want to take, depending
upon the capital we have means available with us plus the capital which we can borrow from the
market.

Means as I told you that say, depending upon the marginal cost of capital we have a say some,
upper limit, the saturation point where we can maximum go up to, we can invest our own capital
as well as we can borrow the funds from the market. Because for the further expansion of any
business and growth you need the funds from two sources.
One is from the say internal sources and depending upon the funds you have available from the
internal sources, you can borrow the funds from the external sources because statutory debt
equity ratio is 2:1.

So in that case minimum if you have 1 rupee in your pocket, then you can borrow two rupees
from the market. But if you have 0 rupee in your pocket and if we want to fund the entire
business on the basis of borrowing from the market, that is not possible. So that is why as I told
you in the previous lecture, the marginal cost of capital concept that the moment you want to
increase your investment in the market, you have to calculate the breaking points.

There is an upper limit of the total investment you want to make say in the market with regard to
all the different projects. And then that breaking point for the individual sources that how much
maximum equity we can invest, how much maximum preference capital we can arrange or
maximum say borrowing we can have from the market. So they are the individual breaking
points, which we talked about.

837
So means taking the lead from the marginal cost of capital, here we now are going to learn about
the determining the optimal capital budget and the determining the optimal capital budget
basically depends upon or requires two important things. One thing is that the internal rate of
return available from one investment proposal or maybe the different investment proposals that
is that internal rate of return or maybe say expected rate of return available from that proposal,
right, that a project proposal or the investment opportunity.

Second thing is the required rate of return or in terms of, you can say, decide that the in terms
cost of capital, so what is the cost of capital which is a required to be invested in that project or
into the different series of the projects and what is the expected internal rate of return available
from these different projects, right. So a point will come where the internal rate of return
available from the one investment opportunity or multiple investment opportunities put together
will be equal to that marginal cost of capital.

So that point where these two intersect with each other will be known as the optimal capital
budget that depending upon our cost of capital means the required rate of return of the investor
and the available or the expected internal rate of return from the different investment proposals.
Comparing these two you have to find a point of intersection and that point of intersection will
be helping us to know the optimal capital budget of the firm, right.

838
(Refer Slide Time: 03:58)

For example, in this case, now what we are talking about here is on the Y axis we have two
important things we taken here, that is the return available from any investment proposal and the
cost of capital here. Both the things are taken on the Y axis, on the X axis we have taken here as
the amount in the possible investment, amount means possible investment to be made in the
million rupees, right. And these are the two curves, one is the investment opportunity curve and
second one is the marginal cost of capital curve.

So what is happening, we are starting with the different say opportunities available and then say
we are starting with the opportunity which is giving us the maximum, say possible return or
where the internal rate of return of that project is the highest. And then we are starting with the
lowest marginal cost of capital because initially the cost of capital will be lower. But the moment
you keep on investing more and more in the market, yours say marginal cost of capital will also
go on increasing.

So on the one side we started with the highest internal rate of return available, in any project. We
started with that after that we took the subsequent opportunities but the internal rate of return was
a lesser as compared to the first one. So we started going down and in this case, initially, we
thought that we found that the cost of capital is lower. But the moment we increased say
borrowing from the market or maybe making our own investment, increasing our own
investment in the market, our cost started rising.

839
So investment is coming down over a period of time. Sorry, this return, internal rate of return is
coming down over a period of time and the marginal cost of capital is going up over a period of
time. And there is one point which is called as a point of intersection and this is the optimal
capital budget.

(Refer Slide Time: 5:46)

So how we have worked out this I will take you a little back and I will share you means some
figures with you. So for example, we have here that different projects available, these projects
are A, B, C, D and E. We have the 5 say investment opportunities which, we have identified on
the basis of survey the market. And then we have discussed means found out here the amount of
investment required here.

So in A you need to invest minimum 30 million rupees, in this you need to invest minimum
requirement is 40 million. Here, the require, investment requirement is a 25 million. Here the
investment requirement is 10 million. And here the investment requirement is 20 million right?
And the IRR, Internal Rate of Return available from these investment opportunities or these
investment proposals is highest is available from the project A that is 18 percent then it is less up
to 16.5 percent then it is less up to 15.3 percent and then it is 13.4 percent and then it is 12
percent, right?

So these are the 5 projects, part of which we have worked out the investment requirements, they
are in the millions of rupees. This is 30 million, 40 million, 25 million, 10 million 20 million of

840
rupees. And internal rate of return is 18 percent, 16.5 percent, 15.3 percent, 13.4 percent and 12
percent, right. Now, on the basis of these five possible investment possibilities or investment
opportunities, now we have to decide that optimal capital budget and optimal capital budget does
not require only one thing that is internal rate of return available from the project.

Because first you have to make investment of this much of the investment in first 30, 40, 25, 10
and 20 right. So then you are going to make this investment this investment has the cost, which
we call it as a COC Cost of the Capital and the internal rate of return must be minimum equal to
the marginal cost of capital because that is my required rate of return, right that is my required
rate of return.

So there will be means the moment you may start making the investment, first you made the
investment in the project A, 30 million we got IRR 18 percent then we made further subsequent
investment, 40 million. Then our IRR available is 16.5 percent then we made further 25 say
millions our rate of return is coming down to 15.3 percent because we are starting with the
project which is giving us the highest internal rate of return.

Others are giving lesser than the first one. So over a period of say a time or maybe when we are
moving from the project A to E, the IRR available in these five proposals or these five
opportunities is going to decline. Then you are moving from A to E. So here it is the one
component, second thing is when you are making the first investment of 30 million your cost of
capital is comparatively lower, but the moment you start increasing the investment on 30 million
first.

Another 40 million is when you invest your own cost of capital is also higher and the cost of the
borrowed capital will also be higher, right. Plus, when we invest further 25 more million. Then
again the marginal cost of capital will go up. So what is happening, this situation will emerge
like this internal rate of return is coming down and the cost of capital is going up.

So it will be a point, which will be known as the point of intersection and this will be known as
the say a budget or the optimal capital budget amount taken here will be known as the optimal
capital budget and this side we are taking that rate of return and the cost, this is what is explained
in the structure which I am a say a discussing here or I was discussing with you before means
giving you this information.

841
(Refer Slide Time: 10:02)

So this is the structure we have worked out here, right. On the Y axis we have taken the return
and the cost in the percentage terms, here we have taken the possibly investment to be made and
here we are taking the investment opportunities. So the curve has been created by putting these
investment opportunities, depending upon the investment requirement, the cost of capital and the
say internal rate of return, not even the cost of capital, but the internal rate of return which is
available.

So it has been done in that descending order first is the project A. We are put at the top. How
much return is available? 18 percent, and how much investment is required, 13 million, this is
investment requirement, this is return available and at this point, because it was our first
investment, so we had to only invest 30 million rupees. Our cost of capital, marginal cost of
capital was means at this rate, 13.2 percent.

Then we moved to the second opportunity and we went up to the, so we thought that still we can
invest more in the market. So then we saw second project B is available here and in the B we can
make the furthermore investment of how much, that is of the 40 million rupees.

So total investment this way will become 30 plus 40, 70 million, then we went to the C, then we
went to the D, so it is the 1, this is number 2, this is number 3, this is number 4, this is number 5,
right? These are the five say investment opportunities available but the problem here is this is
going to give us the highest internal rate of return, when you move from the A to E, 1 to 5 then

842
the internal rate of return is going to decline and the lowest internal rate of return which is
available in this case is that is from the project E and that is the 12 percent, right.

So it means what is happening internal rate of return is going down over a period of time. When
we are moving from the first investment opportunity to the fifth investment opportunity whereas
when your borrowing needs are going up, your marginal cost is going to increase initially up to
some extent up to 70 million, it was 13.2 percent but when you further increase the investment, it
went up, up to 85 million, it is 14 percent and beyond that say it is going to be 14.6 million.

So there is a point, this is a point of intersection where your internal rate of return available from
the different investment opportunities is intersecting with the marginal cost of capital. So it
means this is a point of investment here. Maximum investment you can make up to here is of
how much, that is of the 95 million rupees by borrowing or arranging funds up to 95 million
rupees from the different sources.

Your means that is going to be the upper limit that is going to be the optimal capital budget. If
you further increase the investment beyond the 95 million rupees. So what is going to happen,
marginal cost of capital is going to increase, or going to remain stable at 14.6 percent but the
internal rate of return from that proposal D and E is lesser. And if you look at that rate return is,
it is that 13.4 percent which is lesser than 14.6. In this case it is 12 percent it is lesser than 14.6
so what is about to happen, that your IRR is lesser from the project number D and E where the
cost of capital is higher.

Marginal cost of capital is higher that is 14.6 percent, so this is not that appropriate investment
opportunity or investment proposal. So in this case it is better to stop at this point of 95 million
rupees of investment where the cost of capital, marginal cost of capital and the internal rate of
return, expected return available from this investment which is going to be made into the three
projects. Project A, B and C is going to be equal to each other.

So this is the optimal budget or this is the optimal say investment possibility, which can be
explored or can be finally given the shape and possible projects are only three which are most
optimum and the investment requirements if you look at here, what are the investment
requirements? 30, 40 and 25 so it means total becomes 95 million. So your optimal capital

843
budget is 95 million because after or up to 95 million of investment, your internal rate of return
available is either say equal or little more than the cost of capital.

So maximum you can go up to 95 million rupees of investment depending upon the marginal
cost of capital in the market and internal rate of return available for the investment opportunities.
So this is true in the case of the project A, B, and C requiring the total investment in the 3
projects that is 95 million. But if you increase the investment beyond that, your cost will be 14.6
percent and the return from the other 2 projects D and E will be lesser than 14.6 percent, so that
will not be considered as the optimal capital budget.

So Optimal capital budget means the decision criteria is the internal rate of return available from
the investment opportunity and the marginal cost of capital required say or the marginal cost of
capital to be paid on the required amount of investment to be made in the investment proposal or
in the investment opportunity. So these two factors are required. So ultimately you are going to
compare one thing that is expected rate of return with the required rate of return and required rate
of return depends upon the cost of capital.

So it means that point where the expected rate of return is equal to the required rate of return that
is the maximum limit of investment can be made and that is known as the optimal capital budget.
So with the help of this particular structure, we have been able to explain that how the marginal
cost of capital say restricts the investment possibilities. Because sometimes if the internal rate of
return available from those investment possibilities is not at least equal to the marginal cost of
capital, then there is no point making that investment in the market. So this is how we can decide
the optimal capital budgets.

844
(Refer Slide Time: 16:34)

Now I will take you to with the next concept, which is again, somewhat important in the say cost
of capital process and this is the divisional and the project cost of capital. So, for calculating this
divisional and the project cost of capital, the question arises here that for example, there are the 2
entities, right. One entity is the firm, this is the firm which is existing and this firm is called as
XYZ Limited.

This is a firm and this firm want to take the new investment proposal and this is the new project,
right. This is the new proposal; new project they want to take up right? Now they already when
they are in the market they have their own capital structure. The funds are already invested in

845
XYZ Limited they are into the business already and they already have their own capital structure
and when you are going to create this investment proposal or this investment new investment
you want to make in the market.

This new investment also is going to have it is own capital structure, right. This is also going to
have its own capital structure, so it means while deciding the cost of capital, this is the capital
structure here and this is again going to have the another capital structure, right. So this is the one
existing current capital structure and this is called as the target capital structure. The new capital
structure we are going to have here.

So it means what we are going to talk about here is that know how to calculate the cost of capital
or the weighted average cost of capital for that new project or for the additional investment or the
new investment which we are going to make in the market. Let us see what is written here, using
WACC for evaluating investments or using weighted cost of capital for evaluating investments
whose risks are different of the overall firm leads to poor decisions.

In such cases, the expected return must be compared with the risk-adjusted required return, as
calculated by the security market line, security market line means capital asset pricing model
because two entities are going to be different. When you are talking about this particular
investment already which we have made it has a different risk complexion, different risk profile.
Here we have in the new proposal the risk complexion is different, risk profile is different and
first the risk emanates from because it is a new proposal, right.

So when it is a new proposal certainly the it is going to bring more risk as compared to the one
which is already tested and tried it is already operating in the market, right. So in this case, the
risk factor is more here. So when you are talking about that in the new project the risk factor is
more but while calculating the weighted average cost of capital, if you for example, you assign
the same weights in the new projects also or in the new projects capital structure also as per the
existing weights, as well as the cost of the capital you assign in the same way as we are doing it
for the existing operations then that will not be a correct approach.

For the new project, for the new division we have to calculate the weighted average cost of
capital by adjusting for the risk factor and the risk adjusted say cost of capital has to be
calculated. And for example it is written here that risk adjusted cost of capital or required rate of

846
return has to be calculated and the one way of doing that is that with the help of the security
market line or with the help of CAPM, we whatever the say required rate of return because
ultimately that is a cost of equity or the basically the cost of capital and that is going to decide
the required rate of return.

So we should not do this mistake that the cost of capital of the existing firm should be applicable
or should be applied to the new proposal also because the risk profile being different of the
existing firm as compared to the new investment opportunity or possibility. So accordingly the
rate of return, required rate of return from the new proposal, new project has to be that risk
adjusted and for calculating that we have to or calculating the weighted average cost of capital
see if for example, the funds that are coming from two sources, one is the borrowed capital,
second is that equity capital.

So for the borrowed capital there is no problem because the interest we are going to pay to the
lender that is going to be the cost of borrowing or the cost of the debt. But as per as is the cost of
equity is concerned. You cannot use the cost of equity as we are already using for the existing
investment proposal. For that the new cost has to be calculated and there, that cost has to be
calculated by making use of CAPM.

Where we will calculate the risk adjusted cost of capital for the new equity investment or the risk
adjusted a required return. We have to calculate by using the security market line approach or the
CAPM method. Second multidivisional firms that have divisions characterized by the different
risks may calculate separate divisional cost of capital, separate divisional cost of capital has to be
calculated. And for that, two approaches are commonly employed for this purpose.

For every division, you do not apply it that for the existing firm. I am repeatedly telling you that
what is the cost of capital for the different so or weighted average cost of capital for the existing
firm, if they are going to take up the new investments, it is going to be same for this. Also, this is
going to be the foolishness. We cannot afford to do like that, right. We cannot afford to do like
that. So it means in this case the, it is a new division new project.

So you have to have the different approach because new project, new division is going to bring
the higher amount of the risk as compared to the tested and tried investment process which we
are already into. So for the new divisions, for every division we have to calculate that separate

847
cost of capital or the divisional cost of capital has to be calculated. Two approaches are given
here.

One approach is pure-play approach, pure play approach says or the pure play approach requires
one important thing here that what we have to do is before calculating the weighted average cost
of capital for the new project, we should try to find out, an entity or the company or the project
which is already into the market which is say listed in the market which have issued the stock
capital, share capital in the market.

It is listed in the market and for which the certain information that is number 1, beta of that
company is available, right. Second thing is debt equity ratio of that company is available and
debt rating of that company is also available. If something is already say working in the market
of the similar kind which we are proposing to create. If similar entities already operating in the
market, which we are planning to create as a new entity in in the same field, in the same area or
in the same sector.

Then you can emulate that information which is already available with regard to that existing
company or existing unit for the new project also. So you can calculate the beta also what is a
beta of the existing company or the on basis of the returns of the existing company that you can
make use of debt equity ratio of that company can be made use of and debt rating of that
company can be made use of.

So pure play requires that we are able to find out an entity which is already working in the
market in the same sector, in the same field of the same size and say producing same product or
service. Then there is no problem in determining the new capital structure as well as the
weighted average cost of capital because all market related information is available with us. But
since it does not happen so easily, so if the pure play is not possible, this approach, pure play
approach is not possible to be adopted.

In that case, we will have to follow the subjective approach and in the subjective approach, what
we have to do is, we have to find out that first what is going to be the capital structure of the new
investment opportunity or the new investment proposal, one, this much of the capital will come
from the equity, this much will come from the preference capital. this much will come from the
debt and this will be the capital structure of the company where the debt equity ratio will be this.

848
First we have to decide it on the subjective estimates, right and when you talk about the
subjective estimates, we can take the help of the financial experts in the market. We can take the
help of the say consultants, financial consultants in the market. So first you decide the capital
structure of the new project, right. And then you say try to find out that what is the cost of capital
with regard to these different three sources, what will be the cost of equity capital, what will be
the cost of preference capital? And determining the cost of debt capital is not a difficulty at all
right.

So on the normal cost of capital, you can add some premium on the basis of subjective estimates
and then risk adjusted cost of capital or the required rate of return can be calculated. So normal
for example, the equity capital is where we are anticipating that in the normal course the equity
capital is available at 15 percent but since it is a new investment opportunity. So you can add
some premium for the risk and you can say that no for the new project, my cost of equity will be
19 percent, so 15 plus 4 percent the premium for the risk we are going to take.

Similarly, in case of the preference capital, normally it is 14 percent but I want to add the
premium risk premium of 2 percent so for the new project it will be 16 percent and that there is
no issue at all. You can easily means take the cost of the borrowing. So for the equity capital and
the preference capital subjective estimates can be made use off if the pure play is not possible, if
the similar kind of the entities not available in the market, already working in the market.

Then the over and above the expected cost of capital, some premium for the risk can be added
and that say the project based, the division based new capital structure as well as the cost of
capital can be calculated. But the entire cost will be based upon the subjective estimates and the
subjective estimates are done by the financial experts, so you cannot reject them they are largely
worth accepting.

So this is how we decided the cost of capital of the division or the new project and if it is the
project to be taken up by the existing firm, then in no case the cost of capital of the existing firm
has to be applied for calculating the weighted average cost of capital for the new project because
the risk profile of the two entities is going to be different, right?

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(Refer Slide Time: 28:09)

Now we are going to talk about the next concept and this is a very important concept. This is the
flotation cost and in this concept I am going to talk about 2-3 things. Flotation costs first of all
you understand what is the flotation costs. When you talk about the sources of the funds, right in
the capital structure when you talk about the sources of the funds, we already have known till
now a lot of discussion has been done and we say the first source is that equity, right.

And when you talk about the equity, you call it as equity comes from the two sources. First is the
retained earnings and second one is the fresh issue of the stock or that shares in the market. Fresh
issue of the shares in the market, so this plus this makes the total equity capital, right. Now in

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this case retained earnings are coming from within the firm within the organization. So it has to
zero flotation costs because we have not to pay any cost to anybody.

These funds are lie in with us, there means in the form of the free reserve and surplus they are
available with us. So it means retained earnings is free of any kind of the flotation costs. But yes,
when it is a question of the fresh issue. Introducing the equity through fresh issue, you have to
pay the flotation cost. Here comes the question of the flotation cost. So what is the flotation cost,
how adjust the flotation costs while calculating the total cost of capital, this I am going to discuss
here in this particular part now right.

So first of all, please read it, what is the flotation cost of capital? Flotation or issue cost consist of
items like underwriting costs, brokerage expenses, fees of merchant banker, under-pricing cost
and so on. So then you go for the fresh issue in the market before means raising the capital
before the capital start coming in to the say companies account, company has to incur so many
expenses and these are expenses on account of these different heads and total of this cost, which
is on these different heads is called as the flotation cost.

Now we have to adjust and that is only applicable on the fresh issue, not on the retained earnings.
Not on the say this, any other kind of internal source of that capital. Now how to adjust for the
flotation cost, how to calculate that the flotation cost? So in this case for calculating the flotation
costs, we have a number of things to means take care of and for calculating the flotation cost
here.

First thing is first method given to us is, it is written here, one approach to deal with the flotation
costs is to add just the weighted average cost of capital to reflect the flotation cost. One approach
to deal with the flotation costs is to adjust weighted average cost of capital to reflect the flotation
costs. So you can adjust it, you can upscale the weighted average cost of capital and the revised
cost of capital can be calculated.

So how you can use this formula for calculating the revised weighted average cost of capital by
adjusting the flotation costs, for example we assume here and we learn how to do that. For
example, here the let us say there is a company XYZ Limited. Again, it is a company. So, their
normal weighted average cost of capital is say a 12 percent, we assume that weighted average
cost of capital for the company is 12 percent but they want to raise additional capital for making

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a further investment or maybe for any, investment proposal, they want to raise further capital
from the market.

So equity capital from the market and in their case, the flotation cost is expected to be 6 percent
right. So weighted average cost of capital is for the existing project which is already going on
that investment, that business, that production process, that opportunities already going on and
the weighted average cost of capital is 12 percent. Now for the expansion of their activities, they
want to further say expand and want to create the new facility or the one more division, one more
plant. So they want to borrow farther capital from the market.

And partly it is coming in the form of the equity capital by way of the fresh issue. So they have
calculated that since the weighted average cost of capital is the 12 percent for the company
coming from the different, capital coming from the different sources. But here the flotation costs
will be 6 percent, so normally the annual cost of the funds which will be paying will be 12
percent but flotation cost is 6 percent, so as per the first approach, which is written here.

What we are going to say here, we have to calculate the revised WACC weighted average cost of
capital. And in this case, the revised can be calculated as how much weighted average cost of
capital the formula says what, weighted average cost of capital divided by 1 minus flotation
costs. So it is weighted average cost of capital, how much? 12 percent, 1 minus flotation cost is
how much? This is going to be 0.06 percent means so this is going to be how much?

If you solve this, this is going to be 12.77 percent, so the first approach says, the first approach
requires or first approach says here, one approach to deal with the flotation costs is to adjust the
weighted average cost of capital to reflect the flotation costs. And when you are adjusting it, it
means say before adjusting the flotation cost you had estimated your weighted average cost of
capital, with regard to all the sources of the funds is going to be 12 percent.

But when you are adjusting the 6 percent as the flotation cost, it is becoming 12.77 percent but
this approach is not correct approach, this approach is not correct approach because when you
are using this rate, 12.77 percent, it means you are assuming that the flotation costs of 6 percent
is the annual cost, this is not the annual cost, this is only one time cost. So, once it is not annual
cost, it is the one time cost.

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It means in this case what is going to be the justification of adding into the weighted average cost
of capital and means up scaling the total weighted average cost of capital from the 12 percent to
12.77 percent that is not justified because one cost is the one time cost. Second is the annual cost,
recurring cost, right. So two costs being of different types cannot be put together, cannot be
merged cannot be mixed.

So in this case, but we have to do is we have to use some different approach and for using this
different approach, but we have to do is second approach. A better approach is to leave the
weighted average cost of capital unchanged. But to consider flotation costs as part of that project
cost. This is the better approach. That is one approach is that is means the second approach is,
this is the better approach is to leave the weighted average cost of capital unchanged but to
consider the flotation costs as a part of the project cost.

So how to treat it, for example, we are assuming here that your project investment requirement
we had calculated is 200 million rupees, right, 200 million rupees, but we understand the
flotation costs is going to be 20 million rupees. So why do not you do something that your total
project cost, why do not you say it will be 220 million, so that after paying this 20 million as the
flotation costs, we are still left with some amount and this 200 million is available with us and
here all the conditions are met that this is the 20 million is a onetime cost, so we are only, it is a
only one time cash outflow.

So when you are showing the cash out flow of the project, it will not be 200, it will be 220
million. Finally, while comparing the cash outflow with the inflows, you have to earn that much
of the inflows or that much of the returns from the project, which are say meeting the, the project
basic investment also plus the flotation cost also. So this is a better approach and then means
with the help of this approach we can calculate this that yes, it is all best possible.

It is always better to say make use of it and to increase the overall cost of the project rather than
say up scaling the say the weighted average cost of capital. So how we can do it, let us see there
is a problem here, flotation costs.

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(Refer Slide Time: 36:59

The problem we have identified we have done here, one is, the problem is the cost of capital or
the cost of equity of XYZ Limited and all equity firm is 18 percent. The cost of equity of XYZ
Limited and all equity firms is 18 percent. The company is considering a rupee 200 million
expansion project, which will be funded by selling additional equity.

Based on the advice of the merchant banker XYZ Limited believes that it is flotation cost will be
8 percent of the amount issued. It will be the flotation cost will be the 8 percent of the amount
issued. This means the net proceeds will only be 92 percent of the amount of the equity raised,
right. So required, what will be the cost of expansion of the project for XYZ Limited considering
the flotation cost.

It means when I am saying we have to follow the second approach and that second approach is
the, what we have to follow this approach and this approach is requiring a better approach is to
leave the weighted average cost of capital unchanged but to consider the flotation cost as a part
of the project cost. So it means it is given in the problem also that the total capital, the company
want to raise is 200 million.

But that financial expert has advised that your flotation cost will be 8 percent, it means if you
raise 200 million only and pay 8 percent as the flotation costs, it means net proceeds available
with this will be only 92 percent because out of 200 million, 8 percent will be paid as a politician
cost. So it will create a problem because we needed 200 million, we need 200 million.

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So in that case, what we have to do is, we have to jack up the project cost. We have to jack up
the upscale the project cost. So how we can do that, let us do it and try to understand how we can
say upscale the project cost for this purpose.

(Refer Slide Time 39:10)

For example, how much investment is required to be made? This investment that required to
made this rupees 200 million, right. So if you want to have 200 million available with us after
paying the flotation costs. So how much of the amount has to be raised? The amount to be raised
should be something that should be equal to 1 minus a 0.8 percent means that is the 8 percent,
0.08 into amount to be raised into amount to be raised, right.

So now the amount to be raised so that finally after being the flotation costs, we are left with the
200 million with us, this if you calculate this will become rupees 200 million divided by 1 minus
8 percent or 0.08 if you calculate this, this amount works out as rupees 217.39 million, this is the
amount, 217and 39 million. So it means it is very clear that 8 percent of the flotation cost for
raising 200 million rupees of investment works out as 17.39 million rupees.

So it is better to increase the funds to be raised means the project cost. It will not be rupees 200
but it will be 200 plus the flotation costs which we have already calculated 39, so this will be
217.39 million and this cost we have to raise from the market means this much of the funds we
have to raise from the market because which is, this is going to be the ultimate project cost. So

855
the cash outflow we will not treat as 200 millions only cash outflow will be 217.39 millions and
this will be known as the total project cost.

So, this is the correct method rather than upscaling the weighted average cost of capital and
creating a problem of mixing up the two different types of the costs. One is the annual cost
another is the one time cost. So there is going to be that say that entire process is going to be
principally incorrect. In this case we are going to jack up the overall project cost. So it means for
making the investment of 200 million rupees and if the entire funding is coming, coming through
the equity financing and equity financing has the flotation cost.

So how much is the flotation cost? Financial expert has advised, it will be 8 percent, so if it is 8
percent, why do not you add up that 8 percent into 200 million, so let us see how much it works
out and this works out as 217.3 millions. So if you raise this much of amount from the market,
considering it as a total project cost, then finally 200 millions will be easily available with us for
meeting the project cost.

And 17.39 millions can be used as the flotation costs. So there will not be any kind of the
problem. So here means this is the better way of calculating and adjusting for the flotation cost.
But here, the question further arises that we have treated in the second method, we have treated
only that the entire funding of 200 millions is coming from equity capital, is coming from equity
capital. But in the practical sense, entire capital never comes from the equity capital it comes
from different sources.

It comes from the equity capital, it comes from the in the equity capital also there are the two
sources, fresh issue, second is that retained earnings. Second is the preference capital. Third one
is the debt capital. So in that case you have to calculate the weighted average flotation cost. In
that case you have to calculate the weighted average flotation cost because flotation cost will be
different for the equity capital, for the preference capital for the debt capital.

And finally we should try to find out that what is the flotation cost, how to adjust it and means
applying it to the different sources from where the funds are coming we have to calculate the
weighted average flotation cost. And then accordingly, finally adjust there that cost to that total
cost of the project. And finally we will have to make available that much of amount for the

856
project for meeting the project cost, which is the actual requirement plus raise the additional
amount as the flotation cost.

So both the, say expenses or heads of expenses have the sufficient funds available. So how to
calculate the weighted average flotation cost and some other related concepts with regard to the
means concluding say remarks with regard to this cost of capital process. I will discuss with you
in the next class for the moment I will stop it here and now we have only one more class in that
we will conclude the total discussion on the cost of capital. After that after that, I will take you to
the next concept and that is the capital structure. Till then thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 53
Cost of Capital -Part 7

Welcome all. So, we are in the process of learning about the floatation cost and in the previous
class, I discussed with you that how the flotation cost can be taken care off and can be say,
adjusted in the total cost of capital.

(Refer Slide Time: 1:02)

So, we discussed the two approaches in the previous class and say, the first approach was that we
can use this particular process revised working this weighted average cost of capital and we can
jack up the say, WACC that is our say a weighted average cost of capital and say, that way it will
be a say going up.

For example, we saw that if it is 12 percent then if we add up the floatation cost of the 6 percent
also it will become as a 12.77 percent, but that is a wrong approach because the floatation cost is
not the annual cost. It is the one time cost. So, the second approach which we discussed in the
previous class that I suggested you that yes it is better that the floatation cost must be added into
the cost of the project in the total cash outflows.

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So, that means, it is one time cost and the cash outflow is also the one time out flow. So, the total
outflow we have to work out by adjusting the floatation cost and jacking up the total cash
outflow means the total cost of the project or the total cost of establishing that business unit, or
that project. So, a second approach I suggested you is much better.

(Refer Slide Time: 2:06)

And to means understand the second approach well. We did this problem and then, we try to
understand that how we can say jack up the project cost. So, we have seen that in that process the
project cost became 217.39 million and 17.39 million was the floatation cost.

So, I think that seems to be a better analogy, because being a onetime cost you add it up into the
project cost and then when we recover the say total project cost through the cash inflows or the
project cash inflows then we have not to recover only 200 million in the present value terms but
the 217.39 million. So, being a one-time cost it should be adjusted in the project cost not in the
weighted average cost of capital, right.

So, we discussed these two approaches in the previous class, fine, but here now the million-
dollar question is that when I discuss this problem with you that when we say agreed that the
floatation cost is 8 percent and then the say final capital proceeds will be left with us is the 92
percent right. So, we have to make it as the 100 percent. So, we have to jack up the total project
cost.

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But there I only talked to you was that is, please look at this the company is considering a rupee
200 million expansion project which will be funded by selling the additional equity, by selling
the additional equity. It means in this particular problem, in this particular case I considered only
one source of funding, I considered only one source of funding that is the equity capital, but you
would agree with me that in practice it is not only one source of funding but the capital to be
invested in the project comes from the different sources, right.

And normally we have the four different sources two are the internal sources which are the say
retained earnings, then the equity capital to be issued to the equity shareholders. These are two
we can say, for calculating the cost of capital. We considered these two as the internal sources of
funds and then the two external sources of funds, preference capital and the debt capital.

So, a preference capital is also considered is as good as the debt capital or like external source of
fund for calculating the cost of capital, because the approach of calculating the cost of capital for
the preference capital is as same as the say, approach of calculating the cost of debt capital, or
the borrowed capital. So, we have, means minimum four sources or at least three sources not one
source, not entire capital is going to come from the equity, it is going to come from different
sources at least there has to be an appropriate mix of the debt and equity.

So, if that is a case then how we have to calculate the or how we have to adjust the floatation
cost? So, in that situation, if for example, the capital is coming not from one source only equity,
if it is coming from multiple sources internal, and external. So, it means the floatation cost has to
be incurred in the same way, we have to incur the floatation cost on the equity, we have to incur
the floatation cost on the preference capital. We have to say, incur the floatation cost on the debt.

So, it means when the floatation cost is associated to all the say, three sources minimum three
sources of the finance. Then certainly we have to take care of the total floatation cost associated
to the three sources of the finance. So, simple floatation cost as we learnt to calculate in the
previous class will not work. In that case, we will have to work out the weighted average
floatation cost, in that case we have to calculate the weighted average floatation cost.

And we have to find out how much floatation cost is required for equity, for the preference
capital, for the debt capital, and then we have to say calculate the weighted average floatation

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cost to arrive at the say the final cost you can call it as that is a weighted average floatation cost
we have to take into account, we have to calculate. And then finally we have to adjust that cost
into the total cost of the project.

We will be adding up into the total cost of the project as we have seen that in the previous case it
became 217.39 million against the normal cash flows required of the 200. So, 17.39 was the
floatation cost. So, the same way will be adding now the floatation cost again in the cash flows
of the 200 million but this will be the weighted average floatation cost not as the say simple
floatation cost. So, how to calculate the weighted average floatation cost, let us understand that.

(Refer Slide Time: 6:47)

The process of calculating the weighted average floatation cost is something like this where we
call it is as fA we call it as fA, here fA is equal to Wr fr plus We fe plus Wp fp plus Wd fd. So, this
way you can calculate the fA. So, what is fA now? fA is basically the weighted average floatation
cost, f A is the weighted average floatation cost and this will be calculated by taking care of all
the different sources.

So, we have taken the four sources here, one source is the retained earnings, Wr means the
proportion of the retained earnings and the floatation cost associated to the retained earnings that
is the say component that is becoming Wr multiplied by the fr then plus say the proportion of the
equity capital and the floatation cost associated to the equity capital.

861
Similarly, the preference capitals or proportion Wp is a proportion of the preference capital, fp is
the say the proportion of the you call it as a say floatation cost for raising the preference capital,
and Wd is the proportion of the debt capital, and the fd is the say proportion of the floatation cost
associated to that right.

So, in this case, we have to now find out the weightage of the different sources of the funds, or
the funds coming from different sources what is the respective weighted of that and then we have
to say at the same time ascertain the say source wise floatation cost also. So, number one, you
have to find out the say source wise say proportion of the funds and then the source wise say
proportion of the total floatation cost.

So, so that by multiplying the source of fund, or the proportion of the source of fund with the
proportion of the floatation cost and then summing up all the sources and the products of the
sources and floatation cost together, we can calculate the weighted average floatation cost. So,
we assume here for example, we let us take now the figures for example, the company again I
assume is the XYZ limited right.

This is the company and they want to raise the capital for the new project and we are given here
whatever that capital amount is going to be the weights are given to us and here are given the
Wr, Wr is given to us is the say 20 percent, then we are given the We and We is the say 30
percent and then we are given the weight Wp, Wp is equal to 10 percent and then we have got
the say proportion of the debt and Wd is 40 percent.

So, this becomes how much? This becomes 100 percent; this total becomes 1. So, it means the
proportions are 20 percent is coming from the retained earnings, 30 percent is coming from the
equity capital and 10 percent is coming from the preference capital and then the debt proportion
is 40 percent right. And now we have calculated the, we have founded out the floatation cost,
right. So, floatation cost is to be found out here. So, if you talk about the say floatation cost here
in case of the retained earnings when you talk about the fR, we have taken here fr.

So, fr is 0 because normally there is no floatation cost for the retained earnings as I have
discussed with you while talking about floatation cost that in the internal sources of the finance
when the retained earnings are concerned. There is no floatation cost because these funds are

862
easily available with us as the free reserves. So, we can make use of those funds. So, no
floatation cost has to be paid So, fr is 0, we have say assumed here.

Then fe floatation cost with regard to the equity is given to us and their cost is the 10 percent,
right. Next thing is the floatation cost with regard to the preference capital fp is given to us and
the fp amount is 5 percent. This is the 5 percent and finally is the floatation cost associated to the
debt and that cost is 4 percent, right. So, these costs are given to us, retained earnings is 0 and
equity is 10 percent, preference is 5 percent and debt is the 4 percent, right.

So, our job is now to calculate the fa right, we have to calculate the fa or the flotation cost. So,
for calculating the floatation cost we have to now find out the product of these four and then we
have to add it up. So, floatation cost is fa is going to how much? This is going to be, what is the
first proportion? This is to 20 percent and then we have to multiply it by something that is 0,
right?

So, we are going to calculate the now weighted average floatation cost fa is basically the
weighted average floatation cost. Second source is the, your equity capital which is how much?
30 percent and the costs associated to that is 10 right. And then next is the, say next proportion is
10 percent and the cost associated to that is how much? 5 and then is the next cost is the debt
cost or the debt component, or the source of fund is a debt.

So, it means this amount is say again 40 percent and the cost associated to this is 4, right. So, it
means if you try to take it up you can find out here is that the cost associated to these are, say 0
for the retained earnings, 10 percent for the say equity capital and then 5 percent for the
preference capital and the 4 percent cost is for the say you’re the debt capital. So, if you calculate
the product of these, so, you can find out the fa is going to be 5.1 percent, fa is going to be 5.1
percent.

So, this is called as the weighted average floatation cost 5 percent is the floatation cost, which
means now what we have to do is, we have to as I told you like as we did it in the second case
that we have to add up this cost into the total project cost. So, what does it mean? That when we
are to say add the, this floatation cost into the project cost. So, we have to adjust it like this. How
we have to adjust it? We have to adjust it like this 1 by 1 minus this is how much? Point, this is

863
the how much, 5.1 percent. So, it is 0.051, right 0.051. So, it means if you solve this, this works
out as rupees 1.054.

Now what does it mean? This figure has come up after adjusting the floatation cost. We have got
this figure that is 1.054 it means, this indicates, this figure indicates actually after adjusting the
floatation cost for all the four sources of the funds. We have got this one figure which is called as
1.054, it means, for raising every rupee of investment or for the purpose of investment in the
project we have to raise 1.054 rupees, right.

So, every rupee of investment, every rupee of investment requires raising of the 1.054 rupees it
means that means only the investment requirement is 1 rupee but we are going to raise to meet
that investment requirements. So, that 1 rupee is available as 1 rupee, we are going to raise not
only 1 rupee from the market we are going to raise 1.054 rupees. So, you can say that for every
rupee of investment, for every rupee of investment we have to raise now 1.054 rupees.

So, it means this 0.054 is basically the floatation cost component. So, it means if you want to
raise 200 million rupees for investment in the project you have to multiply by this factor and
accordingly, whatever the amount is comes up is that amount we have to raise. So, if you have to
raise means the total amount you have to raise is that is including the weighted average of
floatation cost.

So, finally means the right approach what we discussed is that right approach is you add up the
floatation cost into the total project cost, but the limitation of the previous second method which
we discussed was we considered only one source that is the capital is coming from equity but in
the real sense the capital comes from the different sources.

So, in this say, in the improvement upon the second method we discussed in this class and we
found it, we assumed that there the four sources from where the capital is coming and all the four
sources have some floatation cost. So, we have to calculate the weighted average floatation cost
and finally when we calculated the weighted average floatation cost we got one factor and that
factor was 1 point means after adjusting the weighted average floatation cost we got one factor
and that factor was 1.054.

864
So, it means now we have got an idea that whatever the investment we want to make whether it
is a 200 million, 300 million, 400 million or 100 million for every rupee of investment required
to be made in the project you have to raise 1.054 rupees. So, that 0.054 rupees are the floatation
cost, we have already added into the total investment required for the total investment required
for this project.

So, it means after raising this much of the amount you will have 1 rupee means at least 1 rupee
available for making investment in the project. So, if you want to raise the 200 millions for the
project cost is 200 million multiplied by this factor. So, you can get that much of the amount, so
after paying the even the floatation cost, after paying the flotation cost at the rate of 5.1 percent.
We will be sufficiently left with the 200 million rupees which can be invested in the project.

So, it is not the case that only 92 rupees will be available out of 100 rupees because 8 percent is
the floatation cost. Since, we have adjusted into the total cost of the project. So, now in this case
every amount we want to raise you multiply it by this factor and you will get the total amount
including the floatation cost. So, even after paying the floatation cost you will be left with the
sufficient amount which is required to be invested in the project according to the cost of the
project right.

So, this the concept of the flotation cost, we discussed the three situations, one situation was the
floatation cost is there, and first situation was how to adjust the floatation cost. So, we saw that it
can be added into the WACC. So, we can jack up the WACC but for the reasons discussed in the
previous class we found that is a wrong approach right, because it is not the annual cost. So, we
found out the second approach, second approach was that we have to add up the flotation cost
into the total project cost, or into your total cash outflows, so that is a correct approach.

But the limitation of the method we discussed in the previous class was we considered only one
source of finance that is equity capital whereas in the real sense, whereas in the real sense capital
comes from the different sources. So, we in this class we removed that limitation also, we
created a situation where we assumed that the four different sources from where the funds are
coming all the four sources, we have identified the floatation cost also.

865
Then we calculated the weighted average floatation cost and we got one factor, we got the
weighted average floatation cost that is 5.1 percent and with the help of that we got one factor
that was rupees 1.054. So, it means now, with the help of this factor you can find out any
amount, whatever the amount is required to be invested in the project that will be multiplied by
this factor.

So, you are not going to raise that much of the amount but plus for by means say the amount for
the floatation cost also. So, finally I would say that for every rupee of investment are required to
be made, to be invested in the project, for every rupee that is required to be invested in the
project we have to raise 1.054 rupees. So, this is the concept of the floatation cost, how we
calculate the normal floatation cost, how we calculated the weighted average floatation cost, and
how we adjust that in the total cost of the project, right.

Now, I am going to conclude discussion on this say cost of capital, but means as the concluding
remarks have to discuss some other important concepts also and the last part of the discussion on
the cost of capital is that some misconceptions with regard to the cost of capital, some
misconceptions with regard to the cost of capital.

(Refer Slide Time: 20:05)

And the misconceptions here are, first misconception is the cost of capital is too academic and or
impractical. Means, in the real sense projects or the firms while making investment into the new

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projects they never calculate the cost of capital it is only academic issue, impractical issue and
we should not care for that but this is wrong, this is a misconception, this is a practical issue and
practically the firms.

So, many surveys have been conducted over a period of time. The book which I am referring
here for this discussion Financial Management by Prasanna Chandra in almost every chapter he
has given, reported the findings of the surveys where the researchers have conducted the research
and they have found out which method or different methods are used by the firms in the practical
sense to calculate the cost of capital. So, it means it is not academic issue, it is the practical issue
and it is always useful, always the weighted average cost of capital is calculated and that plays
the role of say calculating the discounted cash flows.

Second misconception is the cost of equity is equal to the dividend rate or return on equity, this
is not the dividend rate, cost of capital is not simply the dividend rate, cost of capital is the
required rate of return by the equity investors or the equity shareholders. It is a required rate of
return and dividend rate is not the required rate of return, dividend depends upon the profitability
of the company and say depending upon the profitability board of directors decide every year in
the annual general meeting or maybe before the annual general meeting board of directors decide
and they announce in the AGM that this much of the dividend is being paid.

So, sometime they pay high amount of dividend, sometime low amount of dividend, sometime
no dividend is paid because investment is required within the firm. So, dividend rate has nothing
to do with the cost of capital. It is basically the say a rate of return required by the equity
shareholders. And rate of return required by the equity shareholders is more than the normal
interest rate, because they want some premium for the risk which they are taking by investing
their funds into the equity capital of the companies.

Third misconception is retained earnings are either cost free or cost significantly less than the
external equity. It is a cost free or the cost is significantly lesser than the external equity, this is
also not correct. It is not cost free first of all, it is having the sufficient opportunity cost. It is
having the sufficient opportunity cost because we assume it that retained earnings if are not
invested into any investment proposal they will be distributed to the equity shareholders and

867
equity shareholders will invest those say retained earnings as per their own liking and the
required rate of return.

So, it has the opportunity cost and almost you can treat it as it is having the say cost as equal to
the external equity. So, how much return is expected by the new shareholders while issuing the
external equity same is the cost of the free reserves or the retained earnings. So, retained earnings
are not free of cost, it should be treated as the source having the same cost which is the cost of
the external equity being issued a fresh.

Share premium has no cost, this is again a wrong notion because every rupee which the firm
owns and going to invest in the business has the opportunity cost, if it is not invested in the
proposed project it will be invested elsewhere or it will be say used in some very useful manner
because it is the money which belongs to the business and every penny in the business has
opportunity cost.

So, it means neither the retained earnings nor the share premium has any kind of the say source
or they are not the kind of the source which are free of cost, they have the equal say importance
like all external and internal sources of the funds and the cost has to be calculated accordingly.

(Refer Slide Time: 24:24)

Depreciation has no cost, again a wrong notion depreciation has no cost. Now, finally the amount
of depreciation which is collected by debiting the amount of depreciation in the profit and loss

868
account. Since, it is a non-cash expense. So, this amount comes back again to the firm and this
amount is say kept safe and has to be used for reinvestment purpose means number one at the
time of the replacement of the asset we will be making use of this money.

But in any case, for example, that replacement is not required or that replacement has not to be
done because it may be possible that by the time the say technical value or the usefulness of the
fixed assets become 0 or it will go out of say usable life we will dismantle the project. Project
itself has the life equal to the life of fixed assets. So, it means this amount will be distributed to
the equity shareholders.

So, if this amount is to be distributed to the owners of the company, why not it has a cost? It has
the same opportunity cost they can invest it somewhere else and earn the desired rate of return
so, it is also not free of cost. Next is, the cost of capital can be defined in terms of accounting
based measures, no it is not accounting based measures, in accounting based measure when you
talk about you debit the say profit and loss account with the say interest cost.

It is not accounting measured. Number one, cost of equity you never show in the accounting
records and only the cost of debt we show in the profit and loss account debit side that is the
interest cost, but I am talking to is that cost of capital is not simply the interest cost required by
the equity shareholders. It is the interest plus some premium required for the (invest) risk they
are taking for making this investment in the business.

So, in that situation it has to be something more than the interest cost. So, it cannot be only
accounting measure or accounting based measure. Next thing is, a company must apply the same
cost of capital to all the projects. We have practically seen in the previous classes to all the
projects, we have seen in practically that the company cost of capital is different and the project
cost of capital is different, because the risk profile of the company and risk profile of the project
is not same.

So, if different projects are going to be undertaken by the company they cannot be say applied
the same cost of capital because risk profile of every project being different, we have to treat it as
a independent investment say entity and we have to say calculate the cost of capital depending

869
upon the amount of risk associated to that project. So, it means, the cost of capital for the
company is different, for the project is different.

And the last one is that if the project is financed heavily by debt, it is WACC is low. If it is
financed heavily by the debt, it is WACC is low. It is a very contentious issue that if the project
is financed heavily by the debt its weighted average cost of capital is low. So, this issue is not
very simple you can call it as, if it is given there it is not as simple as it looks, because a lot of
debate has happened in the past.

And this question I will be in a position to answer in the next topic which I am going to start
after this say completion of discussion on the cost of capital and that topic is the capital structure
which I am going to start. So, in that topic this question has been answered very clearly, initially
when the proper organized theory on the capital structure was not there and we assumed that first
organized theory was given to us by the Modigliani and Miller in 1958.

Before that we had the unorganized thoughts you can call it as about the say you call it as the
cost of equity and the cost of debt different approaches were there but they were not the
mathematical approaches. So, the real thinking was started with the say pronouncement of the
theory on the capital structure first, theory on the capital structure in their seminal works by
Modigliani and Miller, who gave the first theory in 1958.

So, they in the beginning like other theories on the capital structure, they also agreed in the
beginning that the cost of capital or maybe say the value of the firm does not depend upon the
capital structure, because both the sources internal as well as external have the same cost. And if
you say that debt is cheaper than equity then it is not correct, that is say cheaper than equity is
not correct.

But now the latest, now the latest, now the say established outcomes of the different researches
in the different say analysis on the capital structure as well as on the different sources of the
finance that yes this misconception is that yes that is cheaper and not heavily cheaper. If the
project is financed heavily by the debt it is WACC is low, yes it will be comparatively low
because that debt has the tax deductible advantage which is not there with the equity.

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So, I agree that this misconception is not a misconception it is agreeable point that yes even the
all the theories, now the latest theories of the capital structure also have proved that if that debt
component in any companys capital structure is more than certainly the overall cost of capital is
going to be lesser. Initially it was not agreed even by the Modigliani and Miller also initially they
agreed that say there is one approach in the capital structure which I will discuss with you after
this completion of discussion that is a net operating income approach.

Net operating income approach says that the cost of debt and cost of equity is same and overall
cost of the capital of the firm is not affected by having the different proportions of the debt and
equity, because cost of both the sources is same. So, same was the case, was the theory which
was propounded by Modigliani and Miller, capital structure theory in 1958, they also agreed that
yes the capital structure does not affect the firms value.

But now the latest thought is that yes capital structure makes a difference and if the debt
component in the capital structure is high certainly the overall cost of capital of the firm comes
down and it helps to say maximize the value of the firm right. But here, we have to take into
consideration so many factors that when debt comes in the say capital structure of the firm it
brings lot of risk right. So, the cost of capital is comparatively lower but the risk element goes
up.

So, we have to be very careful while deciding about the debt component in any investment
proposal and simply if you look at that because it has that say tax deductible advantage. So,
heavy debt oriented capital structure should be created for the project that is not going to be the
say true or the say you can call it as the rational thing. So, certainly the weighted average cost of
capital will be low if the say element of the debt is high in the capital structure of the firm.

But it has to be discussed or to be taken into account by considering so many other factors and
one important factor is the risk factor. So, these are some misconceptions which I discussed with
you in the summarized firm quickly, for the detailed reference, detailed learning about these
misconceptions and for the other important concepts of the cost of capital also again you can
refer to any good book on the financial management.

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So, many books are there in the market you can buy, I have given 4-5 books and my course plan
also but the book which I am following for all this discussion if you buy that I think most of the
doubts will be clear and that book is the Financial Management by Prasanna Chandra. So,
remaining discussion or for any kind of the doubts and the detailed reference you can refer to the
book as I told you that is the Financial Management by Prasanna Chandra.

So now, with this I close the discussion of the cost of capital and now after this we will move
forward with the next part and the next part is a very important component of the overall
financial management and that component is the capital structure.

Now, I will discuss the capital structure in detail and after learning about the capital structure and
the impact of the capital structure on the value of the firm you would understand that what is
important, importance of the cost of capital and how it impacts the say capital structure of the
firm and what are the different sources of the funds, what is the cost associated to them. How
that can be taken into account while determining the capital structure of the form.

So, now let us learn in detail about the next important topic, next important component that is the
capital structure and the firm value. So, capital structure and firm value it is a very interesting
topic, it is very interesting area and the area of long debate were the financial experts for many
years even today also sometimes this thought comes in the mind of many financial experts that is
there any importance of the capital structure in the say overall say capital structure of the firms,
should be bothered about that from where the funds should come in the businesses.

Whether they should come from the debt or they should come from the equity or if we raise the
funds more from the debt or less from the equity. So, is it going to be any impact upon the say
cost of the capital because ultimate objective of every business or any business or any business
activity is the maximization of the value of the firm and the firms value will be maximized if the
total cost of production including financial cost is as low as possible.

Because in todays scenario if you want to increase the profitability of the business it is not
possible to increase the profits by increasing or jacking up the selling price of the product or the
services. The moment you increase the say selling price of the product or services people may
even stop buying the product or service because it may go out of their reach, right.

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So, what you have to do is, you have the second strategy available with you and that is reducing
the cost of production and when you talk about the cost of the production financial cost makes a
lot of difference here. So, we talked about say how to deal with the financial cost or cost of
capital, so what we discussed in the previous say number of classes including in this class also
something about the cost of capital.

(Refer Slide Time: 35:46)

So, now we are going to talk about that, that in the practical sense how the cost of capital matters
and capital structure when we talk about or when we think the cost of capital in terms of the
capital structure because ultimate focus is upon the something which is called as the firm value.
This is the focus and this is ultimate objective of any financial management process or any
financial management say exercise.

So, it means, we can say that capital structure and firm value if this topic is given here and all the
times when we talk about the capital structure, we always remember about the value of the firm,
right. So, it means there must be some relationship of the capital structure with the value of the
firm and that to in terms of the cost of capital, right. So, let us discuss in detail that what is the
capital structure?

What is the cost of capital that have already talked about, we have learned about and what is the
capital structure and how the capital structure affects a cost of capital and ultimately say

873
contributes in the maximization of the firm’s value? So, let us first understand the some relevant
say concepts, or in a way I can say let us answer some of the relevant questions right. First, we
will answer some of the relevant questions then you will be able to understand that how capital
structure or its importance is building up or is so important to learn about the concept of the
capital structure being a student of finance or the financial management, right.

So, first question here is what is the relationship between the capital structure and firms value?
So, this the relationship between capital structure and firm’s value, this is a million-dollar
question. Second question, what is the relationship between the capital structure and the cost of
capital? Is there any relationship? Now, what is the question, that is there any relationship? What
is the relationship between say capital structure and a firm value? And what is the relationship
between the capital structure and cost of capital?

So, it means when we are asking these questions, so you should get an idea that yes there is a
relationship between the capital structure and firms value, there is a relationship between the
capital structure and cost of capital. And third important question is valuation and cost of capital
are inversely related, because if, the cost of capital is high value of the firm will come down and
if, the value of the firm has to be taken as high as possible you have to manage the cost of
capital.

So, it is certainly an inverse relationship and we have to understand that if you want to increase
the overall value of the firm then you have to control the cost of capital. So, whether capital
structure plays any rule in lowering down the say cost of capital that we are going to learn in this
entire discussion in the next few classes. Then different views about capital structure, yes, there
are the different views about the capital structure but now if you talk about say the era till 1958
when the first theory was systematic theory, mathematical theory was propounded by two
financial economist Modigliani and Miller till then you can call it as different views were there.

And even Modigliani and Miller were also not clear whether there is any relationship between
the say capital structure and the cost of capital, capital and the firm value or not. In their first
theory as I told you just now that they also rejected the hypothesis that capital structure impacts
the value of the firm, but later on they came out with the second proposition and the second
preposition they have themselves agreed that yes if the debt component in the companys capital

874
structure is high then certainly the cost of capital goes down and it adds to the value
maximization of the firm, right.

So, these are four important questions which we will like to answer in the subsequent discussion
and we would like to know about that how to say decide the capital structure the best and the
optimum capital structure of the firm and how to maximize the value of the firm.

(Refer Slide Time: 40:09)

Now, here we talk about the assumptions and the assumptions are like, first one is to examine the
relationship between capital structure and cost of capital, the following simplifying assumptions

875
are commonly made. The following say simplifying assumptions are commonly made because if
you do not take these assumptions, if you do not make these assumptions, if you do not assume
anything and if you assume that say dividend is also paid as per the policy of the firm.

If you say that tax is impact the overall cost of capital and the value of the firm, if you say that
the firm is having the different profitability situation then what is going to happen? In that case
no say you can call it as acceptable answer is going to be available. So, when we are going to
talk about the capital structure and its impact upon the firm’s value, we are going to say that we
are going to assume certain pre-conditions and these certain pre-conditions are first condition is,
no income tax.

That firm has not to pay, they are most impractical assumptions but when we say add means or
you can call it as remove these assumptions then the capital structure start dwindling. But if you
say we have assumed a very plane situation, no hurdles are there, no say different situations are
there and if we have assumed all these things how the capital structure will be decided and
whether that capital structure will have any impact on the firm’s value or not.

So, first is the no income tax, first assumption. Second is, 100 percent dividend payout, whatever
the profitability is there with the firm there is no retention of the profitability and whatever the
firm earns that is paid as the dividend.

Third is, investors have identical subjective probability distribution of operating income,
subjective probability distribution of the say operating income that say between the distribution
of the operating income between the debt suppliers or the landers and the equity shareholders
everybody understands that depending upon the risk and return of the firm how much or which
part will go to the debt suppliers or to the lenders, how much will come back to the equity
shareholders all the investors have the identical say subjective probability or their distribution is
known to the all the almost all the investors, no growth firm is stable.

There is no increase in the profitability, there is no decline in the profitability, firm is operating
at the same level in the form of a straight line, means you cannot say that there is a situation
something like this or there is situation like this, firm is moving like this, the profitability is
moving like this. So, it means there is no growth we have not assumed any growth here.

876
And no transaction cost, no transaction cost that when you raise the funds you have not to pay
any transaction cost or sometime when you have the surplus you invest in the market, or when
you convert that say security into the cash, no transaction costs has to be paid. So, these are the
five important assumptions have been taken here or taken into account and on the basis of these
assumptions we are going to now proceed further that if these assumptions are held true or if
these assumptions hold good then how the capital structure will be decided.

(Refer Slide Time: 43:35)

Now, focus of analysis, this is the focus of analysis is here first of all we will learn about the say
the process of calculating the cost of individual sources or funds, then we will say learn how to
calculate the say overall cost of the firm, or cost of say you can call it as the cost of the capital
for the firm and then we will apply these say focal points to different discussion points or in the
different theories or in the different processes.

So, here when you talk about the different sources of the funds, we talk about here is that is the
debt capital, equity capital and rA is the overall capitalization rate that is the you can call it as a
weighted average cost of capital. rA is basically the weighted average cost of capital. So, how we
calculate the cost of debt? Cost of debt is basically I/D. So, I is basically I represent the interest
part and D represent the market value of the debts.

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So, it is written here as annual interest charges divided by the market value of the debt and how
we calculate the cost of equity? Cost of equity is that is the say equity earning, P means the
payout ratio and payout ratio decides how much is going to be paid out of the profit which part
of the profit, or how much part of the profit is going to be paid to the equity shareholders and
then E is the market value of the equity, right.

And O is the, so it means this is a cost of debt, this is a cost of equity, and this is the overall rA is
the overall capitalization rate of the firm. Which depends upon the or which is calculated with
the help of this thing and this if you look at it is same thing what we discussed in the cost of
capital rA is basically the weighted average cost of capital. So, rA is to be decided with the help of
how, operating income divided by the market value of the firm.

So, it is the operating income divided by the market value of the firm, so it means finally rA you
can call it as rA is going to be calculated, rA is basically the weighted average cost of capital and
how we are going to calculate the weighted average cost of capital here? That is depending upon
the component of debt, the component of equity.

So, what we are saying, this rD is the cost of debt and this is the proportion of the debt in the total
capital structure. And this is a cost of equity RE multiplying, multiplied by this the proportion of
equity, this is E divided by total capitalization that is a debt plus equity. So, finally the product of
this becomes RA and RA is the weighted average cost of capital which will be say depending
upon the say operating income and the market value of the firm.

So, the weighted average cost of capital can be calculated if we know the cost of debt, if we
know the cost of equity and their respective proportions in the capital structure. From here we
now say raise the issue or this question that if there is no difference in the cost of the two, if the
debt and equity are available at the same cost then why not to bring the 100 percent debt in the
firm or why not to bring 100 percent equity in the firm, or why should be bothered about or why
there is stipulation that debt equity ratio has to be 2 is to 1.

Then any debt equity ratio can we had why people think about that we have to go for debt, we
have to go for equity, the proportions have to be like this. So, it means there must be some reason

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that is why the weighted average cost of capital is calculated and the proportions of the different
sources of the funds in the capital structure are worked out and decided accordingly, right.

Now, we move to the next important part after talking about the basics of the capital structure,
we move to the different approaches, different approaches which have try to answer the
questions pertaining to the deciding of the capital structure of the firms but these approaches,
three approaches we are going to discuss initially which are called as the unorganized frequent
say fragmented approaches of say is the capital structure.

First approach is the net income approach, then is the net operating income approach, and third
one is the traditional approach. These approaches were available or were being say accorded lot
of importance when the say standard theory the say systematic theory of the capital structure
given for the first time by the Modigliani and Miller in 1958 was not available.

Till then these three theories, fragmented theories were available and some people said that
capital structure does not make any difference. Some people said that yes capital structure makes
the difference, some people say that yes it makes a difference, it may not make the difference.
So, it means they were totally the unorganized thoughts, not based upon any kind of the say
systematic research or any kind of the mathematical modeling.

But from the Modigliani and Miller era onwards from 1958 onwards, now we the systematic
theories of the capital structure, but before you move to the Modigliani and Miller theory, we
will first have to learn about these three approaches of the capital structure, net income approach,
net operating income approach, and traditional approach.

So, that after building the foundation and knowing about that before the Modigliani and Miller,
what other approaches talk about the capital structure and do these approaches have any
importance or carry any importance even the era of today or not. So, one by one we will discuss
these say first three approaches and then we will move to the next fourth approach given by the
Modigliani and Miller or the capital structure theory of the, capital structure theory given by the
Modigliani and Miller. So, all these three approaches and the fourth one given by the Modigliani
and Miller we will discuss in the next class. Till then thank you very much.

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 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 54
Capital Structure - Part I

Welcome all, so in the process of learning about the capital structure of the firms, which we
say started talking about in the previous class. Now I will take you further with say remaining
important conception approaches of the capital structure and while talking about the capital
structure of the firms this say you can call it as say, the process of arguments always goes on
that whether say capital structure plays any role in the value maximization of the firm or not.

Means that if we bring more funds from the equity or more funds from the debt, does it make
any difference in that say reduction in the say average cost of capital and then say value
maximization for the equity shareholders. So, this process is a means years old ages old, a
decades old and now, it has started stabilizing because now many scientific theories are
available, many say research based theories are available that capital structure yes makes a
difference.

And if you say have more amount of the debt, if you employ more amount of the debt in the
firm in the total financial resources or in the total capital structure of the firm, then the overall
cost of capital can be brought down, the weighted average cost of capital can be brought
down and the value maximization of the firm for the equity shareholders can be attained, this
objective of the value maximization for the equity shareholders can be attained.

So, it is a now say empirically proved also but we should have the complete knowledge,
because sometime you confront you may confront with the question from any person any
form any side that how does the capital structure makes a difference? And what are the
different say theories, different approaches concerning that? So, you should be clear about all
the theories all the approaches and the background.

And the say now the final decision that we have arrived at after the say systematic research
that capital structure makes a difference. So, now before that what was the situation and
where we started learning about this capital structured process systematically and now what
is the current state of affairs you should be very clear, being a student of finance, you should
be very clear about that.

880
So, now I will take you back a little bit and then we will start with the different approaches
and we will divide the learning of the theories of the capital structure into two broad say
ways. One is those theories which are you can call it as not as such as a systematic
approaches or any kind of the theories based upon the research rather they are simply based
upon the general understanding or maybe the rules of thumb or maybe the answer dots.

And no you can call it as systematic theory has been developed on the basis of the research,
but those theories are equally important even today you cannot ignore them. And they are
basically the basis of the systematic research and say finding it out by the different
researchers that yes, capital structure makes a difference.

And the moment you increase the amount of leverage in the firm, you employ more amount
of the leverage in the firm, leverage means the debt capital, the borrowed capital, because of
the tax deductible advantage of the borrowed capital, it says, reduces the overall cost of
capital of the firm weighted average cost of capital of the firm and otherwise also the cost of
the debt being a fixed cost.

It does not increase with the profitability or does not come down with the reduction in the
profitability. So, the firms if they are sure about earning the profitability or they are going to
be the highly profit making firms for them for say those firms for deciding their capital
structure, yes, they must bring a more amount of the debt in the firm.

So, means this say, a process of learning about the composition of debt and equity in the firm
and the process of deciding the capital structure of the firms is a very-very important
component of the say discipline of financial management and being a student of financial
management, you should be clear about all these theories and the systematic processes and
how this genesis of the capital structure has moved forward.

And now, where we stand and what is the latest thought right. So, different approaches are
there I will discuss with you the 4 important approaches, one means, one approach is a
systematic approach, whereas, the other 3 are the unsystematic approaches. So, when the
systematic approach was not available which was given in 1958 for the first time by say
Novel laureates, two Novel laureates in economics, financial economics, Modigliani, Franco
Modigliani and the say Merton Miller.

So, these two economists they have given the approach which is called as a systematic
approach of the capital structure that came in 1958 for the first time and even 1958 the report

881
they gave or the theory they propounded that they themselves rejected over all later on over a
period of 3 to 4 years in, I think 62 when they gave the second say version of the theory or
second proposition of the theory.

So, they have changed their view which they gave it the first theory 1958 but these theory is
called as the systematic theory of the capital structure and before that, we had 3 theories,
which are called as the or 3 approaches which are called as a net income approach, net
operating income approach and the traditional approach.

So, first we will learn about the unsystematic approaches, unsystematic theories which are
based upon the general understanding, accounting rules, rules of thumb or accounting process
or the anecdotes and then means when this say systematic research in the capital structure
was not available. So these theories were forming the basis.

And at that time people were not clear, businesses were not clear, whether the capital
structure makes any difference or not, because we are going to discuss now the three say
approaches before the Modigliani approach and these three approaches put forward the three
different views. So, which view to accept that was not clear at that time with the people and
businesses were just using the trial and error methods to decide the capital structures.

So, we will systematically learn about all these approaches of the capital structure one by one
and finally, we will move to the systematic approaches that is the Modigliani Miller approach
and then we will conclude that how does the capital structure of the firm means say, affects
the overall profitability or the cost of capital because if, the cost of the capital is under
control, then the say value of the firm will be maximized, value of the form for the equity
shareholders will be maximized.

So let us learn about these approaches one by one. First the unsystematic approaches or the
you can call it as the, say, the approaches which had their own view, which is not based upon
any research or any kind of the scientific findings, but they are not ignorable at all we have to
learn about these three. And then after that, we will move to the one the theory of the capital
structure most important theory of the capital structure given to us by the Modigliani and
Miller.

So first we will start with these three approaches. And the first approach is the net income
approach. I will tell you that the abstract of this or in abstract I will tell you about this
approach, that as per this approach or as per this particular theory of the capital structure, this

882
approach says that debt amount of the debt means, the moment you increase the amount of
leverage or amount of the debt in the firm, the overall cost of capital comes down and the
value of firm stands maximized, value of the firm stands maximized.

So, it means that as per the net income approach, we have the two sources of the funds, one is
the debt and then is a equity. So, in that total capital structure, you should have the high
proportion of the debt, the moment you increase the amount of the debt in the firm or the
financial leverage in the firm, the overall capitalization rate or the cost of capital means the
cost of capital not capitalization rate, I would say cost of capital would come down.

Overall cost of capital would come down and if the overall say cost of capital comes down
weighted average cost of capital comes down; it means ultimately after servicing the fixed
amount of the say of the of the funds. That is the debt component the remaining amount will
go to the equity shareholders because operating income remaining the same.

And if the average cost of capital is going to reduce by employing the more amount of debt in
that situation, your overall value of the firm for the equity shareholders is going to be the
maximum, right. So, this approach says that yes debt and equity are the two sources, but debt
is cheaper source of finance as compared to the equity and the moment you increase the debt
or the component of leverage in the total capital structure of the firm, it reduces the overall
cost of capital.

Weighted average cost of capital and it helps in the value maximization of the firm. So, let us
see what is written here.

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(Refer Slide Time: 9:42)

It is clearly given here that according to this approach, according to this approach, rD and rE,
rD is basically the cost of debt, we have seen in the previous class in the first lecture. That is,
we have decided how we signify that cost of debt, how we signify the cost of equity and how
we signify the overall capitalization rate that is rA and that is the weighted average cost of
capital rA is basically the weighted average cost of capital.

So, we are going to talk about all these three here are given. So, what is written here? What is
the crux of this approach? It says, according to this approach, rD and rE remain unchanged
when DE varies, rD and rE remain unchanged when the DE varies means a debt and equity
ratio varies. There is no change in the costs of debt or in the cost of equity means these cost

884
of debt and equity they remain same whatever the amount of the funds you are bringing up in
the overall capital structure of the firm.

So, because we this is a say well understood fact that cost of debt is much less as compared to
the cost of equity because of it is a tax deductible nature. So, it means when the approach
says that the say the rD and rE, the cost of debt and the cost of equity does not change, when
you change the debt equity ratio or the capital structure of the firm.

So, it means if the debt is cheaper than the equity and you employ more amount of the debt,
so, what is going to happen? Since the cost of the individual sources not going to increase
means beyond a particular point. So, in that case, if you employ the more amount of the debt
in the total capital structure of the firm, then the overall cost of capital that is rA is going to go
down. So, it means, it is written here, this constancy of rD and rE with respect to the debt
equity ratio means that are rA.

rA is the overall capitalization rate or the weighted average cost of capital with the help of we
have seen in the previous class it is given here. For example, rA is basically the weighted
average cost of capital the total capitalization So, rA declines as DE increases. As a debt to
equity ratio increases, rA declines overall cost of capital declines, weighted average cost of
capital declines because debt being the cheaper source of finance.

When its weightage in the capital structure is increased, then certainly it is the beneficial
position for the equity shareholder and the objective of the value maximization can be
achieved right. Now, for example say graphically it is shown here that on this, this say X axis
you are given the debt equity ratio, and here you are given the rate of return and here you are
given the three important costs, right.

So, first line is talking about the say this is depicting the cost of debt, then this third line is
talking about the cost of equity and in between this dotted line is this is talking about the rA
that is overall cost of capital weighted average cost of capital right. So, here you are at the
zero level, right. So, here is a rate of return going from this to this upwards, you can say that
this is like this, and this is like this, and this is the debt equity ratio.

So, it means in this debt equity ratio when you move from this side to this side, what you are
going to do here is that if you employ the more amount of the debt in the firm. If you employ
if we're having the amount of the debt in the firm up to this level, the overall cost of capital is

885
at this level. If it increases up to this level, cost of debt goes like this, because when the debt
amount increases in the firm, cost of the debt will also increase.

But the overall capitalization is going to go down and if it is reaching here, then it is reaching
here and for example, if it is the say debt component is further going up in the debt, this is a
debt equity ratio, then the overall capitalization rate is going to be the minimum. So, what is
happening? Cost of equity is stable, that is not going to change, means if you are increasing
the say the debt equity ratio, cost of equity remaining change, even the cost of debt is also
unchanged.

Cost of equity is unchanged it is given in the approach itself that the costs of debt and equity
remain unchanged. Only the overall cost of capital goes down, when you increase the
component of debt in the say overall capital structure of the firm and that is happening here
we are showing it here cost of debt is same cost of equity is same and when the moment in
the debt equity ratio, you are increasing the component of the debt here going from this side
to this side.

Overall, your cost of capital that is rA is declining this with the say increase of the debt in the
overall capital structure of the firm, right. Because it this approach says this approach
advocates that debt being the tax deductible number 1, it is fixed in terms of the cost. If there
is increased profitability in the firm, then the cost of debt does not change, does not increase
and since it is the tax deductible, so the moment you increase the amount of the debt, so,
means in the larger.

For example, in the total capital of the firm, 80 percent is coming from the debt and 20
percent is coming from the equity as it means overall, say out of the total cost of capital, 80
percent is the controlled cost or the lower level of the cost as compared to the equity costs.
Only 20 percent is an equity costs which is the higher cost. So, it means higher the amount of
debt, it means the average cost of capital is going to go down.

Only negative advantage or the sorry, only negative feature of the debt is that your risk level
goes up because it is a fixed cost on the or against the revenues of the firm. It is a fixed
charge, it is a fixed cost, you have to service the debt in any case, whether you have the
revenue, you do not have the revenue, whether you are a profit making firm, you are a loss
making firm. In any case, you have to service the debt you have to pay the cost of the debt,
which is not the case with the equity.

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But if the firm is able to cross that threshold level and the minimum income is going to be
ensured by the firm, then certainly as per this approach, larger the amount of the debt, lower
is going to be the overall cost of capital and the firm is going to means say increase the value
of the firm this overall value of the firm is going to increase because of this capital structure
when the financial leverage is high.

(Refer Slide Time: 16:17)

So, we have to say learn with the help of this particular example here, if, you look at this
particular example, you can say net income approach and this example will help us to
understand how the overall cost of capital goes down the movement, the amount of debt in
any form increases.

Here we are given the 2 firms, firm A and firm B and we have written here there are two
firms A and B. Similar in all respects, similar in all respects except in the degree of leverage
in the degree of leverage employed by them. In one firm, the degree of debt is higher as
compared to the other firm or maybe in the one firm the level of debt is zero, in the second
from the level of debt is high.

And the financial data which is given to here which is given to us here is that will help us to
understand the overall capital structure of the firm. If you look at this firm, so, you can call it
as market value of the debt given here and it is zero, whereas the market value of the debt
given here is the 50,000 say rupees, right. Other incomes are other say a particulars are same
here operating income is 10000, 10000 and interest on debt because the debt component of
debt is zero.

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So, our interest on debt is zero whereas, here we have the interest on the debt. Equity
earnings are 10000 because whatever the operating income is, that 100 percent will go to the
equity shareholders because no cost of the debt has to be paid because the level of debt is
zero, whereas here the equity earnings have come down means the total earning total income
minus the cost of the debt, so remaining is going to be the say equity earnings.

Cost of equity capital is 10 percent, same 10 percent, cost of debt capital 6 percent, 6 percent
and value, market value of the equity is 100000 and here it is 70000 and say if you talk about
the total value of the firm, it is 1 lakh, it is 120000 rupees. So, the firm which is employing
the debt component the overall say the total value of the firm of total value of the firm is
more and here this firm is employing total amount of in their capital structure, total amount
employed is 120000.

Whereas, in this case the total amount employed is 100000 rupees. So what the amount of
debt is here 50000 and amount of the debt in this form is 0. So you can say this firm is the
levered firm, this firm is unlevered firm. This firm is the levered firm this firm is the
unlevered firm. So, I am saying or not I am saying but this approach says the moment you
increase the amount of debt in the firm or any firm having the say a higher amount of the debt
in its capital structure, overall cost of the capital of the firm goes down.

So let us solve this and try to calculate, from this say total information. Let us calculate the
say weighted average cost of capital or the average cost of capital. And then we will be able
to understand whether it was certainly going down when the firm employs the amount of debt
or it remains a stable or it is otherwise, right.

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(Refer Slide Time: 19:27)

So, you can see it that is the weighted average cost of capital for the firm A or of the
weighted average cost of capital of firm A, of the firm A. So here what is the formula if you
look at? It is given here and you can take it as the cost of debt, what is the cost of debt? 6
percent and with this we have to multiply the proportion of the debt and the proportion of
debt given here is how much?

The proportion of debt given and this is, that is 100000 rupees is a total capitalization, portion
of debt is 0 here and then it is the equity costs of equity is a 10 percent. And here the total
amount is coming from the total say capital is coming in the capital structure only from the
equity capital. So, if you calculate the weighted average cost of capital for this firm, we have
the proportion of the weights.

So, weight of the debt is 0 and the weight of equity is 100 percent and the cost of debt is 6
percent, cost of equity is 10 percent. If you calculate the cost of say average cost of capital
here, so you will find out this comes out as say 10 percent, this works out as 10 percent and
this firm is the say unlevered firm. This firm is the unlevered firm there is no leverage, no
debt is employed here, right.

Now, we talk about the weighted average cost of capital for the firm B for Firm B. So if you
calculate the weighted average cost of capital for this firm, so, we can again take the same
thing cost of debt is how much? 6 percent and what is the, if you look at this, what is the total
capitalization? Total capitalization is 120000 and the component of the debt is 50000, right.

889
So, it means, we have employed the debt in this firm which is 50000 and the total
capitalization is 120000. So, this is the one component plus the second component is the
equity and in this equity this amount is the say how much is the amount remaining?
Remaining is the weightage of the equity 70000, weightage of the debt is 50000 and total is
120000. So, if you calculate this cost, this works out as say 8.3 percent.

So, you can understand that the firm which is employing a certain amount of debt or more
amount of debt in their capital structure, they their cost of capital is lesser as compared to the
firm having the no debt at all in the capital structure or the lesser amount of the say debt in
the capital structure. So, as per this approach, though, the cost of these sources of the funds
internal and external sources of the funds, debt and equity remains unchanged.

Means, even you vary the say, do any kind of the variations in the capital structure, so debt
because it is a well-known fact debt has the tax deductible advantage. So, because of that
particular feature which is not associated to the equity capital, so because of that tax
advantage feature of the or the feature associated to the debt, it makes the debt as the cheaper
source of the fund or the cost of the debt is much less as compared to the cost of equity.

And because of that the moment you vary the say capital structure or the debt equity ratio and
the you increase the component of the debt in the overall capital structure, so the overall cost
of capital or the weighted average cost of the capital of the firm goes down, because cost of
equity remains unchanged, cost of debt remains unchanged, but cost of debt goes down
because of its tax deductible nature. So, overall cost of the debt is lesser normally as
compared to the cost of equity.

And that say create the situation where the higher amount of the debt or higher amount of
leverage in the capital structure of the firm reduces the overall cost of capital for the firm.
And if the cost of capital goes down, certainly the reverse will happen that the value firm
value of the firm will be maximized or the say value maximization objective of the firm will
be achieved. So, this is the net income approach.

Now, we will move to the next approach, which is the net operating income approach. So,
this approach is totally different from the net income approach this income, this approach
says net operating income approach says that both the cost of debt and equity is the same in
the beginning, so the cost of debt and equity like the say net income approach, the cost of
debt and equity remains the same.

890
But the moment you say varies the debt equity ratio, the moment you vary the debt equity
ratio and increase the proportion of debt in the total capital structure of the firm, the cost of
equity capital goes up, it does not remain stable. This is the crux of this say approach net
operating income approach. The moment yes, the cost of these two is same, we understand,
but the moment you increase the component of debt in the capital structure of the firm, cost
of equity increases.

Because equity shareholders increase their required rate of return because of the increased
element of risk, because of the increased amount of the debt in the firm. Equity shareholders
assume that the more amount of the debt you are employing in the firm; it means the overall
risk of the firm is going to or overall risk of the firm is going to increase. So, they have to be
or more amount of the risk because of the increased amount of the debt employed by the firm.

So their cost of capital will also be going up, because the required rate of return goes up
because they want more compensation to be compensated means those people want the
equity shareholders want to be compensated for the higher amount of the risk they are going
to take because of the higher amount of the debt employed by the firm.

So the moment you increase the component of debt or the proportion of the debt in the
overall capital structure, cost of equity does not remain the same. Rather it goes upwards.
Because equity shareholders believe, by employing the more amount of debt you have
brought in more amount of risk in the firm. And in that case, their required rate of return
cannot remain same, rather they are going to jack it up.

They are going to increase it and because of that means if the say cost of debt is lower, but if
the cost of equity goes up, so ultimately, it does not make any difference. It does not make
any difference in the overall cost of capital of the firm. Because we understand this approach
also accepts debt is a cheaper source of the funds as compared to the equity right, but it is to
that extent, when the debt and equity are in equal proportion right.

The movement to increase the debt with the objective of reducing the overall cost of capital
of the firm, the cost of equity goes up because equity shareholders increase their required rate
of return because they assume that higher amount of the debt employed by the firm brings
more amount of the risk in the firm. And since the equity shareholders are going to take more
amount of the risk, so their required rate of return goes up.

891
It does not remain stable and ultimately the cost of capital or cost of the equity capital goes
up. So, as per this approach, both the things rE and rD, they are not going to remain same, they
are only same if they are means debt is employed to a certain extent, but if, you increase the
debt, then the cost of equity is also going to increase. So, you are going to increase the debt
with the objective of reducing the cost of capital because debt is a cheaper source of finance.

But cost of equity is going to increase so, net result is going to remain the same. So, as per
this approach, the net operating income approach concludes that debt capital structure has no
meaning. Whether you bring the funds in the firm from the debt or the equity, overall cost of
capital is going to remain the same. It is not going to change. You cannot say that the debt as
having the tax deductible advantage so it is a cheaper source of funds. That thing is not going
to happen mind it.

So this approach and this approach is literally followed by the Modigliani and Miller, the first
proposition, the first hypothesis of the Modigliani and Miller which they propounded or they
proved in 1958 under their first theory of the capital structure, they themselves agreed with
this say approach net operate means it says the first proposition.

The first part of the Modigliani-Miller theory is the replica of the net operating income
approach in that approach, they have empirically proved it after the systematic research they
have proved it that debt and equity has no say difference to make in the overall capital
structure or the capital structure has no meaning the debt and cost of debt and equity is same.
But the moment you increase that debt in the firm with the objective of reducing the cost, cost
of equity goes up. So, it has no meaning, overall cost of the capital is going to remain the
same.

So, if you are employing them in the equal proportion, then there is a different cost of capital,
but if we want to reduce the cost of capital and increase the component of debt in the firm,
because the debt has the tax deductible advantage, in that case cost of equity is going to
increase. So, net result is going to remain the same, it is empirically proved by the
Modigliani-Miller in the first part of their theory.

However, they have rejected their own theory in the second version, and then they have
proved it that yes, the say employing the more amount of the debt in the firm reduces the
overall cost of capital, so, the capital structure has a meaning. It means the first approach was
then accepted by them, that is a net income approach. First, they accepted the net operating

892
income approach, this approach which says that it has no meaning, capital structure has no
meaning.

Whereas, the second proposition of the Modigliani-Miller says that capital structure has the
meaning and cost of equity and debt remain unchanged, but debt having the tax deductible
advantage, reduces overall cost of capital of the firm and maximizes the value of the firm.

(Refer Slide Time: 30:07)

So, now let us understand this approach systematically, the net operating income approach.
So, first see what is given here, according to this approach the overall capitalization rate rA
and the cost of debt remain constant for all degree of leverages. This is not going to change rA
is not going to change, rD is also not going to change right.

The cost of overall cost of capital and the overall capitalization rate and the cost of debt
remain unchanged constant for all degree of leverages. So, finally, if this is, these two are
constant, so you can easily calculate the cost of equity with the help of this equation that rE
will be equal to overall capitalization rate rA plus rA minus rD.

So, from the total capitalization rate when you subtract the part or the cost of the debt, say in
in the proportion of the debt equity ratio, so you will be means left with something which is
called as the say cost of equity, right. So, they have, what this approach says this approach
was basically given to us by the David Durand, right. So, he was advocate of that, I
understand that the cost of debt is lesser as compared to the cost of equity, but what happens?

893
See here, now, he has said he has proven with the help of this structure, that here we have the
rate of return, this is a debt equity ratio on the x axis we have the debt equity ratio on the y
axis we have the rates of the return. And these are the cost. This is the cost of debt, like in the
previous approach, costs of the debt is unchanged in this case.

In the previous approach, this RA was say showing a declining trend and RE was stable. But
in this case, RA is now showing the stable trend. And RE is showing the rising trend. So what
is the meaning what I discussed with you just a moment back that the moment that
component of debt increases in the firm when you move in the debt equity ratio from the zero
to this side. So, if you are having the amount of debt in the firm, so cost of debt is this much,
but the cost of equity is this much.

And if you increase the amount of debt in the firm, so, the cost of debt will be this much but
the cost of equity will be this much and if you (break) make the amount of debt in the total
capital structure on the debt equity ratio up to this level, then the cost of equity is this level.
So, what is happening? You are increasing the amount of the debt in the firm with the
objective that this is a cheaper source of the firm because of the tax deductible advantage.

So, you are increasing this component and you want to reduce the overall cost of capital but
what is happening? The moment you are increasing the amount of debt in the firm the equity
shareholders are increasing their cost. So, this reduction in the cost of capital because of the
cheaper source of the firm is offset by the increased cost of the capital coming from the
equity capital.

So, ultimately RA is same here, RA is same here and RA is same here. So, in all the 3 levels,
the overall cost of the capital or overall capitalization rate for the firm is same, because equity
shareholders assume that increased amount of the debt employed in the firm brings more
amount of the risk in the firm and that is not means good for the equity shareholders. So, they
should be compensated for bearing the increased amount of the risk because of the increase
the amount of the debt. So, our cost of the capital has to go up.

So, one source you are reducing the cost of capital, other source is increasing the cost of
capital as a result the net result remaining the same that ultimately your overall say
capitalization rate or the say weighted average cost of capital that is RA is going to remain
same, it is not going to change. So, what we conclude? You can say that this capital structure

894
has no meaning, it does not affect the say the cost of the capital largely the cost of capital
remains the same, whether the funds come from debt or the funds come from the equity.

So, if you feel that we are employing more amount of the leverage or debt, the overall cost of
capital can be brought down. So, this is a myth, it is as per this approach it the overall cost of
capital or the overall capitalization rate which is depicted here by RA is going to remain
same, it is going to remain unchanged. So as per this approach capital structure is not
important.

So, firm should not spend time on deciding about from where the funds will come, it will
depend upon the easy availability of the funds, whether the funds are available from the
equity or from the debt wherever from whatever the source the funds are available, they
should be employed and the capital structure of the firm should be formed, but not with this
objective that they have more amount of debt, then the overall cost of capital will go down.

(Refer Slide Time: 35:01)

So, let us understand this with the help of this say one example, some say conceptual
discussion is given here. So, what this net operating income approach says? This approach
says, let us read these points quickly. Market value of the firm depends on operating income
and the business risk.

This is the person who has propounded this theory, David Durant, he has said that basically
the market value depends upon the two things, the operating income and the business risk.
Second thing he says, change in the degree of leverage. Change in the degree of leverage
employed by the firm cannot change these two underlying factors.

895
Change in the degree of leverage employed by the firm cannot change these underlying
factors which means the operating income is going to remain the same because cost of capital
is going to remain the same and business risk is also going to remain the same. So no change
is going to be there. It merely changes the distribution of income between debt and equity.

It merely changes the distribution of income between debt and equity without affecting the
total income and risk, which influences the market value of the firm without affecting the
total income, this is most important and the risk which influenced the market value of the
firm. And the last, second last point is hence the degree of leverage per se cannot influence
the market value of the firm.

So, what is the purpose of spending the time trying to know about how much debt has to be
there, how much equity has to be there? So, it is written here, MM also endorsed the this
approach in their seminal work, which was say presented and published in 1958. So, first
theory, propounded by the Modigliani and Miller in 1958 also accepted this approach.

(Refer Slide Time: 36:50)

Now, let us understand this approach in the practical sense. And if you try to understand this
approach in the practical sense, here is the one example and this example will help us to
understand to calculate the overall capitalization rate. So, in this case, net operating income
approach and we are given here the information like the net income approach, we are given
the say information about the two firms.

So, one firm here it is, this is the firm A and this is a firm B right and we are given the
particulars. So, you can understand that what the information is given to us, net operating

896
income this is basically the EBIT earnings before interest and tax. This is the say EBIT you
can write it here as EBIT earnings before interest and tax net operating income. So, which is
same in both the cases firm A and firm B, again 10000 rupees.

Overall capitalization rate is again same, overall cost of capital is same, that is 15 percent
right, total market value is of this form is also same Rs 66,667 right. And interest on the debt
is Rs 1000 here, interest on the debt is Rs 3000 here, interest on debt is this much here and
interest on the debt is this much here and here we talk about that capitalization rate,
capitalization rate is again 10 percent, it is again 10 percent.

Market value of the equity is Rs 56,667 and here it is Rs 36,667. So, market value of the debt
is this much, market value of the debt is this much and debt equity ratio is this much debt
equity ratio is this much in this firm, debt equity ratio is just 17.6 percent and in this firm the
debt equity ratio, debt to equity ratio is at 81.8 percent. So, we should means be able to find
out, what we have to find out here? Calculate the equity capitalization rate for both the firms.

Calculate the equity capitalization rate for both the forms so if you talk about the equity
capital capitalization rate for both the firms so you can call it as that means equity
capitalization means the cost of equity for both the firms. So, in this case, we have to prove it
missing with the help of this example, we are going to prove it, the moment you increase the
amount of the debt in the firm, the cost of equity increases and this is the equity capitalization
rate we are going to calculate here.

So, it means, in this firm A, the amount of debt is much less that is just Rs 10,000 as
compared to this firm, firm B. So, it means the equity capitalization rate for the firm B must
be higher as compared to the firm A and that is what we are going to calculate or we are
going to find out. So let us calculate the equity capitalization rate for both the firms and then
try to find out whether the equity capitalization rate increases with the increase in the amount
of financial leverage or debt or not.

897
(Refer Slide Time: 39:52)

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So, equity capitalization rate for, and equity capitalization rate or equity cost, equity
capitalization rate for the firm A. Let us calculate this, so if you calculate the equity
capitalization rate for the firm, firm A. So, how you can calculate is? Equity earnings divided
by the market value of equity, equity earnings divided by the market value of equity. So, let
us see what is the equity capitalization rate here?

So what is the equity earnings here? We are given equity earnings if you look at the problem,
equity earnings given to us are here, that is total operating income is how much? Net
operating income is Rs 10,000. So, what is the cost of debt here? Rs 1,000, so equity
happening is Rs 9,000, in this case equity earning is Rs 7,000 because cost of the debt is Rs
3,000. So it is going to be how much? Rs 9,000 and what is the market value of equity?

Rs 56,667 in the total market capitalization of the firm Rs 10,000 is coming from the debt and
Rs 56,667 is coming from the equity. So this will work out as 15.9 percent right. This is this
will work up as 15.9 percent and now will calculate the equity capitalization rate for the firm
B. So, you can write here for the firm A and B not for only the one firm, so firm B, the equity
capitalization rate for the firm B is how much? Equity earnings are how much?

Equity earnings we have seen, because total earnings are Rs 10,000, cost of the debt is Rs
3,000. So, equity earnings are going to be Rs 7,000 and here the composition market value of
equity is because Rs 30,000 is coming from the debt. So, only Rs 36,667 is coming from the
equity. So, the market says this capitalization rate of equity goes up that is 19.1 percent. So,
we were say trying to find out here that with the help of this equation also with the help of
this equation also you can calculate the say equal equity capitalization rate.

899
So, let us you calculate it for the firm A you can calculate with the help of this equation also,
this is going to be how much? 15 plus the 15 minus 10 into what is this 0.176 debt equity
ratio, so what the equation requires? The cost of equity is equal to the overall cost of capital
of the firm into overall cost of capital minus cost of debt multiplied by the debt equity ratio.

So, overall cost of capital of the firm is over a capitalization rate is how much? Overall
capitalization rate is 15 percent here overall capitalization rate is given here 15 percent. So,
we are going to make use of it. So, 15 percent is the overall capitalization rate plus 15 minus
10 into this, so, this will come out as straightway it is the same amount 15.9 percent. This will
come up as 15.9 percent and if for the firm B with the help of this equation, you can calculate
this amount is going to be 15 plus 15 minus 10, 15 plus 15 minus 10. Again, this is the cost of
the debt is going to be a 10.

So, we are going to take here as the, what is the cost of the debt capitalization rate is 10
percent. So, this is the say cost of the debt is 10 percent overall cost of capital is 15 percent,
but the debt equity ratio is changing and now the debt equity ratio is 0.818. This is 81.8
percent. So, the same amount you can calculate as calculated above and this is going to be the
equity capitalization rate.

So, equity capitalization rate goes up, the moment the amount of financial leverage or the
debt increases, and this is what we have tried to prove here in the two firms, one is employing
the lesser amount of debt another is employing the higher amount of debt in the one there is a
Rs 10,000. in the other there is the Rs 30,000. So, we have seen here empirically with the
help of this example, the moment the amount of debt in the total capital structure on the debt
equity ratio increases, equity shareholders increase their capitalization rate and ultimately the
overall cost of capital that is rA depicted by rA remains same.

So capital structure has no meaning, whether you bring the funds from debt and equity that is
not going to affect because ultimately, the value of the firm depends upon the operating
income and the business risk. So this is what this approach says. And this approach I am
again say repeating that it is also supported by the Modigliani and Miller in their first part of
their say very so you can call it as a renowned and classical theory on the capital structure.

So, before we close the discussion for this class, let us talk quickly about the next approach
also. And that approach, the third approach is the traditional approach. The third approach is
the traditional approach and in this approach means finally you can say something is drawn

900
from the first something is drawn from the second approach, something is from the net
income approach, something from the net operating income approach.

And finally, this approach says that means ultimately it also concludes that capital structure
has lesser meaning. It does not totally reject that the capital structure has no meaning. It
guides it to some extent, but ultimately not in the way that a normal standard theory on the
capital structure should be guiding the firms to form their capital structure.

(Refer Slide Time: 46:18)

So, what this traditional approaches says? rD, the cost of debt remains more or less constant
up to a certain level of leverage. But rises thereafter at an increasing rate, cost of debt remains
constant, cost of debt remains in the other two approaches, we assumed or we found that the
cost of debt remains unchanged. Here this approach says, cost of debt remains constant up to
a certain level, but rises thereafter, at the increasing rate.

And cost of equity as per this approach remains more or less constant, or only rises gradually
up to a certain level of leverage. This is supporting the second approach and rising sharply
thereafter, right. So this is a say partly it is supporting the net operating income approach that
the movement the amount of leverage increases in the firm, cost of equity rises at a very
faster rate or at the sharper rate.

And overall cost of capital rA, as a consequence of the above behavior of rE and rD does what?
Number 1 decreases up to a certain point because amount of the debt is higher and the cost of

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debt is low and the amount of amount of equity is low and amount of cost of equity is higher.
So, as a result of that, the rA decreases up to a certain point.

Number 2, remains more or less unchanged for a moderate increase in the leverage thereafter,
and rises beyond a certain point and that too at a very sharper say pace or at very faster pace.
So it means the cost of debt is stable to a certain point. Cost of equity is also stable up to a
certain point, but the moment you increase the debt, cost of debt also increases or starts going
up and cost of equity also goes up because a component of the debt is increasing.

So, your overall cost of capital also behaves like that, it remains say it decreases to certain
extent, because the amount of debt is say there in the firm, but the moment you increase the
amount of debt. So, overall cost of debt also goes up equity costs also goes up and the overall
cost of capital say increases overall capitalization rate of the firm increases, because that debt
has increased.

So, cost of debt is also increasing. So, debt has increased, so cost of equity also has increased
and overall capitalization rate has also increased. So, this is more you can call it as a practical
theory or maybe what is happening in the market or has been happening in the market. At that
point of time, this theory has been pounded out of the practical as empirical situation in the
market.

So, a next thing is not sharply defined like say this approach, not sharply defined like net
income and the net operating income approaches. This means we are talking about the
traditional approach. So, as per this approach the cost of debt, cost of equity and overall, cost
of capital has been defined first, after that it is say observed here that this approach is not
sharply defined like net income approach or net operating income approach.

And its approach says, cost of capital is dependent upon the capital structure and there is an
optimal capital structure that is, that minimizes the cost of capital. Means this approach talks
about the optimal capital structure that minimizes the cost of capital, optimal capital structure
and this approach further also says that, at the optimal this capital structure, cost of debt and
equity is same. So, that is, that capital structure is called as the optimal capital structure.

But the moment you say change the proportion of debt and when the say in this case what it
is written here? At the optimal capital structure, the real marginal cost of the debt and equity
is same, that is why we call it as the optimal marginal, this capital structure. Because
marginal cost of debt and equity is same at this level.

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And next thing is before the optimal point, the real marginal cost of debt is less, the real
marginal cost of debt is less than the marginal cost of equity and beyond the optimal point,
the real marginal cost of debt is more than the real marginal cost of equity. So, overall cost of
capital goes up. So, it means, we need to develop a capital structure which can be called as
the optimal capital structure which way can be called is the balance the capital structure,
where the proportion of debt and equity should be in the say more or less you can say in the
equal proportions so that two costs are equal.

So, that is called is the optimal capital structure, but the moment you change the proportion of
debt or equity, so the level of optimization is going to get disturbed and the moment the level
of optimization gets disturbed. So, if you increase the amount of debt in the firm, initially the
cost of debt will be low, but beyond that beyond a certain point, it will increase at a very
faster pace, increasing the overall cost of capital.

Similarly, because of the increased amount of the debt beyond the optimal point, the cost of
equity will also increase because of the increased amount of the risk because of the higher
amount of the debt in the firm. So, overall cost of capital will increase because cost of debt
has also gone up, cost of equity has also gone up so overall capitalization rate has gone up.

So, this seems to be some practical say basis of defining this approach, which is the
traditional approach observed maybe say about 50, 70 or 70 years back in the market. And
whatever was happening at that time, it was found it was observed at that time. So, the
traditional approach was developed. So till now we discuss the three approaches. One is the
net income approach, net operating income approach and traditional approach.

And now a million-dollar question is that which approach is the most appropriate for defining
or deciding the capital structure of the firm? Which approach is the most appropriate, it is
very difficult to decide which approach to accept, which approach is say going to give us the
final result of these out of these three. It is a very-very conflicting issue, because these are all
three say approaches are going to give us the conflicting results.

So, it is totally not means it will be totally incorrect to accept either of the three or maybe not
to accept any of the approach or finally we have to means get an answer that one approach
says something, other approach says something, third approach say something. So, which one
is correct, which one is to be accepted?

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And for that, we have to move to the next level and that next level is the say, systematic
research based scientific theory of the capital structure given for the first time in 1958 by
Franco Modigliani and Merton Miller, and in the next class, I will discuss with you in detail,
the Modigliani-Miller theory of the capital structure.

We will first learn that what was the original theory, first proposition of the theory given by
these two novel laureates, financial economists who were who became novel laureates later
on what was the first version first proposition of the capital structure theory given by these
two people, these two novel laureates and how they change their own findings of the first
propositions in the second proposition.

So that all means we will be talking about, we will be learning about the say systematic
approach of the capital structure, Modigliani-Miller theory of the capital structure, but in the
next class till then, thank you very much I will stop here for this class and we will resume
next class or we will start talking about say the capital structure, we will resume the
discussion on the capital structure in the next class, where we will talk about the MM theory,
Modigliani-Miller theory of the capital structure. Thank you very much.

904
 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 55
Capital Structure –Part 2

Welcome all. So, in the process of learning about the capital structure and its various theories,
now I will take you forward with the next important theory, which is a landmark in the
history of say studying the capital structure of the firms. That theory is called as the Capital
Structure theory given by the Modigliani and Miller, Franco Modigliani and Merton Miller
they have given a very-very say after their classical say research, they have come out with a
very classical theory of capital structure.

So, before as I told you in the previous class, also that before this say standard theory or the
classical theory of the capital structure given to us by these two Novel laureates in financial
economics. Before that, whatever the approaches we had with us we have already discussed
those approaches, net income approach, net operating income approach and traditional
approach, they all had the different views and we were not able to accept which one is correct
and which one to accept.

But after this work, which was a say first of all say presented to the people in 1958, for the
first time, and later on, they revised it and then they changed their own say first proposition
and the second proposition of the capital structure theory was given. So, now we are going to
discuss that historical work that historical say a model of capital structure and say, we are
going to conclude logically that how the capital structure of the firms has to be decided.
Because earlier we concluded that the say capital structure has no meaning.

For example, if you talk about the net operating income approach, so net operating income
approach says that the cost of debt and equity does not remain the same right. Say as the
moment the debt moves into the firm; the cost of equity capital goes up. So, finally, if you
talk about the overall capitalization rate or the cost of capital for the firm that remains the
stable but the net income approach was contrary to this that was the reverse to this, and it said
that yes, debt is cheaper than the equity.

And say, if we say infuse more amount of the debt in the firm or in the firm’s capital
structure, then the say overall cost of capital tends to go down. So these are the two
approaches, which were scientifically tested by Modigliani and Miller, and when they gave
their own say, standard approach of the capital structure, it also was divided into 2 parts, first

905
one is the first proposition of that capital structure theory given by the two these nobel
laureates and the second one was given as a second proposition again by these two people.

So, if you talk about the first theory, the first theory is basically almost you can call it as the
replica of the net operating income approach. in the net operating income approach also, as I
just I told you that net operating income approach says that, overall cost of equity overall cost
of capital remains same, because the moment you infuse the amount of debt in the firm, the
cost of equity capital goes up.

Because the required rate of return is increased by the equity shareholders because of the
increased amount of the debt in the firm, right So, that is a net operating income approach
and Modigliani and Miller hypothesis or this approach also supported the net operating
income approach. And for that they gave one argument which was called as very famous
argument in support of their proposition was arbitrage argument right.

So, let us discuss what this approach is both the propositions I will discuss with you in detail,
that is the first proposition of this theory and the second proposition of this Modigliani and
Miller theory of the capital structure and then we will conclude that now, say is there any say
reason or the meaning of the capital structure for the firms or say capital coming, maybe from
the equity or debt has equal cost and it does not make any sense to increase the amount of
debt or the amount of equity and to differentiate between the say overall cost of capital.

So, we will conclude it after say having the detailed discussion about this theory of the capital
structure given by the, Modigliani and Miller, right.

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(Refer Slide Time: 4:53)

So, before we move into the theory, let us say read these very important lines, which are
given to us by one, say another novel laureate in economics, that is, Robert Merton and
Robert Merton has means created a clear cut demarcation, a line of demarcation between the
say theories before the Modigliani-Miller theory and the theory given by the MM that is a
Modigliani and Miller.

So he has very nicely, very beautiful he has said that what was before this theory and what is
after this theory, and how this theory has totally changed the landscape of the capital structure
discussion. So, let us see here what Robert Merton has to speak about the say Modigliani
Miller theory of the capital structure. He says that Modigliani-Miller work stands as the
watershed. It stands as the watershed between the old finance and essentially loose
connection of the beliefs.

It is a loose connection of the beliefs because one approach says that the debt makes a
difference in the overall costs of capital, second approach is that the moment that comes the
cost of equity capital goes up. So capital structure has no meaning and traditional approach,
say something else. So, you can call it as these this was nicely means a remarked as that lose
connection of the beliefs based on accounting practices, rule of thumb and anecdotes.

Anecdotes means theories or sorry the stories or tales. And the modern of financial
economics, the modern financial economics means it is a point of demarcation here. There is
a point of demarcation here that Modigliani Miller work stands as the watershed between two
between old finance and essentially loose connection of beliefs based on accounting

907
practices, rule of thumb and anecdotes and modern financial economics which is given by
these two people Modigliani and Miller.

Franco Modigliani and the Merton Miller with it is a rigorous mathematical theories and
carefully documented empirical studies. So after very long and say detailed research on the
capital structure of the different firms these two say financial experts have proposed this
model. So, being a student of financial management you cannot afford to say not know
anything about the MM theory of the capital structure, which is the most scientific and the
say systematic theory of the capital structure which has come up after the long, very long and
the detailed research conducted by these two financial experts.

So, we are going to learn about that what is this say MM theory of the capital structure and
what difference does it make. So, this theory is based upon the 2 parts means first part is the
first proposition of the MM theory. Second is the second proposition of the MM theory. In
the first preposition that things are totally different. In the second proposition, the things are
totally different.

So, in nutshell you can see in the first preposition Modigliani and Miller have supported the
net operating income approach and in the second say preposition, they have finally supported
the net income approach and they have agreed they have accepted it say after the empirical
say analysis that yes that makes a difference that the amount of the debt if means the amount
of the debt increases in the capital structure, overall cost of capital goes down and say, it
increases the return to the equity shareholders right.

Whereas, in the first case, they have said that the costs of the debt and the equity is same, so
it means, in the first case, they will say that overall cost of capital of the firm remain same.
And the moment you increase the amount of debt in the firm, the cost of equity goes up. So,
you are bringing the funds from a source which have the lesser cost of funds whereas, the
other source is increasing its cost.

So, overall capitalization rate remains the same overall cost of capital remains same. This is
the first proposition and the second one is that when that debt comes in the firm, the overall
cost of capital goes down and this is a benefit to the equity shareholders. So, in this case, let
us discuss the first preposition and to understand the first preposition very clearly, Modigliani
and Miller have taken the say these 5 important assumptions right.

They have taken the 5 important assumptions, their first part of the theory is based upon the 5
major assumptions and these assumptions are first is the perfect capital market, it means,

908
there is a complete say flow of information, symmetrical flow of information in the capital
market, all the managers, all the investors know that what is going to happen in the market,
what are the different stocks are available, how the market is going to respond, which stock is
going to go up, which stock is going to come down.

So, perfect capital market situation is expected by them as the first assumption before
proposing this model. Second is rational investors and managers, managers and investors
have the equal amount of information because of the capital market and they whatever the
decision with regard to the investment in the say, stocks of different companies of say maybe
of the different nature or different durations they take that is means rationally, the decision is
taken.

There is no amount of or element of irrational team amongst the investors and managers.
Everybody is equally say, rational homogeneous expectations, the rate of return as well as the
say costs of capital means is well understood by all in the same way by one and all. And then
is a equivalent risk classes. Whatever the different stocks are available in the market, they
carry the equivalent amount of the risk. T

he amounts of the risk is not different, with a different kind of the say sources or may the
avenues of investment and absence of taxation there are no taxes right. Absence of taxation,
there are no taxes. So, if you look at these 5 assumptions, they look or they seem to be highly
unrealistic, because capital market is never perfect. Second thing is investors and managers,
all investors and managers cannot be rational, homogeneous expectations cannot be right.

And equivalent risk classes are not expected to be there in the market that all the stocks are
carrying the equal amount of the risk and absence of taxation is again another unrealistic
assumption. But they have taken they have developed this theory this model on the basis of
these assumptions, and if you say consider these assumptions, means a carefully, then how
the model has been proposed, how the model has been say given by or the first proposition of
the capital structure by the Modigliani and Miller has given that is we are going to understand
here.

909
(Refer Slide Time: 11:57)

So, MM proposition this is a fast proposition this is a proposition number one. This is the first
part of the Modigliani-Miller theory of the capital structure. And what this first proposition
says? The value of a firm is equal to its expected operating income, the value of its the value
of a firm is equal to its expected operating income divided by the discount rate appropriate to
its risk class.

Higher the amount of risk, higher the amount of discount and discount rate and lesser the
amount of risk less of the amount of discount rate and it is independent of capital structure.
You look at this it is independent of capital structure, the value of the firm is independent of
the capital structure. This is a first proposition given by the Modigliani and say Miller is the
first part of the theory.

910
They also supported the net operating income approach. And they said that debt has no
meaning that you have say capital from the debt or you bring it from the equity. The value of
the firm is cannot be affected by these sources of the funds it is independent of the capital
structure. And finally, they gave the first part of the model was that is the V is the V is equal
to D plus E is equal to O by r.

So, V is basically the market value of the firm, D is the market value of the debt, E is the
market value of equity and O is expected operating income and r is the discount rate
applicable to the risk class to which the firm belongs, right. So, it means basically it depends
upon the operating income and that operating income to arrive at the present value of the
operating income you have to discount it with the say some discount rate and that will depend
upon the risk associated to the that particular firm or that particular stock of the firm.

So, finally, they have said they have concluded that independent of the capital structure it has
no meaning, means the capital structure has no meaning for the firm and value of the firm
does not depend upon that capital, you cannot mean, change the value of the firm by having
the funds from different sources, that one has the lesser costs and other has the higher cost.
So, if you increase the amount of the funds, which is having the lesser cost, so naturally the
cost of capital will go down.

So, the rate of return available to the equity shareholders will increase leading to the final say
maximization of the value of the firm right. So, it is clearly written here that it is identical to
something which is called NOIA that is Net Operating Income Approach, they have
supported the say the net operating income hypothesis or the net operating income approach
and in the net operating income approach also, if, you we go back, you will you will find here
that what is the net operating income upload says net operating income approach says that see
the cost of debt is same.

The cost of overall cost of capital is also same. So the, this approach says the moment you
increase the amount of debt in the say total debt equity ratio of the firm, the cost of equity
capital goes up. So, finally, the RA remains the same. Finally, the cost of overall cost of
capitalization or overall capitalization rate of the firm remains the same because one is having
the lesser cost of capital others cost of capital it is increased.

So, ultimately your cost of capital overall capitalization rate of the firm remains same. So,
this is what it is said here. And for that purpose they have given the arbitrage argument also,
they have given the arbitrage argument also.

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(Refer Slide Time: 15:39)

And here what is the arbitrage argument and how they have tried to explain it, let us
understand it in the say clear meaning or in the clear sense. What arbitrage argument says
which is given by these two proponents of this capital structure theory, MM theory. First
point of the arbitrage argument says in equilibrium identical assets must sell for the same
price.

In equilibrium, when there is an equal amount of the supply of the funds from all the sources
from different sources, identical assets must sell for the same price, irrespective of the fact
how they are financed. For example, you talk about any asset of the firm, whether it is
financed from the debt or equity, it is not going to make any difference at that if it is financed
by equity. So it is going to fetch the lesser price from the market, or if it is, say financed by
the debt is going to fetch the higher price from the market, that is not going to say make the
difference.

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So it means capital structure means if you think about that, you can reduce the cost of capital
overall cost of capital of the firm, so more funds should come from debt or lesser from the
equity. That is not going to make the difference. No matter how you package a set of cash
flows, it is value remains unchanged this is a second argument they have given. And third is
the most important argument to support their arbitrage argument is to see how arbitrage
mechanism works.

Consider 2 firms’ U and L, they have we can understand this argument with the help of an
hypothetical case, where we are going to take up now the case of the two firms. Firm U is the
unlevered firm and financed by the equity alone whereas the firm L is the levered firm and it
is finance by a mix of debt and equity right. So, let us create a situation where if you want to
understand the arbitrage argument, where say these two people say these two financial
experts say that debt and equity does not make a difference.

And for that they have extended the arbitrage argument. So what is arbitrage argument and
how we can well understand it, let us means so consider 2 firms here. And these 2 firms, I
have put the data of the two hypothetical firms here, we have put the firms, 2 firms here, one
is the firm U and second is the firm L. U means the unlevered firm, which is the total capital
structure of the firm is financed only through equity, no debt is there and is totally unlevered.

Levered means, when you talk about that leverage is the debt, if you bring any amount of the
debt in that capital section of the firm that is called as the levered firm, and if it is free of the
say debt in the capital structure then it is called as the unlevered firm. So, sorry if it is I will
correct it that for example, the say what is the unlevered firm? Leverage means the debt the
amount of debt, leverage means the amount of debt so, when you talk about the firm U, it is
unlevered firm.

The amount of debt in this firm is 0. The capital structure of this firm is totally financed by
the equity and no amount of the debt has been used here in the capital structure of this firm.
And even you look at this say what is given to us here, operating income is EBIT that is
Earnings Before Interest and Taxes Rs 150000 interest is 0, because no debt is there, entire
amount has come from the equity and say you see here that is a market value of the equity
here is a Rs 10 lakhs, 1 million rupees, the total investment made in this firm is 1 million
rupees Rs 10 lakh rupees, entire amount has come from the equity, so no debt is there.

That is why this form is say as a named as firm U, it is totally unlevered firm. Whereas this
firm is named as firm L which is a levered firm. And in this firm if you look at the say total
sources of the funds coming from, so, number one is the market value of equities this much

913
and the market better of debt is this much right. And market value of the firm as a whole, if
you talk about this is Rs 1 million and this is Rs 1.62 million.

So, it means these are the two firms and one is only if equity finance firm, second one is
financed with the equity and debt both. So now, one is unlevered firm second is the levered
firm. And now, let us means say with the help of this arbitrage argument, try to understand
what is arbitrage argument and how Modigliani and Miller are going to say prove it that
capital structure has no meaning and say whether you finance yours say total funds the
requirement to bring in with the help of debt or equity or maybe only equity or only debt, it
has no meaning.

And finally, the overall save cost of capital to the firm is going to remain the same. So what
is the arbitrage argument they have given with the help of this these two firms we are going
to understand that. Now in this case, for example, operating income of the 2 firms, how much
is operating income? Rs 150000, how much is the operating income? Rs 150000, same
operating income of both the firms is 150, 150.

Whereas the market value of the firm which is unlimited from only finance with the help of
equity is 1 million, whereas the market value of the firm is more than this firm by 62500
rupees whereas the operating income is same. So, the market value of the two firms is
different, but the operating income is the same right. And if you talk about the equity
earnings, the equity earnings are here Rs 150000 because total what is the cost of equity here,
market value of equities 1 million.

Cost of equity is 15 percent. So, equity earnings are Rs 150000 entire amount will go to the
equity shareholders whereas in this case because debt and equity have come in the different
proportions. So, only one part of the income will go to the equity because the one first will go
to the say the suppliers of debt or to the lenders. So, it means because the market value of the
debt is Rs 50000 and the cost of debt is 12 percent.

So, it means after settling the claims or servicing the debt component, which is 5 lakhs into
12 percent, is Rs 60000 rupees. So, out of Rs 150000 rupees operating income Rs 60000 will
be going as the interest component here and only the equity earnings will be 90 percent. So,
this is the whole case if you look at that unlevered firm and the levered firm operating income
of both of firms is same the but the market value of the two firms is different.

Market value of the unlevered firm only financed by the equity is 1 million whereas the
market value of this form is Rs 10,62,500. So, in a way you can interpret it that the market

914
value when the market value of the two firms is different, but the operating income is same.
So, in this situation, what is going to happen and how the arbitrage argument is going to work
right, how the arbitrage argument is going to work.

So in this case, what is going to happen that this situation cannot persist? As per the arbitrage
argument, when the say market value of the two firms is different and the operating income is
same, this situation cannot sustain in the market, this situation cannot say persist in the
market, this situation is not permissible, this is going to change, how this situation is going to
change? Because in this form normally what happens that say when you talk about the say the
firm which is having the higher value.

The firm which is having the higher value there because we always assume that the scope for
the further growth of the firm is not there in the market. So, what they investors do, sometime
what the investors do that say who are the short term investors in the market they say that
now, this is a maximum growth of the firm and this firm is not further going to grow in the
market.

So, let us sell our stake whatever the earnings we had to do in this firm, let us sell our stake in
this firm and say part of the stake we can invest into the firms which are say still have the
scope to grow in the market. So, if you look at this, these two firms market value of this firm
has already reached to Rs 10,62,500, whereas the market value of this firm is lesser. So, this
firm is having the lesser market value as compared to this firm. So, it means, there is a
possibility that the unlimited firm may further grow up in the market.

So, if you buy the stock of the unlevered firm today and further it grows over a period of
time. So, it will be the net gain to the equity shareholders. So, it may be possible because and
the market value of the two firms is different either the market value of all the firms has to be
same, then the arbitrage argument is not going to work, but if the market value of the two
firms this is different.

So, what is happening, the investors having the higher market value, the firms having the
higher market value, they will sell the stocks of those firms to earn the say differential
amount in the terms of the profit or that return on investment and then they can invest into the
say the firms having a lesser market value and finally they expect that the firms which are
having the lesser market value, they will also grow.

And normally it happens in the market also that you do not tend to buy the stocks of those
companies whose market value is already very high. Because the growth rate is already has

915
been attained and further possibility of the growth is not there. We try to buy the stocks of
those companies whose stocks are at the at the lesser price. And we expect that they will also
grow over a period of time and at least reach up to a level where the other firms in the
industry are there in the market.

So if you buy at a lesser price and the stock grows over a period of time. So, at that time,
when it grows up and you sell that stock in the market, you earn the better returns right. So,
for example, same thing will happen in this case, because the firm which is having the higher
value, the stock of this may be sold in the market by the investors and the firm having the
lesser value, the stock of this firm will be purchased and over a period of time means,
expected that the stock of the firm U will also grow in the market.

But what is the arbitrage argument? Now, what happens that when the people will start
selling the stock of the firm L which is having the larger or the higher market value, the stock
price of this firm will start falling and the stock price of the firm is start going up, because the
demand for the stock of the firm U is now increasing. So the price of the stock of the firm
whose demand is increasing the market start going up and the price of the stock of the firm
whose stock is being sold in the market who supply is increasing in the market will fall down.

So, what will happen? Today the value of L is higher, so, people are selling L and buying U
right. Tomorrow, what will happen that the price of U will go up. So, people will start selling
U and start buying L. So, this process will continue unendingly and that is not possible
because this is arbitrage, this process is called as the process of arbitrage and this process will
continue.

So, we have to stop this process somewhere, if you want to stop this process somewhere. So,
means we have to create a situation where the market value of all the firms is equal. So,
ultimately the market value as per the first preposition of the MM model, the market value of
all the firms remains the same, it remains unaffected otherwise arbitrage will start taking
place will happen in the market and if arbitrage continues in the market, so it means they will
be no stability in the overall, say capitalization process of the firms.

So, now how this process will work, how the arbitrage will work and how the things will say
keep on moving in the markets, I will discuss with you means further taking this discussion
on. So, how we can do it?

(Refer Slide Time: 28:20)

916
917
For example, there is a investor who has a 10 percent stake in firm L right, he will sell his
stake in the 10 percent stake in the firm L and what is is a total value of that stake in the firm
L say, what is a total equity value in the firm L? The equity value of the firm L is market
value of the equity is this much right.

So, if any investor who is having a stake of 10 percent in this firm L if he sells his stake 10
percent stake which he has, if he sells entire stake in the market how much amount he will
get? He will get the total amount is number 1, he will get the total amount of rupees, how
much, Rs 56,250, right he will get this amount.

And now in the second case because now he wants to sell the stake in firm L and want to buy
the stake in firm U to earn, say differential amount of the profit, so what he will do? He will
borrow, he will borrow another amount of say I will call it as Rs 50,000 from the market, he
will borrow rupees Rs 50,000 from the market how much that is equivalent the 10 percent of
this total debt in this firm say L and what is the cost of borrowing, 12 percent.

So he will borrow 50, another Rs 50,000 at the rate of 12 percent. So, total amount which is
available with him is how much? That is going to be Rs 1,06,250 this amount is going to be
Rs 1,06,250. And out of this number three, he will buy the stake, how much? 10 percent stake
and 10 percent stake of this firm is how much is the total, market value of the firm, it is 1
million rupees 10 lakh and he will buy 10 percent of this and he will shell out how much?

He will shell out that 1 lakh rupees here and still the difference how much amount is still
available with him? Rs 6,250 still available with him right, so he has 10 percent stake in the

918
firm L which is sold in the market and he borrowed another Rs 50,000 at the same rate of
interest which is the firm L is paying in the market.

So, what is doing? This 10 percent borrowing Rs 50,000 is equal to the 10 percent of the total
debt in the firm L, so what he is doing, he is replacing the corporate debt in firm L be this
personal debt and by raising the total amount of how much, 1,06,250 rupees he is buying the
10 percent stake same amount of the stakes in the firm U and if he buys that, so he has to
shell out only how much?

He has to shell out only 1 lakh rupees and remaining Rs 6250, he can invest somewhere else
in the market. So, if he does this kind of thing, what is going to happen, ultimately his overall
income is not going to be say get affected his overall income is going to remain the same
right. So, because earlier he has that total investment in the firm, say again 10 percent right.
Now, he is also having that investment in the firm equal to the 10 percent of the equity but of
the firm U.

But his income is going to remain the same. So, earlier he has almost invested how much? Rs
1,06,250 by investing the same amount because corporate debt belongs to him as well
because he is the owner of the firm and tomorrow if there is a say problem, any kind of the
financial problem, then out of his equity stake that debt will be paid back to the lenders. So, it
means he is responsible for the corporate debt.

So, in a way you can say earlier he had invested Rs 1,06,250 in the firm where the Rs 56,250
was in equity and he has the share of the debt equivalent to 10 percent of Rs 50000. So, total
income of the total say investment, his investment in the firm was Rs 1,06,250. Now, by
investing the same amount say investing the lesser amount by Rs 6250 by investing just 1
lakh rupees, he can get the same amount of income in the firm or from the firm L.

So, ultimately he is still left with the surplus amount of the Rs 6250. And this amount if he
invests somewhere else, his income will be more than what he is getting from the, from his
investment in the firm L. So how it will work, let us see it that how it is going to be this. So
we will call it as that, say for example old income, this is the old income of the person, this is
the new income.

This is the new income so where old income was when he was in firm L. And now he is in
the firm U right, so in this case 10 percent of a firm’s equity income is equity income is how
much, 10 percent of firm’s equity income in the old firm, if you talk about the old for it is

919
90,000 rupees, which is an equity earning at 10 percent of it because ultimately he has the 10
percent stake.

So this income is going to be Rs 9,000 here. Whereas, in this firm now, the new income is
going to be how much, Rs 1,50,000 he has bought the stake of 10 percent. So his income is
going to be how much? His income is going to be now 15,000 rupees, right. In this case, less
12 percent interest, 12 percent interest on borrowings he is not going to pay any interest here,
whereas he is going to pay the how much is borrowing in from the market? 50,000 rupees.

So, how much interest is going to pay 6,000 rupees, so, we are subtracting this. Finally, the
total income in both the cases, total income here is Rs 9,000, total income here is Rs 9,000.
So, it means, in this case in the new income is means 15000 plus means in this income 15000
less he has to pay the interest cost also because he has only invested from his pocket half of
the investment, half he has borrowed from the market.

So, it means in this case his total income has gone up from the Rs 9,000 to Rs 15,000 and he
has borrowed, he has replaced the corporate debt with a personal debt, so he is going to pay
the interest cost of 6000 rupees. So, it means Rs 9,000 is going to be his residual income,
whereas his income in the old investment was Rs 9,000. So, what is happening, the difference
here is income level is going to remain the same, whereas the investment level is different.

The investment level here is Rs 1,06,250 which was old investment level, Rs 56,250 was the
investment in equity and Rs 5,000 stake he had in the debt of the firm, whereas the new
investment is here only 1 lakh rupees. So, by investing lesser amount by Rs 6,250 he is
ending up having the same amount of the income, so he has left over with the say some
balance of the Rs 6,250 and this he can invest in the market.

So, his overall income will be, the new income plus the income for this investment and
whatever the income for example, if he earns even 200 rupees, so, this income will become
9,200 rupees, whereas this income is only 9,000 rupees. So, it means, this arbitrage will
continue, this arbitrage will continue to happen until and unless the market value of both the
firms remain the same, because what we are seeing here.

If you look at the two form situation operating income is same, but the market value of the
two firms is different or other way around you can say the market value of the two firms is
different, but the operating income is the same. So, what is happening that the firm which is
having the higher market value, the people will start selling their stake in that firm and start

920
buying the stake of the firm whose market value is lesser in the expectation that the market
value of this firm will also go up as a market value of this firm is already very high.

So, market value of this firm will also increase. So, they will earn the increased income over
a period of time. So, in this process what will happen?

(Refer Slide Time: 37:16)

In this process we look at now, say we were we were here that we started talking about the
firms and now, we will say the value of the levered firm is higher than the unlevered firm
even though both the firms have the same operating income and belong to the same risk class,
this is what I was just talking to you value of the levered firm is higher than the unlevered
firm.

Even though both firms have same operating income and belong to the same risk class. Same
such a situation cannot persist because equity investor would do well to sell their equity in
firm L, which I just explained it to you that they will sell the equity in the firm L because that
is that having the more value so they will be able to fetch the higher price from the market by
selling their stock in the market and invest in the firm U which is less valued firm.

So, in the anticipation of increasing the value of the firm U also they will sell it in the say
highly valued firm and then they will invest into the lesser valued firm with the personal
leverage which I told that they will borrow some amount and Rs 50,000 they will borrow
from the say market. So, earlier their investment was Rs 1,06,250, Rs 56,250 was in equity
and his responsibility towards the corporate debt was equivalent to 10 percent which is Rs
50,000.

921
So, in a way total investment becomes Rs 1,06,250. Whereas in the new investment now, he
has got Rs 56,250 by selling the stake in the levered firm, Rs 50,000 he borrows from the
market at the rate of the same rate of interest which the firm L is paying in the market. So,
total amount of the funds now available with him is Rs 1,06,250, so he is now investing only
1 lakh setting aside Rs 6,250 whereas, investing Rs 1,06,250 and investing 1 lakh in the
unlevered firm, his net income is same that is Rs 9,000, what we have seen earlier.

And plus he has 6,250 rupees plus surplus left with him if he invests that also in the market,
he will get some additional income. So, what will happen? Arbitrage says people will keep on
selling in the firms which are more valued and will keep on investing in the firm which are
valued as less in the anticipation that the say valuation or the value of the lesser valued firm
will also go up and the say their stock price will also increase.

So, the moment the value of the lesser valued firm increases, they will sell the stock and they
will make the differential profit and again by the stock of the firm which is less valued. So,
this process will continue and this all is happening because of the say in the levered firm we
had the funds from the two sources and in the unlevered firm we had the funds from the one
source.

So, if you accept the argument Modigliani-Miller said, if you accept the argument debt is
cheaper, and it increases the cost of capital and increases the value of the firm as it has
happened in this case. So, what will happen, the people will sell the stock in this firm, they
will buy the stock in this firm.

Later on, they will sell the stock in this firm, they will buy the stock of this firm and this
process will continue. So, people will keep on making profit just because of the arbitrage.
Arbitrage means, selling the stock in the highly valued firm and buying the stock in that
lesser valued firm. Then later on, after increasing the value of the lesser say a valued firm
selling the stock in the more valued firm and again buying the stock of the lesser valued firm.
So, this process will continue in the market and the market will never stabilize.

So it means if, you bring the sources means the funds from the different sources, you cannot
have that equal value for the say the firms having the same asset class and the same level of
the risk, which is not expected to happen in the market, which is not acceptable argument. So,
in this case finally, what they have said is in that say support of their arbitrage argument.

922
(Refer Slide Time: 41:20)

Note that his risk exposure remains the same right, as we have seen both the firms are having
the equal risk class L and U. Level of risk is same in both the firms because he has merely
replaced 50000 of his personal borrowings for his share of firm Ls corporate borrowings or
he has substituted homemade leverage. He has substituted homemade leverage for the
corporate leverage for the corporate leverage.

Second, when investors sell their equity in firm L and buy the equity in the firm U which I
just means, I was telling you, the market value of the two firms tend to change. The firm
where people are selling the stock, the market value will come down and the people, the firm
people are buying the stocks market value will go up.

So, this process will continue, this process will continue until the market value of both the
firms become equal. Until the market value both the funds become equal because only then
possibility of earning a higher income for a given level of investment and leverage by
arbitrage is eliminated. Arbitrage otherwise is also not supported in the market. It is not a
good thing that just for the artificial change in the price you keep on buying and selling the
stocks in the market.

And if you say that capital structure makes a difference, then arbitrage will be supported.
Whereas on the other side we are not in the position to support arbitrage, we do not consider
the arbitrage as a good thing. So, it means then you want to condemn the arbitrage, but if you
say that the capital structure makes the value of the firm (difference) different, so naturally
the arbitrage is going to be encouraged. And as a result, the cost of capital of both the firms
become the same right.

923
So, it means what is happening, say for a given level of the investment and leverage by the
arbitrage is eliminated. Until and unless the arbitrage is eliminated, so, people will keep on
making the higher incomes simply means there is no increase in the overall value of the firm
practically, but just by arbitrage people are making money in the market, which is not a good
thing.

So, as a result, the cost of capital of both the firms becomes the same. So, it means, if you
want to stop the arbitrage, what you have to do is, you have to make the cost of capital both
the firms the same and if the cost of capital of both the firms is same. So, what will happen,
final value of the firm will also become the same. And if the value of the firm becomes the
same, arbitrage will not happen. And we want to condemn the arbitrage. We do not want to
support the arbitrage.

So, because of that reason, you cannot say that the market value of the two firms will be
different. If you say Modigliani Miller have said in their first proposition, if people say that
debt is cheaper than the equity and if we have the more amount of debt, lesser amount of
equity or the debt equity ratio of 1:1 as compared to the debt equity ratio of the 0:1, so it
means the firm having the debt equity ratio 1:1 as compared to the firm having a debt equity
ratio of the 0:1 will be having the lesser cost of capital, overall lesser cost of capital and the
market value of the firm will increase. So, what will happen.

If there are 2 firms in the market, one is totally equity financed another is financed with the
mix of the debt and equity. So, it means as per the say argument of the debt and equity having
the different costs, the market value of the firm which is having the debt equity ratio of 1:1
will be more, because their overall cost of capital will be less right.

So, when the market value of the firm will be more, people having the equity stake in the firm
having the higher market value will start selling and start investing into the firms having the
lesser market value in the anticipation that the market value of the firm having no debt at all
in their capital structure will also go up and they will then sell the stock in the in the firm
which is only equity financed over a say period of time then the value will go up.

They sell the stock or their stake in the firm U and will invest in the form L. So, it means
what will happen.

(Refer Slide Time: 45:53)

924
In that situation that in these 2 firms what will happen? Arbitrage will continue happening
because if you are selling in the firm L buying firm U, so the price of the stock will go down
in the firm L. So, this overall say capitalization market value of the firm will go down, firm L
will go down and the market value of the firm will go up. Later on, we will start selling in the
firm U. So, market value of the firm will U will go down and the market value of the firm
will go up.

So, this all is arbitrage and this is not supported, this cannot be means allowed to happen in
the market for long. So, we have to create a situation ultimately where the cost of capital of
both the firms is same, market value of both the firms is same. So, that arbitrage does not
happen.

And if, that is the situation expected to happen in the market that varies the difference in the
cost of capital of the different sources of the funds. All the source of the funds are means at
the at the same cost of the capital. And if the all the sources of the capital are coming with the
same cost or they are having the equal amount of the cost, then how can you say the capital
structure makes a difference?

Capital structure does not make a difference; capital structure has no meaning. So, this was
the first argument. This was the first proposition of the Modigliani and Miller. But later on,
when they came out with the second argument, when they considered some important, say
changes in their assumptions and the major change in their assumptions which they affected
was the taxes.

And they accepted that because of the taxes say, affecting the debt cost or the cost of the debt,
overall costs of the debt goes down and the cost of equity automatically increases, the cost,

925
the required rate of return automatically increases. So it means if you want to increase the
market value of the firm for the equity shareholders, then certainly the capital structure makes
a difference.

So in that case, more amount should come from the debt and lesser from the equity. So that
debt being the tax deductible will increased means reduced overall cost of the capital for the
firm and when the overall cost of the capital will go down, automatically the market value
will increase and after say servicing the debt borrowed from the market, the ultimate value of
the firm for the equity shareholders will be high.

So, what is the second proposition of the Modigliani and Miller and how they have means
proved it that yes capital structure makes a difference and different sources of the funds have
the different cost and they can impact the say value of the firm. I will discuss with you in the
next class. Till then thank you very much.

926
 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 56
Capital Structure Part-3

Welcome all, so proceeding further with the process of learning about the MM theory of the
capital structure. Now, I will discuss the second proposition of this theory proposed by the
Modigliani and Miller second proposition in which they themselves have rejected the first
proposition where they said that capital structure has no meaning and debt and equity have the
same cost. But now, later on say realizing the importance of taxes, that debt being tax
deductible source of income, which the equity is not.

They themselves have updated their first preposition and in the second theory in the second part
of the theory, rather I would say they have improved their own outcome or the theory and they
have agreed that yes capital structure makes a difference. And preposition 2 of the theory says
that debt capital being tax deductible or having the advantage of a tax deductible, it is cheaper
than the say, the cost of equity.

And ultimately, means employing the debt capital in the firm brings more return to the equity
shareholders because the cost of debt remaining fixed number one, and second thing that say
that the cost of the debt is tax deductible. So, means the cost of the debt capital remaining under
control or maybe remaining as minimum as possible increases the income of the equity
shareholders.

So, if you the equity shareholders want to maximize the value of the firm or the value of say, of
the firm for themselves. In that case that capital makes a difference. So said that is a second
proposition of the Modigliani-Miller theory of the capital structure.

927
(Refer Slide Time: 2:17)

And, for example, if it is written here that preposition 1 says that financial leverage means the
debt capital has no effect on the wealth of the shareholders that is a proposition 1, that financial
leverage has no effect on the wealth of the shareholders. And the proposition 2 says that the rate
of return expected by shareholders increases with the financial leverage.

So, it means you can understand that the first proposition supports a net operating income
approach, where it is said that if the debt capital is cheaper than the equity capital becomes
costlier and overall cost of capital remains the same. Whereas, the first approach if you recall,
the say net income approach, which says that the debt capital being cheaper brings the overall
cost of capital that is rA means down or makes it lower.

Because debt capital being remaining the cheaper source of the funds as I say and equity capital
remains the same the cost of the equity capital remains the same. So, overall cost of the capital
comes down and the value of the firm for the equity shareholder maximizes. So, this is the net
income approach, which you call as the second preposition of the Modigliani-Miller theory and
the first one is say the replica of the net operating income approach.

But the second one now, we are going to discuss in detail that how debt capital makes the say
or reduces the overall cost of capital of the firm and maximizes the value of the firm for the
equity shareholders. So, next point if you read here is an increase in the financial leverage

928
increases the expected earnings per share after a certain limit, but not the share price, means
only the say income increases per share income earning per share increases.

But the share price remains the same, why? Why the share price does not increase? Because
that increase in income is demanded by the equity shareholders, because of the increased risk of
the firm, overall risk of the firm because of the induction of the debt capital. The moment the
debt capital comes in the firm the overall risk profile of the firm as a whole increases and for
the equity shareholders also the risk profile goes up, the risk complexion goes up.

So they want the extra premium for the compensation, as a compensation of increased risk. So
the return on the equity shares or the earnings per share increases, but the share price does not
change because that increase in the earnings per share does not mean that the share price will
also say reflect increase, because it is clear in the market that whatever the increase earnings per
share is being experienced by the firm or by the equity shareholder that is a compensation of the
increase the risk, because the firm has employed the debt capital.

So share price remaining the same, only the risk is compensated by the increase in the earning
per share to the equity shareholders. So, means, ultimately the purpose here is whether the
income to equity shareholders can be increased anyway or not, that is a purpose of deciding
about the capital structure. Ultimately the owners of the firm, the equity shareholders of the
firm or the owners of the firm their objective remains that how to maximize the income for
them, how to maximize the value of the firm for them or the value of their equity investment in
the firm.

And that only happens when the overall say capitalization adopted in the firm lowers its cost of
capital, so says that debt is a cheaper source of finance as compared to the equity. So, the
movement that comes in the firm, overall cost of capital of the firm goes down and it increases
the value of the firm for the equity shareholders in a way you can say that the return to equity
shareholder a holder maximizes.

But at the same time, because the risk also increases because debt capital though it is cheaper in
terms of the costs, but it is quite risky, because it creates a fixed obligation on the firm, whether
you earn the profits you do not earn the profits, you have to service the debt, you have to pay
the interest on the debt and on the due date, you have to repay that debt also back.

929
So, it means it we are going to create a fixed obligation, because in case of equity, the income is
not fixed or the say the cost is not fixed, same way say the obligation also not fixed. So, it is say
link to the income, if the firm is earning the income they can pay the cost of equity as a
dividend as a return on the equity, but it is not the case in case of the debt. Whether you earn
the profit, you incur a loss, you have to service the debt in terms of interest and you have to
repay the principal on the due date.

So, that creates the risky situation for the firm and overall risk profile of the firm increases. So,
ultimately, that risk profile risk of completion increases for the equity shareholders, so they
want extra return. So, their cost of capital increases or in a way their required rate of return
increases. So, because of that, the rate of return on the equity capital increases, so per share
price remains the same, but the return increases and that return is the compensation of sharing
or maybe bearing the extra risk.

So, the answer is that the change in the expected earnings is offset by a corresponding change
in the return required by the shareholders. So, it means share price is not going to get affected
because increase is demanded as a premium of bearing the extra risk and not because of any say
special efforts made by the firm, that the overall return to the equity shareholders have gone up.
So, certainly the share price should also change.

You have reduced the cost of capital by inducing debt in the firm. So, debt has come, cost of
capital has gone down, but since the risk because of the debt capital has gone up. So, equity
shareholders demand the premium for that and certainly say debt capital, it reduces the cost of
capital increases the risk, but overall increases the return to the equity shareholders. This is the
second proposition of the Modigliani-Miller say theory of the capital structure.

So, they themselves have accepted in the second preposition which is improvement over the
first that yes debt capital having that tax deductible advantage is cheaper as compared to the
equity cost and if debt capital is brought in the firm, then though the risk profile changes, it
increases the risk of the firm, but the return to the equity shareholders’ increases, so capital
structure now it has a meaning.

930
So, if you want to decide the capital structure of the firm looking at the operating income
situation, looking at the risk profile of the firm, if we are able to employ some amount of the
debt, certainly we can expect that yes, the return to equity shareholders will be maximized.

(Refer Slide Time: 9:21)

So, this proposition you can say now a nutshell you can decide, you can define this proposition,
the expected return on equity is equal to the expected return on assets, is the total return of the
firm plus a premium it means I just told you, they demand that normal returns should be equal
to the return on the assets plus some premium and premium what for they ask for the premium?

Premium they asked for is the risk they are going to take because the firm has employed that
debt capital. The premium is equal to the debt equity ratio times the difference between the
expected return on assets and the expected return on the debt. Since the cost of say debt remains
lesser than the cost of equity.

So, the total return on the firms say assets minus the cost paid to the debt or the suppliers of the
debt or to the lenders, whatever the say residual income is that goes to the equity shareholders
and since the cost of the debt is lesser than the equity, so the residual income to the equity
shareholders remain much more as compared to that capital structure means totally financed by
the equity capital.

931
So in this case, whatever that increased income we are giving to the equity shareholders, that is
the return on assets plus some premium of bearing some extra risk because of employing the
debt capital. So, this is now the new equation comes up as per say proposed model and this
equation is rE. rE means the return on equity is equal to rA, rA is the return on assets or the total
return of the firm plus rA minus rD total return on the assets minus the return or the cost of debt.

rD is the cost of debt and in the proportion of say debt equity ratio, whatever the cost of debt is
paid, after that whatever the residual income is left that income goes to the equity shareholders.
So, it means the equity shareholders get two components of income, first income is normally
they are going to get that is the equal to the rA that is equal to the total return on the assets plus,
because the returned to debt capital is lesser than the say a return to the equity shareholders.

So, that difference also goes as a premium which is defined by this bracket inside the bracket
items and that difference as a premium also goes to the equity shareholders right. So, it means
now the as per this preposition the cost of equity or return on the equity capital will be more
because they are getting the normal return on the assets plus the premium for sharing that extra
risk.

932
(Refer Slide Time: 12:16)

So, we can understand with the help of this for example, a few figures that say for example, you
can calculate the cost of equity or the return on equity, which is the normal case is the return on
assets, if the firm is financed only by the equity capital. For example, if the form is financed
only by the equity capital is the capital structure you have the debt equity ratio has 0:1, there is
no debt only equity is there.

And we assume that say for example, your operating income is how much? Operating income is
say operating income is Rs 4 million and the total value, market value of the shares total equity
capital is say for example, Rs 2 crores or the Rs 20 million, this is 2 crores. So, if you calculate
the because in this case there is no debt capital employed and only equity capital is there and
the market value of the equity is say Rs 20 million or the Rs 2 crores.

And the operating income of the firm is for example, Rs 4 million or the Rs 40 lakhs, so this is
the Rs 4 million are the Rs 40 lakhs. So, in this case you can find out what is the rA, that is a
return on the total assets is how much? That is the same means whatever that return on the total
lessons that is the return on that total equity also, because whatever this return is will go to the
equity shareholders and this works out as point 0.20 or you call it as it is 20 percent.

It is 20 percent, right but the moment when you bring the debt in the firm, if you bring the debt
in the firm and for example, the cost of debt is 15 percent right, the cost of debt is 15 percent.
So, now we are going to find out the return to the equity shareholders which you can call it rE

933
that is a returned to the equity shareholders that will be as per this model, as per this model you
will calculate the cost and if we calculate the cost as per this model, this will be equal to rA plus
rA minus rD and in the proportion of times debt to equity ratio, times debt to equity ratio if you
do like this, so, you will get something like this, what is the, for example we assume that what
is the return on the total assets is in case of the firm being financed only by the equity return on
the total asset says, for example, 20 percent.

So, this is 0.20 plus this is 0.20 minus what I told you the cost of debt, the moment we bring in
the debt in the form, the cost of debt is for example, say 15 percent right. And the debt equity
ratio is the 1, equal amount of the debt is brought in. So, the debt equity ratio is 1 we have taken
here that equity ratio. So, it means, in this case, we have to now find out the say cost of equity
or return on equity and for finding out this return on equity you can use this model.

So, the moment you use this model, this will be having the this is a return on the assets plus
which will be available to the equity shareholders, not in the normal course plus the extra
premium they are going to get and that premium is the difference of the return on assets minus
the debt capital and the debt capital, the cost of debt capital not debt capital, the cost of debt
capital, so, this is 1.

So finally, this is going to be how much? This if you solve this, this is going to be point 0.25 or
25 percent, this is going to be 25 percent. So, it means, what is happening now, if it is an all
equity capital structure, the cost of equity or return to the equity shareholders is 20 percent. But
if it is a capital structure having partly debt or the debt equity ratio is of the 1 is to 1 then equity
shareholders are getting 20 percent, the normal equal to the return on assets plus extra premium
for bearing the extra risk.

Because now the debt has come in, 50 percent of the capital as come as the say source maybe as
an as a debt. So, they are going to take extra risk. So, they are getting a premium of 5 percent.
So, now the return on the equity capital will become as the 25 percent and not you call it as the
not is that say 20 percent. So, in the entire process you can explain like this, that is 100 percent
equity capital structure, 100 percent equity capital structure one and the capital structure which
has 50 percent equity and 50 percent debt.

934
So, in this capital structure if, you take the 50 percent of the equity and 50 percent of the debt,
so and 50 percent is the debt, so debt equity ratio is the 1, so what will be there? Earning
expected per share, so, EPS will be EPS for example, we are assuming here is that is rupees 4
and in this case it will become rupees 5 and the price per share is, price per share will not
change.

Price per sale for example, if it is 20 it will also remain 20 it is not going to change and
expected return to equity shareholders is now, earlier it was 20 percent as we have calculated
here, this is 20 percent. But now in this capital structure, it will go up to 25 percent. So, what is
said here, that it will not change the share price, it will change the movement the debt comes in
the firm, Modigliani-Miller is the second proposition says per share price will remain the same.

It is not because of any other factor, it is only because the risk profile, risk complexion of the
firm as a whole has gone up. So, equity shareholders are going to take the extra risk. So, they
want some extra return for that. So, the returned to the equity shareholders in this case will
become 25 percent otherwise, it is 20 percent. So, in all equity, 100 percent equity capital
structure, the return is 20 percent, which is the return on the total assets of the firm also.

But in case of the debt equity ratio, 1 is to 1 in that case, the return to the equity shareholders
will be increasing by 5 percent. And this 5 percent is the premium of taking the extra risk,
because the debt capital has come in the form. So, EPS is going to increase certainly it is going
to increase by how much, again from 4 to 5 rupees by 1 rupee. And per share price is, price per
share is 20, 20 same it is going not going to change, because overall performance of the firm
has not changed, it has remained same only cost of capital has come down.

So, returned to equity shareholders has to increase because the risk profile of the equity
shareholders has gone up and it has changed. So, this is the second proposition of the model and
Miller model.

935
(Refer Slide Time: 19:36)

So, the risk return trade off, finally, this theory is called as second preposition of the
Modigliani-Miller is also called as the means by the other name which is the risk return trade of
theory also or you call it as a tradeoff theory also, where we have the risk and return trade off
because you are going to take the extra risk because of induction of the debt capital in the
capital structure of the firm.

So, naturally you will deserve the extra return. You can expect the extra return and that extra
return is the same reward of bearing extra risk because of say bringing in the borrowed capital
in the capital structure of the firm. So, why the shareholders are indifferent to increased
leverage when it enhances the expected return? Why the shareholders are indifferent? They are
indifferent because they are ready to take the risk and if they are taking the risk, their return is
also increasing.

So they do not object to the say induction of the debt in the overall capital structure of the firm.
Yes, they will object if their say a risk is increasing but the return to them is not increasing, then
they will object then why should we take extra risk where is a premium for extra risk? So, their
reason of their indifference is the reason is that an increase in the expected return is
accompanied by an increase in the risk which in turn raises the shareholders a required rate of
return.

936
So, they are totally indifferent because, yes, they say the capital is coming from a source, which
is cheaper than the cost of equity. So certainly they are means going to pay the firm as a whole
is going to pay the lesser cost of capital. But since it is a risky source of finance, so equity
shareholders who are going to bear the extra risk, they are going to be compensated by the
increased income, but the share price will remain the same.

(Refer Slide Time: 21:28)

Now, we talk about the next part. And as I told you that the second name of the theory is the
risk return trade off theory. So are we will learn it in a way that what is the effect of leverage on
the risk? So here we can understand the effect of the leverage on the risk is there and since the

937
leverage is riskier or considered to be riskier and it increases overall risk profile of the firm.
And that extra risk has to be borne by the equity shareholders. So that is why this theorys other
name is a risk return trade off or the simply the tradeoff theory also.

So, the effect of leverage on the risk can be defined under these three points. First one is
leverage magnifies the spread of percentage return and when the spread of percentage return it
can be this also, it can be this also, it can be this also. So, when the spread is going to increase
for example, now, the spread is for example, is this much they come is going to change this
much or maybe we are talking about the percentage return.

So, it is this but when the spread is like this, so it means it can be this also, it can be this also, it
can be this, this, this also. So, what is going to be there, the variance is going to increase
standard deviation of the return, percentage return is going to increase and that increased in the
deviation of say return or any kind of the profitability or return certainly that increases the risk.

So, how we can understand this that what is the pointed in here? Leverage magnifies the spread
or percentage return that is the say bone of contention, which brings the risk here and for
understanding this concept better let us understand with the help of an example here that again
we have a say create a capital structure and when you have the different capital structure or we
create the firms with the different capital structure.

938
(Refer Slide Time: 23:29)

So, for example, we have the two operating incomes, here we are going to say that this is the
operating income and it can be for example, Rs 2 million or it can be Rs 4 million, right. So,
two operating incomes can be firm might have the income of the Rs 20 lakhs or the firm might
have the income of the Rs 40 lakhs, right. So, first we assume when the debt equity ratio is
equal to 0:1, it means it is all equity capital structure is not a debt equity capital structure.

So, we assume that EPS is for example, is here 2 and here the EPS is 4 right, we talk about is
that is the EPS here is 2 and here EPS is earning per share is the 4 and say return on equity for
example, we assume that return on equity say for example 10 percent and here the return on
equity is 20 percent right. And when we say we create a debt equity structure of debt equity
structure is equal to 1:1.

For example, if the debt to equity structure is 1:1, then EPS may for example, if it becomes 1,
this is rupees 1 and it may become rupees 5, this is also in the rupees right. This is also in the
rupees right. And return on equity may become 5 percent or it may become 25 percent. So, this
is the meaning of this point, what the point says here that leverage magnifies the spread of
percentage returns, leverage magnifies the spread of returns.

For example, not if it is a 100 percent equity finance firm where the debt equity ratio is 0 to 1.
So, earning per share for example, we assume is, this is the operating income and earnings per

939
share is the say 2 and it is 4. So, what is the difference in the 2? That is only the difference of 2
rupees, right.

Whereas, if the equity is supplemented by the debt capital and the capital structure of the firm
becomes like with the debt equity ratio of 1 is to 1, so earning per share of the same amount for
example, will become if it is say Rs 20 million sorry Rs 2 million is the income, operating
income EPS will be 1 and if it 4 million it will be 5. So, now look at the spread here, here the
spread is of the 2 rupees and here the spread is of 4 rupees.

Similarly, RE return on equity is 10 percent and 20 percent. So, what is the spread here? 10
percent, what is the spread here? The spread here is the 10 percent, this spread is 10 percent, but
in this case the spread is of the 20 percent. So, when this spread increases in this terms also and
this terms also, when this spread increases, naturally the spread the difference is 5 percent and
25 percent. The difference is 10 percent and 20 percent in case of all equity firm.

So, since this spread increases, this becomes riskier this because standard deviation of the
operating income is very high. So, it means the return on equity that is the return on equity, the
standard deviation of the return on equity is very high. So, because of that, the risk increases,
the risk complexion of the firm increases and because of that reason they means equity
shareholders want to be compensated for the risk.

It raises the beta of the firm, firm’s equity shares it raises the beta of firm’s equity shares right,
so because as we calculate the say cost of capital as the say weighted average cost of capital of
the firm. Similarly, we also calculate the beta also, which you call it as the weighted average of
the beta of all securities, right. So, what we say is, as expected return on the firm’s assets is the
weighted average of the expected returns, weighted average of the expected returns on its
securities, weighted average of the as expected return on the firm's assets is weighted average
of the expected return on its securities.

Likewise, the beta of the firm’s assets is the weighted average of the beta of its securities right.
So, it means when the return increases, risk also increases, right or first you can say the risk
increases, then only the return increases or vice versa whatever, the way you want to find it out.
So, you have to find it say when you calculate the say cost of capital of the firm you calculate
the weighted average cost of the capital or the in a way, cost of capital you treat it as the return

940
also. So, weighted average return or the expected return is the weighted average of the firm is
the return on all the securities.

Similarly, the beta of the farm is also the weighted average of the beta of its all securities and
all securities are either they are the non-fixed income securities or they are the fixed income
securities. Non-fixed income securities are the shares and the fixed income securities are the
debentures, bonds or the debt capital right. So, because risk is going to increase, because cost of
capital is going to change. So say the cost of capital is going to change return is going to
change.

Similarly, the beta is going to change or the risk is going to change, beta is representing the risk
basically right, the risk of coming up because of the different kind of the securities and since
now it is not all capital, all equity capital structure. So it has the debt also, debt becoming
riskier. So, the beta of the firm changes and the weighted average of the beta for the equity
shareholders becomes different now.

Because debt increases the overall risk profile or the risk completion of the firm. So, how
would you define this beta? You would define the beta like this.

(Refer Slide Time: 29:37)

941
So as leverage increases, it is given here as a leverage increases equity shareholders require a
higher return, because equity beta, equity beta means the risk for the equity shareholders
increases and equity beta is defined here. Equity beta is equal to beta of the firm as a whole plus
debt equity ratio or you can call it as the beta of the firm as a whole minus beta of the debt
capital.

So, the overall say the beta of the equity capital is going to increase, the risk of the equity
capital is going to increase. So, say they want the extra turn and this is the ultimate conclusion
of the second proposition of the Modigliani-Miller model that because beta of the equity is
going to change beta of the equity shareholders is going to change.

So, it is the model which is defining the beta of equity shareholders, where the beta E is the
equity beta and beta A is the asset beta or the risk of the form as a whole and debt equity ratio is
D/E and the say beta debt is the debt beta. So, it means whatever the risk little amount the risk
has to be bound by the lenders after that the entire risk of the firm is the risk of the equity
shareholders.

So, same way, as you are calculating the weighted average return, for example, when you are
talking about the return to be calculated on the equity shareholders. So, when we have
calculated here we use this model, rE is equal to rA plus rA minus rD multiplied by the debt
equity ratio, same way you are going to calculate the beta, beta of the equity is equal to beta of

942
the firm as a whole plus beta of the firm minus beta of the debt multiplied by the debt equity
ratio.

So the first model is going to explain the return on equity and the next one is going to explain
the risk on the equity capital or to the equity shareholders. So ultimately, we call it as the risk
return trade off means if you are going to bring in more amount of the debt in the firm.
Certainly, undoubtedly, this second proposition of the MM model says cost of capital is going
to go down, but the risk of the firm as a whole is going to increase which will be passed on to
the equity shareholders.

So equity shareholders will deserve the better return high return or at least the returns more than
equity capital, which is 100 percent equity financed capital structure. If it is 1 is to 1 capital
structure in that case because the risk is going to increase. So, equity shareholder deserves extra
returns and this is the risk and return trade off theory you call it as a risk and return trade off
theory also, that higher the amount of the risk to equity shareholders higher the return they
deserve.

So, in the second proposition Modigliani and Miller themselves have rejected the first
proposition where they have they said that capital structure has no meaning because of the
arbitrage argument. But in the second proposition, they have proved it that yes debt capital is
cheaper than the equity capital. So, the capital structure if having the more amount of the debt
capital or some proportion of the debt capital, certainly the return to the equity shareholders is
going to increase.

Because the debt capital remaining as a cheaper source of the funds. Overall cost of capital of
the firms gets done and the return to the equity shareholders or other way around operating
income remaining same, but the cost of capital getting down. So, the returned to the equity
shareholders’ increases. So, this is a second proposition of the capital structure model given by
the Modigliani and Miller very-very say you can call it historical contribution or the classical
say theory of the capital structure.

But since means no theories free of any kind of the criticism, so, this theory is also full of the
criticism So, quickly, I will take you through the points of say criticism here and the points of
the criticism here are say some points of the criticism are given here.

943
(Refer Slide Time: 33:40)

So, they are worth noting taking into account. So, first point is firms and investors pay taxes
right. So, it means, when you talk about the say, Modigliani-Miller theory, so it means in the
first proposition, they said that, there are no taxes, but in fact there are taxes and taxes are paid
by the firms at the two levels. One is the taxes at the firm level and second the taxes are paid at
the individual level.

When the equity shareholders get dividend or any other kind of equity income, they get taxed at
the individual level also, right. First performance, pay the corporate tax and then the individuals
pay the dividend tax right. And when they say interest income goes in the hands of lenders then
lenders also are taxed. Means individually say though it is tax deductible expense at the firm
level, but it is taxable when it reaches of the hands of the lenders.

So means this is the assumption that there are no taxes, taxes are there. Bankruptcy costs are
can be high means when means there we have assumed that there is no means there is a
complete information to the investors as well as to the say lenders or any other kind of the
investors in the market and there is a say perfect market is completely perfect. But no, firms say
fail also, firms become bankrupt also, firms become insolvent also.

And because of the existence of the debt capital largely because it is a fixed say obligation
security, it is a fixed income security or a fixed obligation security for the borrower. So,
sometimes in the lack of profitability state, it can lead the firm to the state of bankruptcy also,

944
because when the lenders are not getting their say, loans returned or maybe their loans properly
serviced, they have filed a bankruptcy petitions.

So, certainly means debt brings the, this kind of the situation and causes for the liquidation of
the firms also. So, it means the information is not complete and the market is not perfect, that
assumption is also not true here. Agency costs like this, because we have the different type of
the say a stakeholder who have the agency relationship with the firm, we have the two kind of
agency relationships, we have the three stakeholders largely.

One is the equity shareholders then they are the creditors, then they are the managers. So,
managers have the agency relationship for both the say and shareholders as well as the debt
supplier for the lenders also. Whereas the shareholders and lenders also have the agency
relationship right, so it means because of this agency relationship also, there is a cost and that
cost creates a problem, agency cost I will discuss with you after this.

So, it means, means you can say that if no taxes are there, market is perfect, say expectations
are homogeneous. So, all these assumptions are not going to held good. Managers tend to prefer
a certain sequence of financing, right.

945
(Refer Slide Time: 37:05)

So, it means we have some assumptions here. For example, if you talk about the assumption of
the Modigliani-Miller the first proposition which we have seen here. So, this assumption was
homogeneous of expectations equivalent risk classes and absence of the taxation, all these
assumptions are not going to be held true. So, one more point of the say criticism is managers
tend to prefer a certain sequence of financing.

So, though they have the complete information, but means, they sometimes do not tend to make
use of that information, they follow certain sequence of financing and that is sequence is better

946
explained in the pecking order theory. Later on we will discuss, but it means managers take
their own decisions.

Informational asymmetry also there you cannot say that the market is perfect and totally
information is say communicable to all the stakeholders. There is the information asymmetry
and because of this information asymmetry, wrong decisions with regard to the capital
structures are taken and firms fail. And lastly, the personal and the corporate leverage are not
perfect substitutes.

We have discussed at one point of time during the arbitrage argument, that the person can
borrow 50000 and can replace the, say the corporate risk with the homemade risk, but
sometimes that may not be held true, because the homemade risk is not the true substitute for
the corporate risk. So, these are some of the points of criticism of the Modigliani-Miller theory
of the capital structure.

But despite all these criticisms, despite all these factors affecting the say overall performance of
the theory, you cannot say that this theory has no meaning. This theory has a very important
meaning. This is a first classical and most scientific theory where they have say on the basis of
say empirical research and say, citing the other researchers available at that time. They proved
it that yes capital structure has a meaning.

It creates a difference if the say capital structure is created as a sum of the debt and equity or
because of the internal and external sources of the funds, certainly the cost of capital can be
kept under control and returned to the equity shareholders can be maximized. So, this is the first
scientific theory, this is the first systematic theory, which is based upon the mathematical
research.

And other theories you talk about though they are the not theories which can be rejected or
which cannot be followed at all, but they were only you can call it as the say unsystematic
findings of some observations or you can call it as unsystematic observations, whereas this
theory is the are more scientific, where they have first accepted the net operating income
approach, but later on they rejected it and they accepted that the net income approach where
they proved it that the say debt capital is cheaper as compared to the equity capital.

947
So, now we talk about something about the corporate taxes. We talk about the corporate taxes
which have the important point to say here. So we have two kinds of taxes, one is a corporate
tax and another is the personal tax. So, if you talk about the corporate tax, naturally because of
the corporate taxes, the debt capital becomes a cheaper source of finance. So, how it is
becoming the cheaper source of finance and how say corporate taxes creates a difference in the
total cost of financing as far as the different sources are concerned.

So, we will discuss and learn this concept in detail. So, this is the impact of the corporate taxes.
First we will discuss the impact of corporate taxes. And then the next part we will discuss or
learn about the impact of the, say your personal taxes or the corporate and the personal taxes
together.

(Refer Slide Time: 40:42)

So, what is written here when taxes are applicable to the corporate income, when the taxes are
applicable to the corporate income, debt financing is advantageous, as the interest on debt is a
tax deductible expense, and how it is? With the help of this model you can understand that how
the say debt financing makes a difference. So, what is given here V is equal to O into 1 minus
tC bracket closed say divided by r plus tCD.

So it means where V is the value of the firm, means ultimately the value of the firm is
influenced by operating income right and then the tax payable on the operating income which is
known as a corporate tax and r is the capitalization rate applicable to the unlevered firm. So, we

948
have to divide it by this r and then D is the market value of the debt and the tax deductible
advantage of this debt. So, this has to be added into this. So tax advantage of this say debt has
to be added in this.

So it means how much amount of the tax you are going to save upon the debt capital that has to
be added into the operating income after tax. So finally, in nutshell you can say value of the
levered firm, this is the way you can define VL is the value of the levered firm is equal to where
we are saying value of the unlevered firm. This is the up to this point, this is the value of
unlevered firm right, this is a value of unlevered firm plus tC that is a gain from the leverage,
this is the gain from the leverage.

So, value of the levered firm is more as compared to the value of the unlevered firm. So, why
the value of the levered firm is more here it is that is the VL is equal to that is a value of levered
firm is equal to value of the unlevered firm plus the say taxes the impact of taxes or the gain
from the leverage as in the firm of the tax amount, which we have saved, which we have saved
on account of the interest expense because that is debited in the profit and loss account.

So amount of the tax saved is to be added into the value of the unlevered firm. So, the total
value of the levered firm is more than the value of the unlevered firm and that is because of the
debt capital being part of the capital structure and this source of finance or financing being the
tax deductible source of financing right. So, hope we can understand it we can understand it
better with the help of this particular example.

949
(Refer Slide Time: 43:26)

For example, we will say here corporate taxes and income of debt holders and shareholders
right, corporate taxes and income of debt holders and shareholders. So, how can you take it for
example, we have this particular and we have the say the two firms here one is A, which is an
unlevered firm and this is the B which is the levered firm right. So, in this case, we start with
the operating income.

For example, this is the operating income and operating income of the firm is say we assume it
as 1 million, this is 1 million. And again the same income, 1 million is the operating income of
the both the firms operating income is the same. Interest on debt, first of all, we have to subtract
the interest on debt. So, interest on debt we are taking the unlevered firm, no interest will be
deducted, whereas, this form we assume, they have borrowed Rs 4 million rupees and the rate
of interest is 12 percent.

So, the total interest cost is Rs 4,80,000 rupees, Rs 4,80,000 rupees. So PBT, Profit Before
Taxes, PBT profit before taxes is the same amount 1 million here and here it is the amount is
how much? Rs 5,20,000, Rs 5,20,000 it is the Rs 10 lakhs and this is the Rs 5,20,000. Now we
assume taxes and we are assumed here the tax rate of at the rate of for example 50 percent for
corporate tax rate is a 50 percent. So, what is a tax here? Half a million is the tax going to be 5
lakhs and in this case the tax is going to be how much? Rs 2,60,000 rupees, Rs 2,60,000 rupees,
right.

950
So, now, these are the say taxes amount, taxes at the rate of this So, profit before tax is 1
million and this is Rs 5,20,000 I mean taxes at the rate of 50 percent that is you call it as the
500000 and the 26000 so it means PAT profit after taxes how much? In this case it is Rs
5,00,000, Rs 5,00,000 and in this case how much it is? In this case it is Rs 2,60,000, right this is
a profit after tax and this profit after tax is the income to whom?

Income to shareholders, this is income to shareholders in both the cases, in this case also, in this
case also and now we calculate the combined income, combined income we calculate the
combined income. If you calculate the combined income here, so combined income to whom, if
you calculate this combined income for the debt holders and this is a combined income to debt
and debt holders and shareholders, how much it is?

In this case it is going to be how much? Rs 5,00,000 so, this is going to be the same combined
income of the Rs 5,00,000 to the, because there is no debt suppliers. So, only the combined
income is of the Rs 5,00,000 is to the equity shareholders. Whereas, in this case the combined
income to the shareholders and debt holders the income of the debt holders is how much this
much, Rs 4,80,000 and the shareholders is Rs 2,60,000, so what is the total income?

Total income is the Rs 7,40,000, so it means the combined income to the corporate taxes and
combined income to the debt holders and shareholders is how much, that is the Rs 5,00,000
here and this in this case it is the (Rs 4,00,000) Rs 7,40,000. So, it means, this is all the result as
a result because if you look at this Rs 4,80,000 interest on debt it is tax deductible. Total
amount of the say interest is subtracted from the say total revenues in the profit and loss
account and we do not pay any tax on this because it is considered as a financial cost and we
never pay any tax on the cost always taxes are paid on the profits.

And finally, the profit before tax is becoming this much and we are paying this much of the tax.
So, it means PAT is becoming this. So, combined income is in this case, it is greater than this
you call it as if you calculate the combined income. So, you can find it out that Rs 7,40,000 is
more which is a income total income of the levered firm as compared to the total income of the
unlevered firm. So, this is the say impact of the corporate taxes.

951
(Refer Slide Time: 49:01)

Now we move forward with the next part and that is to understand that impact of the personal
taxes because personal taxes also make the difference. And if you look at the personal taxes
here, when the personal taxes are considered along with the corporate taxes, the tax advantage
of a rupee of debt is we can calculate here because we understand that along with the corporate
tax, the personal taxes are also levered in any economy.

So the corporate income is basically taxed at two levels. One level of the say tax is the
corporate tax, which the firm pays on its PBT profit before tax, then they pay the tax and then
after that, what we saw in the just previous calculations, that the profit after tax is calculated.

952
And depending upon the capital structure of the firm that profit is the say income of the
shareholders and before that the say interest on debt is the income of the say lenders, right.

Second level of the taxation comes at the personal level. And after paying the corporate tax
people who get that income, profit after tax or maybe the interest on the debt, they are also say
taxed at the personal level also. So, the shareholders who get the dividend from the profit, they
are also taxed by the government at means when their dividend, that profit in the form of the
dividend reaches in their hands, that is also taxed.

So, means the corporate taxes plus the personal taxes and in the second case that the debt
supplier, the lenders who get the interest income, that interest income when reaches in their
hands that is also taxed again by the government. So, second level of the taxation comes up in
the picture, second level of the taxation means creates a problem or that comes up in the
picture.

So, first level of the taxation we have seen here that how the corporate taxes impact the overall
say income of the shareholders and the debenture holders or maybe the debt suppliers. And
similarly, there is going to be the impact of the say personal taxes. So, it means when you talk
about the impact of the personal taxes, you can understand that how the personal taxes are
going to make a difference here. So what is this personal taxes?

When personal taxes are considered along with the corporate taxes, the tax advantage of a rupee
of the debt is calculated here as right. And this is the say we are talking about first is the 1
minus tC is the corporate tax and multiplied by the taxation on the say equity capital and then
factored by the say tax on the personal tax on the debt capital and the personal tax on the equity
capital. So in this case in the numerator, the corporate taxes, we are multiplying with the
personal tax on the equity income and then we are dividing it by the personal tax on the debt
income.

And finally, we are going to see the impact of the personal taxes and the corporate taxes. So it
means you can conclude here that personal taxes make a difference, corporate taxes make a
difference and since these taxes are as especially the corporate taxes they are levered upon the
debt capital or because of that debt say corporate taxes that debt capital becomes cheaper means
no taxes paid on the say financial cost which will pay as interest on the borrowings.

953
So, because of that debt capital becomes cheaper and Modigliani and Miller have also a say
accepted it, that yes because of the debt capital being tax deductible source of say, funding, it
becomes cheaper and overall cost of capital goes down and return to the equity shareholders
increases.

So, we have seen till now the impact of the corporate taxes, and then in the next part of
discussion, we will learn about the combined impact of the corporate taxes and the personal
taxes and how the debt capital makes entire means say overall, you can call it as a reduces a tax
burden of the firm and becomes the cheapest source of finance because of both the taxes,
corporate taxes and the personal taxes that I will discuss with you in the next class.

So, in the next class, we will learn about the combined effect of the corporate taxes and the
personal taxes. Till now, we have learned about the impact of the corporate taxes on the say
different sources of funding. And now, we will learn about the combined effect of the corporate
taxes and the personal taxes and then we see how the debt capital is going to be the cheaper
source of finance as compared to the equity and how it is contributing in the maximizing the
value of the firm.

So this remaining discussion with regard to the taxes plus some more important concepts of the
capital structure, I will discuss with you in the next class. Thank you very much.

954
 Financial Management For Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 57
Capital Structure – Part 4

Welcome all, so we are carrying forward the process of learning about the say different other
aspects of the capital structure and continuing with the process of a say taxes and the corporate
structure or the say impact of the taxes on the capital structure of the firm. In the previous class,
we discussed that the capital structure is impacted by the taxes, especially the borrowing part, the
debt part is the say impacted by the taxes.

And say we have seen in the previous class that how the corporate taxes, impact the capital
structure or maybe have the say positive impact on the debt capital because ultimately when we
have seen in the previous class that the impact of taxes on the say borrowing was less severe as
compared to the say equity capital and ultimately the combined income when we calculated of
the say firms that one firm was a levered firm, another firm was an unlevered firm.

So combined income of the debt holders and the say your equity holders was higher in the
levered firm as compared to the say your unlevered firm. So it means in this case we have to
means be clear about that say ultimately the taxes impact to the capital structure and Modigliani
Miller also have accepted in their second proposition that because of the tax impact or the debt
being tax deductible or having the advantage of tax deductible, it is cheaper source of finance.

Overall cost of capital goes down with regard to the debt and if you have the say equal amount of
debt and equity in the capital structure, then certainly the cost, overall cost of capital of the firm
gets down. So in the previous class we have seen the impact on the say combined income of the
debenture holders and the or the debt suppliers or the lenders and the equity share holders
because of the corporate taxes or the impact of the corporate taxes on the capital structure and
now we will see the combined effect of the corporate taxes and the personal taxes.

955
(Refer Slide Time: 02:46)

And even say taking into consideration the personal taxes along with the corporate taxes the
combined income of the say equity (holders) shareholders or the equity suppliers and the debt
suppliers or the lenders will be more in the levered firm as compared to the unlevered firm
because say the debt having that tax deductible advantage.

It helps the firm to reduce the overall costs of capital and increase the total return to the equity
shareholders. So it means ultimately because of this tax deductible nature of the debt finance or
the borrowings, overall cost of the capital goes down and value of the firm maximizes. So capital
structure is getting affected because of the taxes, both the corporate taxes and the personal taxes.

So let us see now that how the personal taxes are impacting the overall capital structure of the
firm and say what is the impact up on the combined income of the shareholders and the lenders
after the personal taxes let us see about that.

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(Refer Slide Time: 03:37)

So we will write here, personal taxes and income of debt holders and shareholders. So again we
take here as the particulars. Again, we take here as the particulars and we take the firms A, this is
a firm A and this firm is called as the unlevered firm. And this is the firm B, which is the levered
firm right. So we are means carrying forward the say same example which we have done in the
previous class, where we have seen the impact of the corporate taxes on the income of the say
combined effect of the taxes on the income of the shareholders and the say lenders.

So we are carrying forward the same example here and we are going to see now the impact of the
personal taxes along with the corporate taxes and how the overall cost of capital goes down and
the income to the say shareholders as well as the say debt suppliers or the lenders gets affected.
So we have taken the two firms again, firm A and firm B and if you take forward the or carry
forward the previous example so you can see here that what was the income in that say previous
case, the income available to shareholders was how much?

Income to shareholders, if you recall that or if you see the previous lecture, so income to the
shareholders we had to calculate was because total income was 1000000 rupees. So 50 percent
was the tax. You call it as that was the corporate tax and remaining income which was passed on
to the equity shareholders was half and that was say here in this case 500000 rupees or the
500000 rupees.

In this case it came down to 260000 rupees right. So this was the income to the shareholders.
And now we say take the effect of the personal taxes, less personal taxes and if you calculate the

957
impact of the personal taxes, so you can say here we are assuming that the tax, personal tax rate
is 30 percent, right. We are assuming it as the personal tax rate is a 30 percent. So if you take this
rate as the 30 percent in both the cases, on the debt as well as on the equity at the rate of 30
percent. So in this case, you can say what is the personal tax rate?

You have to subtract the personal tax and this is Rs 1,50,000. We have to take this amount the
tax amount as the Rs1,50,000 or Rs1,50,000 rupees. So this is the effect Rs1,50,000 rupees and
in this case, how much is the tax effect? This is going to be only Rs 78,000. So you can say
income available to shareholders after personal taxes, income to shareholders after personal
taxes, I am writing here as a pt. How much is this income? This income is Rs 3,50,000 right. And
in this case, the income is 1,82,000.
So this is the income we have carried forward from the previous example. And we have assumed
the tax rate in this case as a 30 percent, personal tax rate as the 30 percent. So income to
shareholders after the personal tax we have calculated is Rs 3,50,000, Rs 1,82,000. Now we take
into the second part of the income to the debt, supplier or the debt holders. So what was the
income?

Income to debt holders or the bondholders the income because in this firm it is unlevered firm,
no debt is there, whereas in this case the income was there and that we had to calculated was Rs
4,80,000 rupees. If we recall, we had assumed that the total borrowing of the firm were the 4
million rupees and say the interest rate was 12 percent. So the say income to or interest cost to
the firm and the income to the debt holder was the Rs 4,80, 000 rupees. This is all in rupees right.

We all are taking this in rupee. So this is also in Rs 4,80,000. And here also we assumed that the
tax rate here is less, personal tax at the rate of 30 percent, personal taxes at the rate of 30 percent.
So how much is a tax? No tax here because there is no income because there is no debt in the
unlevered firm. But here in this case say personal tax at the rate of 30 percent, so if you take this,
this works out as Rs 1,44,000. This works out as Rs 1,44,000.

So finally, you can calculate as that income to, income to debt holders after personal taxes. So
how much is that income to the debt holders after personal taxes? This income is here. You call
it as zero because there is no debt. But in this case, the income is Rs 3,36,000. If you subtract
from the Rs 4,80,000, the total income, the tax component Rs 1,44,000, so income to the debt
holders after the personal tax, is this Rs 3,36,000.

958
And finally the combined income of shareholders and debt holders, d oblique h shareholders and
debt holders after personal taxes if you calculated this income, so this we have if you take the
combined effect of the income, this will come here as after personal taxes, if you take this so you
can say here that only this income is there Rs 3,50,000 rupees. And in this case, if you see this
income will be how much?

This income is going to be the say the income to the shareholders this much and this much. So
this works out as Rs 5,18,000. So you can say that the impact of the debt, if any firm is having
some amount of debt in their capital structure, so you can say that the amount of the debt is going
to create the say the difference here. And if we look at this the difference is going to be very
clear in this case.

So the total combined income, if you look at in both the cases, so combined income of the
shareholders and debt holders after the personal taxes it is Rs 3,50,000 rupees. In this case, it is
Rs 5,18, 000 rupees because the income to the shareholders after personal taxes is Rs 1,82,000.
And the income to the debt holders after personal tax is Rs 3,36,000. So it means combined
income of the shareholders and debt holders after the personal taxes is this much and in this firm
it is this much right.

So it means ultimately, when you talk about the whole thing in terms of the corporate taxes and
the personal taxes, after taking into consideration the effect of both the corporate and the
personal taxes, even the levered firms stand at a better position and ultimate income to the say
combined income to the shareholders as well as the debt holders or the say lenders is more as
compared to the income of the say shareholders in the unlevered firm, because ultimately this is
a very big advantage.

Tax advantage or tax deductible advantage of the debt component is very big advantage. And
because of that, because of this effect of taxes, even the Modigliani and Millar have also
accepted in their second proposition that because of the tax factor or the tax advantages the
(ultimately) ultimate cost of capital of the debt capital comes down, and any firm which is
having the mix of the debt and equity in their capital structure, their overall cost of capital is
going to get down.

And ultimately the purpose of a good capital structure, optimum capital structure is, that the
overall cost of capital should be as low as possible, or at least not low but at least optimum so

959
that the return to the equity shareholders can be maximized, maximizing the value of the firm. So
we have seen the impact of the taxes.

First we saw the impact of the corporate taxes and then we extended the same example means
remaining part towards considering the effect of the personal taxes. And then we have seen here
the ultimate income to the say combined income to the shareholders and debt holders in levered
firm is higher as compared to the unlevered firm.

So the tax deductible advantage or the tax deductible nature of debt capital is totally clear. It is
crystal clear. So it means now after discussing 4 theories net income approach, net operating
income approach, traditional approach and Modigliani Millar’s the two propositions we have
concluded here that a capital structure makes a difference and in the capital structure, if you have
the mix of both internal and external sources of the funds, both debt and equity.

So ultimately the capital structure which is having the funds from both the sources is the better
capital structure and overall cost of the capital is going to go down. So here is the one part we
have seen that in this case, we have assumed the tax rate means further improvement you can
make here. We have to consider the tax rate is equal in both the components, on the debt also or
on the equity also.

But in the real life scenario, what happens? In the real life scenario, the taxes on the equity
earnings or the earnings of the equity shareholders are far less as compared to the taxes of the say
debt suppliers or the debt holders right. And if that is the situation, if that happens, then this kind
of the picture will emerge, means we have assumed in our calculations that the personal tax rate
is of the 30 percent and both, equity shareholders and debt holders.

But in the real life scenario, what happens, the say capital gain as well as the dividend income of
the equity shareholders is taxed at a lesser rate as compared to the say interest income going to
be taxed in the hands of the or at the personal level while it reaches in the hands of the lenders.

(Refer Slide Time: 14:45)

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So the rates are different and if that is going to be the case so with the help of this model
particularly you can see the effect of the debt capital on the per rupee of the borrowing. So it
means with the help of this model, 1 minus 1 into 1 minus 1, minus tc into1 minus tpe divided by
1 minus tpd so tc is basically the corporate tax and say combined effect of the corporate tax. And
then the say equity tax or the say tax on that equity shareholders’ income has to be divided by the
1 minus personal tax on the debt capital or the debt income, especially not capital, debt income.

So it means with the help of this model, you can find out that if the interest rates are different,
sorry tax rates are different, tax rates on the say personal tax rate especially for the equity
shareholders and debt holders are different, which normally remain different tax rate on that debt
income is more as compared to the tax rate on the equity income. So ultimately the advantage of
the debt further increases, right.

So in this case, you can understand here that suppose the corporate tax rate is 50 percent we have
assumed the corporate tax rate is 50 percent and the equity income is taxed at the personal level
at the rate of 5 percent and the debt income is taxed again at the rate of 30 percent at the personal
level. So finally, you can say what this calculation is done here with the help of this model that
the tax advantage of every rupee of debt is how much? 32 paisa.

It means tax advantage on every rupee of borrowing because given this say tax structure or the
rate of taxes, corporate tax rate is 50 percent, equity income is taxed at 5 percent and debt
income is taxed at 30 percent. So if you happen to say have this kind of the scenario. So
ultimately the tax advantage of every rupee of the debt is 32 paisa means you can, just because of
the taxes you can, you can say in terms of the taxes 32 paisa on every rupee of the borrowing.

961
So which is not possible in case of the equity capital, because equity income or you can call it as
a tax deductible advantage is not at the corporate level in case of the equity. So equity income
means whatever the dividends firm pay, that does not have the tax deductible advantage as
compared to the say debt servicing charge. The interest component which the firms are allowed
to deduct as a say you can call it as the cost, the financial cost before paying the tax on that.

That property is not associated with the equity capital. So if you follow this model and consider
the corporate taxes and the personal taxes and the if the tax rates are different so with the help of
this model, you can find out that tax advantage of every rupee of the borrowing every rupee of
that is 32 paisa which advantage is not there with regard to the equity capital.

So it means equity capital is also tax at lesser rate of say lesser rate of tax at the personal level
and at the corporate level, no tax deductible advantage of the equity is there whereas
disadvantages is there are both the levels. In case of the, say debt capital, in case of the corporate
level, at least the financial cost is deductible. Tax is tax deductible and that saves the tax up to
that particular amount. And because of that say you can call it as this disadvantage or the debts
tax deductible nature.

The advantage of the debt is up to 32 paisa you can save 32 paisa by the way of say not paying
the taxes on the debt cost or the financial cost which we are paying to the debt holders for
providing the debt capital in the firm. So ultimately you can say both the taxes that is a corporate
taxes and personal taxes they impact the capital structure. And in both the cases debt capital has
the positive effect and say you can save a lot of money because of the tax deductible nature of
the debt. You can save a lot of money and you can means ultimately the cost of capital can be
brought down significantly.

And if the cost of capital goes down, which is the ultimate purpose of a appropriate capital
structure, so the ultimately the value of the firm gets maximized. So we started with the
discussion on the capital structure with the say capital structure and the value of the firm and
ultimate purpose is to find out the optimum capital structure where the cost of capital is the
optimal one and ultimately the income to the equity shareholders, residual income to the equity
shareholders gets maximized maximizing the value of the firm.

So means if you have the debt component in the capital structure, even the Modigliani Millar
have agreed that yes, because of having the debt capital, which is a cheaper source of finance in

962
the say out of the total sources. So your overall cost of capital goes down, maximizing the value
of the firm or the ultimate say maximizing the residual income to the equity shareholders.

Now we talk about that there are some limitations of the debt capital which do not allow the firm
to enjoy the total advantages of the debt capital despite it having the tax deductible nature or the
tax deductible advantages. There are some disadvantages associated. So you have to take those
disadvantages into consideration and then try to find out that what is the real cost. And for that
purpose, they are the two important things which are important here to be considered.

And first important thing is the cost of financial distress. Now what is a financial distress and
how it comes? The cost of financial distress is basically when the debt moves into the firm or the
debt appears in the capital structure of the firm. So firm moves slowly and steadily towards the
say financial distress right, that is not going to happen in the firm, which is totally equity finance
firm, because equity is the internal source of the firms.

And if there is any ups and downs happen in the firm, there is no sufficient profitability or there
is no sufficient liquidity in the firm. Equity shareholders are not going to raise any hue and cry.
But in case of the debt capital, if debt capital is adjusting in the capital structure of the firm and
because of the fixed nature of the say debt service charge, as well as the repayment of the say
principle component of the debt.

If there is some problem in the firm with regard to its profitability with regard to its liquidity of
the profitability and if the required amount of the funds is not available at any point of time to
service the debt or to repay the principal, then it brings in the financial distress in the firm right.
And their financial distress some time if continues much longer, then can take the firm to the
extent of liquidation or say declaring it bankrupt because say debt suppliers or the lenders cannot
wait for the unlimited period of time.

And if you are not returning their interest, if you are not paying their say principle component
returning on time, then they can take the firm to the court of law and they ask may ask or they
may plead for getting the firm declared as insolvent. So that distress cost is again very-very
important cost. So we should consider it equally means being important that if the debt moves in
the firm, the overall cost of capital gets down because debt is a cheaper source of the funds as
compared to equity.

963
But the real effect of that reduction in the cost of the debt cannot be enjoyed by the firm because
the moment that debt moves in the firm, the distress, financial distress also comes in the firm
because of the fixed nature of the obligations arising because of raising the part of the funds by
way of the debt instruments from the market, right. So there are some costs associated to the say
existence of debt in the capital structure of the firm. First is the financial distress cost. And
second is the agency cost.

These two costs we have to factor to find out the real impact of the say cheaper source of the
finance that is the debt capital being the cheaper source of finance. So what is the direct cost
means the financial distress has the two kinds of the costs. One is the direct cost, second is the
indirect cost.

(Refer Slide Time: 23:27)

So the direct cost of the financial distress is delaying liquidation may diminish the asset value.
Distress sale fetches lower price and legal and administrative costs are high. Sometimes what
happens that for example, if the firm is not doing well and if it has to be liquidated, then there is
a dispute between the equity holders and the say lenders. And that dispute sometimes means
ultimately for example if the firm is doing very well then fine it is, there is no problem. We can
service the debt also because we are getting the sufficient sales, we are getting the sufficient
profits and profits are liquid also.

So we are servicing the debt also and we are returning the principle on the due date. There is no
problem as such but because of any reason, if the firm has to be closed on or the firm has to be

964
liquidated then because of the existence of both internal and external stakeholder, the financial
distress cost further increases and that financial distress which has caused the closure of the firm
further creates the problem that ultimately you have to liquidate the firm, sell of the assets of the
firms in the market and realize the value and distributed amongst the equity and the debt
suppliers.

So means because of the existence of this, both the stakeholders, internal and external this
problem comes and sometime dispute comes up and ultimately means if you are going to sell the
assets today in the market, they are going to fetch the different price. But dispute continues for 1
year, 2 years, 3 years means in future. So after 3 years, if you are selling the assets in the market
of the financial distress firms they are not going to get the same price. So that is a one cost.

Distress sell fetches lower price even otherwise also the say the debt component, which has
brought in the distress, financial distress in the firm and which has made the firm sicker. So if
you want to sell of the assets of the sick firms in the market, otherwise also they not fetch the
competitive price from the market and legal and administrative costs are very high because
sometimes when any legal battle starts between the equity shareholders and the say a debt
supplier, then it longs, it prolongs sometime very long and legal and administrative costs keep on
increasing.

So there is the financial distress cost. But you see financial distress, we have to subtract as a cost
only if the debt is not properly managed in the firms. If the debt is not properly managed in the
firm and because of the debt, because of the existence of the debt in the capital structure of the
company if any company has to be liquidated so number one means there will be two negative
factors associated to the debt.

Number 1 because of the existence of the debt in the capital structure, the firm has to face the
financial distress. And when you are going to know, liquidate the firm as a remedy of taking it
out and then closing down the business even in the closer or liquidation of the firm. This debt is
creating the problem. These are the 3 direct costs which are coming because of the financial
distress and distress is coming because of the debt and indirect costs are many ships become
myopic. They become totally careless.

They do not pay much heed because they know also that the life of the firm is not very long. It is
a distress firm. There is a sick firm and it has to be soon sold in the market. So their quality of

965
the product after sales service, even payment to the creditors, they always created the problems
and they do not pay heed they means do not spend sufficient time. So means the indirect costs
further increases because suppliers also get annoyed, customers also get annoyed and everybody
who was very happy and who was important stakeholder in the growth of the firm.

Now, because of the say not being properly serviced, they are further adding into the say
financial distress of the firm. And then is the stakeholders dilute their commitment. Employees
you talk about; suppliers you talk about they dilute their commitment towards the company. And
the company which is already on the path of closure means they fasten it up. They further add up
to the closure of the firm to close it as quickly as possible.

So means I can say here, if the financial distress does not come because of the debt, if the debt
comes in the capital structure and if it is properly managed, then there is no issue. The cost of the
capital will be very low and the ultimate value of the firm will be maximized, and the residual
income to the equity shareholders will be maximum but if because of the say existence of the
debt in the capital structure of the firm.

If the firm moves towards the financial distress, then the cost is very high. So you have to be
very careful and consider it seriously that distress cost is there and either we should not allow the
distress to come in a firm where the debt exists. And in any case, if it comes, then we should be
prepared to pay a very heavy cost.

So finally we can say the major contributor to the financial distress is the debt. Major contributor
is the, to the financial distress is a debt. The greater the level of the debt and larger the debt
servicing burden associated with it, the higher the probability of the financial distress. So we
have to be very careful that bringing the debt in the capital structure of the firm, but not allow the
firm to go or move into the financial distress.

If you are not able to service the debt, if you are not able to pay the principal on time, mind it
you are going to reduce the cost of capital by bringing more debt in the firm. But taking
otherwise happen that even the entire firm may collapse and because of the non-availability of
the sufficient profitability because of the not proper management of the affairs of the firm. The
profitability may go down.

And even though profits are there but the profits are not cash profits so liquidity may go down.
And the objective with which we brought in that debt in the firm may not be met. And firm

966
moves from say, maximizing rather than maximizing the value of the firm to the equity
shareholders towards the financial distress. And ultimately it has to be liquidated. So we have to
be very careful that debt comes as a steeper source of funds.

It comes as it cheaper to source of funds, but it comes with one limitation. So be careful about
that limitation. Do not allow the debt to create a problem in the firm and manage it clearly and
carefully. So that means as we have borrowed the debt from the market, we are efficiently make
use of it and pay it back to the market.

Second cost is the agency cost because of the existence of the debt in the capital structure of the
firm, we have two kind of the agency relationships now. One agency relationship is between the
say your shareholder and the managers right because managers manage the fears of the
companies and they are agents of the shareholders and second agency relationship is between the
shareholders and the lenders or the creditors, right.

So because debt comes in the capital structure of the firm, so the debt suppliers become very-
very careful. And they sometime start interfering in the affairs of the firm. And when they start
interfering in the affairs of the firm so it increases the overall cost of the managing of the say
affairs of the firm and sometimes delaying the important decisions and ultimately it tends about
into increasing the overall cost of production.

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(Refer Slide Time: 30:34)

So you can see here what is written. There is an agency relationship between the shareholders
and the creditors of the firm that have substantial amount of the debt. Then the people or the
financial institutions or maybe the lenders, any other lenders, when they heavily lend to the firm
or provide the debt to the firm. In that case, they become careful about the proper use of the debt
given by them to the firm and they start interfering.

So it means that becomes the agency relationship and they want shareholders should manage
there or get their funds managed properly but when they are not finding the proper management
of their firms, they start interfering. Hence, lenders impose restrictive covenants and monitor the
behavior of the firm. Lenders impose restricted, restrictive covenants and monitor the behavior
of their firm and this monitoring cost is sometimes very high, which has to be paid by the firm.

Because the loss in their efficiency on account of restrictions when they put so many restrictions
say for example, they say there are the three projects identified by the firm. Project 1 and 2 are
less profitable and project 3 is highly profitable, but little bit risky. Shareholders want that the
investment should be made in the third project, but the say lenders may want that no-no, because
it is highly risky, so you avoid the investment in the third project.

You make the proportional investment into that project 1 and project 2. So what will be the
means outcome? Though you have managed the risk for your personal reasons but the overall
return of the firm has gone down and the return to equity shareholders also has gone down. So it
is on the own account of restrictions on the operational, the loss inefficiency on account of

968
restrictions on operational freedom, plus the cost of monitoring which are almost invariably
passed on to shareholders represent the agency costs associated with the debt.

So because they want, the debt suppliers that never trust their shareholders and ultimately it also
happens in the market that the debt suppliers’ sorry managers in the companies they are first the
agents of the shareholders, the owners of the company, not the agents of the debt suppliers or the
debt holders. So debt holders start suspecting the behavior of managers and they also start
assuming shareholders are not working in their best interests.

So they directly start interfering into the affairs of the firm. Sometimes they do not allow the
investment to be made into the highly profitable but little risky projects. So overall cost of capital
increases and rate of return gets down and that advantage of debt being tax deductible and being
a say cheaper source of the finance and so automatically gets over. And sometimes that becomes
not cheaper, but the costlier source of the finance, because debt comes with the interference of
the debt suppliers or the debt holders.

And that means creates a heavy cost on account of the firm’s operations and efficiency of the
firm can be say negatively hampered. So these two negative factors, one is the say moving of the
firm into financial distress because of the, not properly managing the debt. And second thing is
existence of the agency cost because of the existence of the heavy amount of the debt from
external stakeholders. These two costs create the problem. So if these two costs you take into
account.

969
(Refer Slide Time: 34:00)

So finally, the tradeoff becomes like. Tradeoff model looks like this, that on the one side you had
the value of the firm. Here you have the debt equity ratio. Simply for example, if this component
is not there, if you look at this, this component is not there. If you are say for example we are
applying a cut here, so we say everything is all normal. Firm is not moving to the financial
distress firm. Firm is not paying any agency cost also.

So what is the case? Value of the levered firm is depicted by the straight line right this line and
this line and value of the, this is a value of the unlevered firm, which is only equity financed and
value of the firm considering the tax advantage of the debt is this much because it is going up
because ultimately the cost of capital is going down. So the value of the firm is going up, but this
does not go this way. This behavior of the say firm’s income is not like this because in between
this gap comes here.

So this gap comes because of or this obstacle comes because of the financial distress cost and the
agency cost right. So when the financial distress and agency costs create the problem because of
the debt capital, adjusting in the capital structure of the firm. So finally you can say value of the
firm, considering the tax advantage and the financial distress and agency costs becomes like this.
So it does not go like this. It behaves like this. It comes like this.

So it means gap is not this much gap does not become this much, but the gap comes this much.
So we have to be very careful that debt capital is a cheaper source of finance, comes to the firm,

970
reduces the overall cost of capital. But at the same time, it comes with the two limitations also. It
may take the firm towards the financial distress and it may say create the extra problems for the
managers of the firm because of the existence of the agency relationship and because of the extra
interference of the debt holders.

So if these two costs are carefully taken care of, then ultimate advantage of the debt as a cheaper
source of finance can be enjoyed but these two sources are not sorry these two limitations are not
properly managed or not taken care of then that tax deductible nature of the debt or debt being a
cheaper source of the finance can be means cannot be enjoyed by the firm. So we have to be very
careful that debt is cheaper source of finance, provided the financial distress does not come in the
way and agency cause does not create a problem.

If these two limitations exist, then the ultimate advantage of debt being the cheaper source of
finance cannot be enjoyed to the extent as it was perceived to be. So we have to be very careful
about these two limitations. Otherwise, what will happen? The income will not go up like this
income will be say, moving in a curved form. It will start going up, but then the agency cost and
the financial distress will start creating a problem.

So the gap between the income of the levered firm and unlevered firm will be minimizing. So do
not allow this gap to be minimized and take care of the financial distress and the agency costs
and keep the say cost of the debt intact and ultimately say make sure that we have reduced the
cost of the capital, overall cost of the capital with the objective of maximizing the value of the
firm. So this is a trade of approach. This is the say second proposition of Modigliani and Miller
approach and this is very-very rational approach.

So in the second proposition of the, approach of the capital structure Modigliani and Miller
themselves have accepted that capital structure makes a difference. And because of that, say
existence of taxes debt capital becomes cheaper. So we should have the optimal mix of debt and
equity to have the optimum capital structure. Now I take you to the next level, and that is the say
two more theories of the capital structure.

971
(Refer Slide Time: 37:47)

One is the pecking order of financing. And second is the next is the signaling theory right. So
these two more theories are there. So if you talk the, these say pecking order and the signaling
theory so we will see here that what is the pecking order theory of the financing, which was
given to us in 1961 by the Gordon Donaldson.

Gordon Donaldson after studying the capital structure of different companies. He propounded a
different theory of the capital structure. And he said that there is a pecking order of financing
which goes as follows, that as per this theory first of all, the firms make use of the internal
capital. Then they make use of the debt finance and then they make use of the external equity.

This Donaldson has say concluded after studying the capital structure of the many firms in the
market and he has said that capital structure is important. He has also not denied the Modigliani
Miller theory because Modigliani and Miller theory have assumed that there is a complete
market say clarification and complete information symmetry exists.

And managers and investors know each and everything about the market and complete
transparency exists in the market. So if the complete transparency exists in the market
information symmetry exists in the market, then certainly the tradeoff theory or the second
proposition of the model Modigliani and Miller is important theory.

But sometimes when there is a say informational asymmetry in the market and clear information
is not available to the investors and managers about that, how the firms are doing, or maybe a
new firm want to enter in any industry, where other firms are already existing. So we want to

972
draw a clue about the capital structure of the new firm by drawing a clue from the capital
structure of the existing firms.

So in that case we can say that if the information is easily available about that, how much say
risk is there, how much return is there, how taxes are going to impacted, so finally you can have
the proper capital structure having the different proportion of the debt and equity. So that
happens in case of the complete information asymmetry, in case of the complete informational,
information transformation from the one say place to the another place from the one account to
another account.

But if complete information asymmetry is there or information is not easily available,

transparency is not there, then to know about the capital structure normally it has been found that
this theory can be made use of where the pecking order says that the total sources of the funds
used in the firms are on the basis of the pecking order and the pecking order of these sources of
the funds is number 1, firms make use of the internal sources of the funds which is the retained
earnings.

Then they go for the borrowings from the market and then they go for the external equity
finance. So finally it is written here, given the pecking order of financing there is no well-defined
target of debt equity ratio, right? If there is no complete transparency in the market, information
symmetry is not there then what will happen? The proper debt equity ratio cannot be created as
there are two kinds of equity internal and external, right?

So while the internal equity is at the top of the pecking order, the external equity is at the bottom,
so this theory says that if there is a complete market information asymmetry, information is not
available and say investors and managers are not able to take the proper decision about the
capital structure. So what they can do is they can see how the existing firms are doing in the
market, how their capital structure is decided.

And after studying some say, existing firms of capital structure, Gordon Donaldson has
propounded a theory that there is no point of looking at the debt and equity and anything right.
First of all, firms, because equity is of the two types if theory creates a problem then they say
that equity is of the two types. Retained earnings are also internal funds; you can call them as
equity and say, external equity by issuing the new shares in the market. That is also the equity.

973
So which equity you are talking about in case of the tradeoff theory, right. So you cannot say
much rely up on the say capital structure. It is better that you follow the pecking order and on the
basis of what he has observed from the practical situation in the market. He has said firms raise
the funds in this order; first they raise the funds from the internal sources of the finance because
there is no flotation cost. Raising the funds are very easy because they are internally available
right.

And that is the first source and after that, when they go to the say further requirement of the
funds. If there is a further requirement of the funds, then they do not issue the new fresh equity in
the market rather they prefer to borrow from the market and why they prefer to borrow from the
market? Because of the three advantages. First is the, that debt is not mispriced. Whatever the
rate of interest we are going to pay on the borrowings or on the debt that is going to be as per the
market rates.

So we are not going to be say we are not going to get affected negatively. This is a one part.
Second part is the positive part is that it is not going to affect that the say the position of the
equity shareholders. And third is that since the control is not going to be diluted from the equity
shareholders because it is the external source of the finance. It has to be only service in terms of
the interest and in terms of the repayment of the principal. So the dilution of the control of the
equity shareholder is not going to be there.

Equity shareholders position is not going to affected in any other sense. And it is not mispriced
also means easily you can find out what is the cost of borrowings from the market. So because of
these three properties, raising of the debt is cheaper as compared to raising of the funds by
issuing fresh equity in the market because the floatation cost is very high. The process is quite
tedious.

So the say this, he says that capital structure you cannot follow in all the cases because of having
the two kind of the internal sources on the funds, retained earnings and the equity capital. So the
better theory of the capital structure is the pecking order theory and this is what the firms are
falling in the market. He has observed after studying the capital structure of the firms they are
not following the trade of theory that bringing the equal amount of capital from debt and equity.

But they are following the pecking order and first they are depending upon the internal sources
of funds, then number two is the debt and number three is the say external sources of the funds or

974
even call it as the external equity finance which is coming up by issuing the equity shares, fresh
shares in the market.

So means, this is the say another theory you can call it as the fifth theory of the capital structure
and it is very helpful also say to know about that, if you are not able to decide properly because
of the lack of the proper market information and in the event of the information asymmetry, if it
is very difficult to decide the capital structure having the, say different proportions of the debt
and equity, then always it is better that we should follow the pecking order theory.

First raise the funds from the internal sources because it is not going to create any problem for
the firm. Second is go for the raising that debt from the market and third is then if still you
require the funds then issue the fresh equity in the market and raise the remaining amount of the
funds. But be careful if you raise the funds from the debt distress may come or debt may take the
toward the financial distress or it may create the agency problem.

So we have to be very careful. If we are means careful about these two negative limitations of
the debt capital, then if you are not able to follow the second proposition of the Modigliani and
Miller theory, then it is better to follow the pecking order theory.

975
(Refer Slide Time: 45:47)

One more theory is the last theory that is called as the signaling theory. I, means the reference of
the signaling theory, signaling theory is basically given to us by the Stewart C. Myers and the
Nikolas Majluf in 1984 and Nicholas Majluf these are the two economists who have given the
signaling theory.

And basically they have extended the pecking order theory given to us by the Mr. this your
Gordon Donaldson this theory they extended and they called it the new theory, which they
propounded, these two people they called they propounded a new theory, which is known as
basically the contribution of these two people. Stewart C. Myers and the, say your Nicholas
Majluf who gave this theory in 1984.

And they named it as a signaling theory and signaling he says that these two economists say that
normally the say your second proposition of the Modigliani and Miller has to be held good if
there is a complete information symmetry right.

If there is a complete information symmetry in the market, then it is better to decide the capital
structure by having the different proportions of debt and equity depending upon their respective
cost. But if it is not possible to find out and there is a complete market information asymmetry or
proper information is not available, managers and investors are not able to decide that from
where to raise the funds and how to expect or how much return to expect on particular
investment, then it is better to follow the pecking order theory right.

976
So what is the signaling theory what they have said, noting the inconsistency between the
tradeoff and the pecking order financing because tradeoff says there has to be proper say
composition of debt and equity. Pecking order says there is nothing like that there is a complete
information asymmetry in the market. So the capital structure has to be decided in the form of
three sources. First is internal, second is borrowing, third is the external equity.

So Myers proposed a new theory called the signaling or the asymmetric information theory of
the capital structure. This name of this theory is another name of the theory is asymmetric
information, because when the complete market information is not available then only on the
basis of the signals available from the market or the capital structure of the existing firms you
can decide that what should be the capital structure of the new firm in the industry and how you
can have the signals?

Signals basically come from, because ultimately the managers decide the capital structure of the
firm and since they are the insiders in the firm who manage the affairs of the firm, so they have
the complete internal information about the financial health of the firm right. So whatever the
capital structure, if there is a complete standard capital structure like say, the tradeoff theory
proposed by the Modigliani and Miller then signaling theory has no say even the pecking order
theory has no say.

But pecking order theory and signaling theory become important when the market is not
completely transparent and it is not possible to find out how firms decide the capital structure,
then either the pecking order becomes important or signaling theory becomes important.
Signaling theory means, why it is called as a signaling theory? That you can draw the signal from
the capital structure of the existing firms decided by the managers of the firms because they are
insiders in the firm who manage the affairs of the firm and they know the financial health of the
firm.

So keeping into consideration the overall financial health of the firm, they decide the capital
structure of the firm. So you just try to draw a signal that from there the funds are being raised by
the existing firms in the industry. Are there coming from internal sources retained earnings, that
capital or equity capital? But that can only happen in case of the lack of the proper information
or in the event of the information asymmetry.

977
If there is proper, complete information symmetry information is available in the market, then
the second theory of the Modigliani Miller proposition will be held good and the capital structure
will be decided on the basis of the equal portions of debt and equity. But if, that is not going to
be possible, then draw the, either you follow the pecking order theory or you draw the you
follow the signaling theory.

Because, whatever is the adjusting capital structure of the firms, that gives a signal to the
outsiders because that capital structure is decided with their managers, they are the internal
stakeholders. They know the complete information about the firm’s financial health. So how they
have decided the capital structure maybe they are going to decide the best capital structure of the
firm and if the firm is successful by following that capital structure.

So it is a signal to the rest of the world that the capital structure of the new firm in the market
also has to be what is existing capital structure of the existing firms in the market. So you draw
the signal from the existing capital structure, which is decided by the internal stakeholders, who
are managers of the firms. And then you draw the new capital structure, you decide the new
capital structure of the new firms.

So finally, they say a critical premise of the tradeoff theory is that all parties have the same
information and homogeneous expectations. If this held this is holds good that all parties have
the complete information and homogeneous expectations, then there is no alternative of the
tradeoff theory or the second proposition of the Modigliani Miller. But if Myers argued that if
there is asymmetric information, if there is asymmetric information complete information about
that capital structure is not available and divergent expectations which explain the pecking order
of the financing observed in practice, right.

Myers argued that there is asymmetric information and divergent expectations which explain the
pecking order of the financing observed in the practice because if there is a complete information
available, there is no alternative of the second proposition of the Modigliani Miller theory. You
have to have the optimum capital structure of the firm to reduce the cost of the capital.

But if there is a lack of information symmetry in the market or a complete information

asymmetry exists, then naturally you have to follow either the pecking order theory or you have
to draw the signals from the existing capital structure of the firms and decide the capital structure

978
of the new firm, because that signal is very important that how the existing capital structure of
the firms is decided.

Have they used the first the say retained earnings or they have used the debt capital secondly,
and thirdly they had to use the equity capital or there is any other way of deciding the capital
structure to draw the signal? Either you follow the pecking order theory or you draw the signal
from the existing capital structure of the firms and decide the new capital structure of the new
firm.

So these are different theories available, which we discussed until now. And we started with the
net income approach. Then we moved to the net operating income approach. Then we moved to
the traditional say approach. And all these approaches, all these approaches are considered as
non-systematic approach, non-scientific approaches of the capital structure. And in 1958, one
scientific approach came up given by the Modigliani and Miller and later on they improved their
first proposition came with the second proposition, which became popular as a tradeoff theory
because it a tradeoff between the risk and return.

And means normally this second theory, tradeoff theory which is a replica of the net income
approach is prevalent in the market for deciding the capital structure and the capital structure has
a meaning. People say even today that the capital structure has a meaning more the amount of the
debt overall cost of capital of the firm goes down because that is the cheaper source of the
finance.

But tradeoff theory is possible to be followed only if there is a complete information and
homogeneous expectations of all the stakeholders that is investors and managers and even the
owners of the company, right. But if the complete information is not available, that how to
decide the proportions of debt and equity, what is the cost of debt, what is the cost of equity and
what are the expectations of managers and investors in that case, two other theories are there.

Either you can follow the pecking order theory where we can use the retained earnings first, then
the debt number 2 and number 3 is the equity capital raised by issuing the fresh equity in the
market or even if the pecking order theory is not possible to be followed then we can say use the
say signaling theory which was given which is a modification of basically extension, not
modification, extension of the pecking order theory given to us by the Stewart C. Myers and then
Nicholas Majluf in 1984.

979
And I would add here this signaling theory was first propounded in 1977 by Professor Ross
which was further means extended by these two financial economist Stewart C. Myers and the
Nicholas Majluf in 1984. And basically this signaling theory is the extension of the pecking
order theory and if you are not able to follow any of the approaches, including the pecking order,
then you use the signaling theory and whatever the signals you get from the existing firms, the
capital structure from the market, you also decide the capital structure of the new firm
accordingly.

So as far as the conceptual part the, you can call it is a discussion on the capital structure was
concerned. I have done it to the say extent possible till now. We have started with the
introductory part of the capital structure and discussed the importance of the capital structure and
then we discussed the different theories of the capital structure. So say I will stop here with the
say discussion on the capital structure.

But complete discussion will be over only once we do one at least one practical problem on the
capital structure that how the capital structure of the firms impact the overall cost of capital. So if
there is existing capital structure of the firm and if the cost of capital is more, so if you want to
raise further capital for the expansion or diversification or further growth of the firm. So we have
to be very carefully say look for the sources of the funds which ultimately bring down the overall
cost of capital of the firm.

So I will discuss one practical problem, but not in this class, in the next class. After that, I will
completely close that discussion on the capital structure and move to the next part. And that is
the last topic of this course as a whole and that will be the dividend decisions. So one practical
problem on the capital structure and the next topic, dividend decisions, I will start talking to you
in the next class, till then thank you very much.

980
 Financial Management for Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 58
Capital Structure-Part 5

Welcome all, so as a last leg of discussion on the capital structure, I will do one problem now
and we will try to understand that the if, we change the capital structure or the composition of the
different sources of the funds, then see how the cost of capital can be say affected or can be
increased or decreased. So because ultimate purpose of the capital structure is that we want to
have the optimum capital structures where the cost of capital of the firm is within control or the
optimum, neither too high nor too low.

And ultimate say, value of the firm to the equity shareholders is the maximum. So we have
discussed conceptually till the pre say, previous class all theories, almost all the theories we have
discussed in detail, all the capital structure theories starting with the net income approach, net
operating income approach, traditional approach, then the Modigliani Miller both the
propositions we have discussed, then we say discussed something about the say pecking order
theory and the signaling theory.

So after all these theories though even today you can say that there is not a clear cut answer with
regard to the capital structure that what helps to design an optimum capital structure. But still,
even the Modigliani and Miller second proposition also has concluded that the amount of the
debt in the capital structure helps to bring down the overall cost of capital. So certainly now there
should be the proper mix of the debt and equity.

And if there is a proper mix of the debt and equity in the capital structure of the firm so what will
happen? Your cost of capital will also be within control and risk of the firm as a whole will also
be under control. And the objective of the maximization of the value of the firm will also be
attained. So after discussing conceptually all the say concepts and the say relevant theories of the
capital structure, now I will say close the discussion in this class.

But after discussing one practical problem with you that how the capital structure makes a
difference and how the debt capital being a cheaper source of finance because of the tax

981
deductible advantage. How it affects the overall cost of capital, because ultimate objective of any
capital structure is to minimize the cost of the capital, right. Because if there is no say effect on
the cost of capital of the different sources of the finance, then there is no point thinking about
whether the fund should come from the equity or the fund should come from the debt.

But if we are, say getting the clue from the different theories, for example we started with the net
income approach and net income approach has say helped us to understand that the movement
you increase the amount of debt in the firm, the cost of the debt being lesser as compared to the
cost of equity, overall cost of the capital gets down and say that objective of maximization of the
value of the firm can be achieved.

And reverse to this was the net operating income approach. And both these approaches were
means finally tested and presented by the Modigliani Miller also. In the first proposition of their
theory, they supported the net operating income approach and they themselves have argued that
because of the arbitrage argument, capital structure has no meaning, right. Whether you bring the
say capital from the say equity or with the help of debt ultimately, it is not going to impact the
cost of capital.

So that was a first proposition of the Modigliani Miller. But in the second proposition, they
themselves have agreed and empirically proved it, scientifically proved it that yes, debt being the
cheaper source of finance, if the amount of the debt is included in the capital structure of the firm
then because of the effect of the corporate taxes and the personal taxes, both the taxes, the
overall cost of say capital can come down. Overall cost of capital of the firm can come down.

And because of that, say existence of the debt when the overall cost of the capital comes down,
the value maximization objective of the firm can be attained. So in the first proposition, they
supported the net operating income approach. But in the second proposition, they supported the
net income approach. So it means after talking about all these theories, then we talked about the
pecking order theory, which says that it is not the tradeoff theory which is the second proposition
of Modigliani Miller theory.

But the pecking order theory says that there is no question of equal amount of debt and equity or
having the funds from both the sources largely say studying the capital structure of the firms.

982
The person who propounded the theory he has say concluded, observed, remarked that there is a
pecking order of the different sources of the funds and first the firms make use of the internal
sources. Then they borrow the funds from the market because that is not mispriced and it does
not dilute the control of the existing equity shareholders.

So that is a second option and third option is the equity capital because of so many hassles
associated to the equity capital, the equity capital is ranked as the third source of the finance
right. So later on then the, we discussed another theory given by the Myers that was a signaling
theory and Myers also said that if there is a market asymmetry or the say, there is not
homogeneous expeditions of all managers and investors and the market information is not
complete, it is not transparent, then certainly the pecking order theory is the better to use.

But finally, they said means extending the pecking order theory they gave their own theories,
signaling theory and they said that you can if, you are not able to find out anything because of
the lack of the proper information available from the market with regard to the capital structure
of the companies, then you can make out from the signals coming out of the firms because
whatever that capital structure is designed by the managers of the companies.

They are the internal stakeholders and whatever the capital structure is designed by them that
gives us a signal that, for example, if more funds they are say arranging from the internal sources
and then they are moving towards the debt and then they are moving towards the equity. So you
can draw a signal that firm has lot of retained earnings available and they first want to make use
of that.

Then they prefer the debt over the equity because equity sometimes, when you issue the equity in
the market, it creates a problem that it has the issuing cost and the flotation cost, these two costs
are very high and when we issue the fresh equity in the market it gives a signal in the market that
the existing equity of the firm is overpriced. That is why more number of shares are being issued
in the market.

So signal does not go as well and cost associated to the issuing of the fresh equity is also high.
So it is better to say raise the funds. First after the retained earnings, first from the debt, which is
not mispriced at all, does not dilute the control of existing equity shareholders and then once
these two sources are exhausted, so third one we should go for the equity because the another

983
limitation of the equity capital is fresh equity capital is that it dilutes the control of the existing
equity shareholders.

So you can draw the signal in the absence of the symmetrical information, you can draw the
signal from the existing capital structure of the firms which is designed by the internal
stakeholders who are the managers of the company. So you can draw the signal that how the
existing firms in the industry have designed their capital structure, same way we should also be
means trying to go ahead and form the capital structure of the new company or maybe any new
project of the existing company.

So after talking about these theories basic 5-6 theories of the capital structure, I think if you say
listen to the lectures carefully and then consult the book also, the financial management by
Prassana Chandra or any other book on the financial management, then you will be clear that
whether capital structure has any meaning or not. And what are the different theories say till now
which are in existence which can help us to design the say optimum capital structure of the firms.

So before I conclude the discussion on the capital structure, I will do one problem and we will
try to find out that if you have some existing firm and some existing capital structure, you must
have some existing cost of capital, weighted average cost of capital. But if you want to go for the
expansion, growth, diversification, then as a student of finance, the leaner student of finance,
how you should expand from there the funds should come and how this extended capital
structure should be financed.

So ultimate objective of every good finance manager should be to minimize the cost of capital,
so let us see how that capital structures are decided by the firms, how they influence the say
overall cost of capital of the firm and how the capital structure can contribute in the
maximization of the firm’s value. So let us discuss this problem and then we will close the
discussion on the capital structure right. So it is a very simple problem, is this nothing complex
about it.

984
(Refer Slide Time: 09:27)

I have brought very simple problem here and the problem is the following information is
available for the ABC Limited and the information is 4 point based information. First
information given to us is the operating income till now existing operating income is the 40
million rupees’, interest on debt means we have the two sources of the fund in the existing
capital structure because we are given the cost of debt and we are given the cost of equity.

Interest on debt is 10 million and the cost of equity is 18 percent and the cost of debt is 12
percent, right. So it means these 4-point information is given to us so we can draw some clue
from this information that say both the sources of the funds long term sources of the funds, debt
and equity have been used by the firm and now what we are required to do? We are required to
do is the first thing, what is the average cost of capital of the company.

Looking at the existing situation, existing say composition of the debt and equity first question
we have to answer is what is the say average cost of the capital of the company for the existing
capital structure? And then the second question is what happens to the average cost of capital of
the company? If it employs 100 million of rupees, 100 million of debt to finance the project,
which earns an operating income of 20 million rupees.

So in the existing capital structure, they want to add up 100 more million rupees and they want to
go for the expansion by, say, initiating a new investment proposal so the investment requirement
of that proposal is 100 million and the operating income is 20 million. Assume that net operating

985
income approach applies and there are no taxes, right. Assume that net operating income
approach applies and there are no taxes.

So net operating income approach applies means that you can assume you can draw the signal
here that the cost of equity will be more as compared to the cost of the debt. And what should be
our intention here that we should in the expansion project that is why maybe the intention of the
company’s managers is that for the expansion of the say company’s operations, when they want
to invest an additional 100 million rupees. They want to invest it with the help of debt right. Not
with the help of equity because debt is cheaper than equity.

And it is given clearly that the cost of equity is 18 percent, cost of the debt is 12 percent this is
the maybe the, say after tax, but since there are no taxes given to us, so it means no impact of the
taxes has to be taken. So whatever the 12 percent cost of debt is given to us is, that is the after tax
cost of the debt, we can assume it like this.

Cost of equity is 18 percent and then operating income of the existing operations is 40 million
and interest on the debt is 10 million. So first we will answer the first question by calculating the
average cost of capital basically, it will be the weighted average cost of capital and then we will
see that when we add up 100 million more by borrowing it from the market in the form of debt,
which has the earning capacity of increasing the operating income by Rs 20 million.

So how the cost of capital will be responding so or will be becoming like right. So let us do this
and try to understand that is there any impact of the debt capital on the cost of capital of the firm
or not, right? So the first question is what is the value of sorry, what is the average cost of capital
of the company? Right, this is the first question. What is the average cost of capital for the
company or the say weighted average cost of capital for the company?

So for calculating the weighted average cost of the company, you need to point information, one
information is the cost of the respective source of the funds and amount generated from that
source of the funds. And finally, we will be summing up the all the funds coming from different
sources, making it as the total amount available and then deciding the proportions of the debt and
equity multiplying it by the respective cost of debt and equity.

986
You will be able to find out the weighted average cost of capital. So in this case we are given the
cost of equity and we are given the cost of debt, but we are not given the amount of equity and
we are not given the amount of debt. Without that, you cannot afford to calculate the weighted
average cost of capital. So you have to calculate, first of all, the market value of the debt and the
market value of the equity.

And once you have got the market value of debt, market value of equity, you will be able to find
out the total value of the firm in the financial terms and the cost of these two sources is given to
us. So proportionate amount if you multiply by the respective cost of the source of the finance,
you will be able to find out the weighted average cost of capital. So let us find out the say market
value of debt and equity.

(Refer Slide Time: 14:36)

So first point, what you have to do is first question we are going to answer. So you have to find
out the market value of debt and equity so which we need right, because without proportions
what component you will be multiplying with the cost. So market value of debt and equity. So
first of all, we calculate the market value of debt and that is equal to how much? You can easily
calculate it. That is the, what is the debt amount, total amount of the debt is given to us and that
is the say cost of the debt is this.

Interest on the debt is 10 million. So it means we have to find out the, we are given the amount
of debt. So interest on the debt is it is given to us here, interest on the debt is Rs 10 million and

987
the cost of the debt is 12 percent right. So if you see here the for calculating the market value of
the debt, you have to divide the say, interest on the debt, Rs 10 million by the cost of the debt
and the cost of the debt is how much? It is 12 percent. If you try to solve it, you will be able to
find out the final amount comes up as Rs 83.33 million.

This is the market value of the debt by dividing the total amount of the interest paid on the debt
with the by this means dividing the total amount of interest paid on the debt by the cost of the
debt. You will be able to find out the market value of the debt. And in the present case, we have
found out is Rs 83.33 million. Now let us calculate the market value of equity.

So if you calculate the market value of equity, how we can calculate the market value of equity?
For calculating the market value of equity we will have to now again follow some process here.
And for this purpose we have to again move the same way. We are given the cost of equity;
market value of equity, it is given to us. So for calculating the market value of equity, you are
given the total information that is what is operating income? Rs 40 million, right and what is the
interest on debt? Rs 10 million so the remaining amount available is to the equity shareholders.

So the amount available or the cost of, or the amount available to the operating income available
to the equity shareholders if it is divided by the cost of equity we will be able to find out the
market value of the equity. So what is the total amount? Operating income is Rs 40 million and
after paying the interest of Rs 10 million, how much is left with us Rs 30 million. We are left
with the Rs 30 million. So you have to divide it by the cost of equity and the cost of equity is
given to us is 18 percent.

And if you follow this approach so the amount of equity works out as the value, market value of
the equity works out as Rs 166.67 million. Now you have got all the four components, you have
got the amount of debt, you have got the amount of equity means the, market value of the debt,
market value of the equity. You have got the cost of the debt. You have got the cost of equity. So
now calculate let us calculated the weighted average costs of capital. So how much it works out
as?

We are going to take as the first of all the cost of the debt, which is 12 percent and you multiply
with the help of this 12 percent. You have to find out what is the amount of debt, market value of
the debt is 83.33 rupees, Rs 83.33 million. And what is the total amount? This plus this, this plus

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this, if you sum these up so you will find the total amount and total amount works out as Rs 250
million and then you have to take the second component.

Second is the equity. Equity cost is 18 percent. And what is that equity composition market value
of the equity? This is Rs 166.67 million. It is also million divided by Rs 250, so you can if you
solve this, you will be able to find out that the weighted average cost of capital is the 16 percent
that in case of existing capital structure.

This is the cost of say, capital weighted average cost of capital for the firm ABC Limited is for
the existing operations because out of the 250 rupees’ total market value of the 250 million
rupees’ total market value of the firm, that component is the Rs 83.33 million and equity
component is the Rs 166.67 million. So and the cost of the debt is 12 percent, cost of the equity
is 18 percent, so weighted average cost of capital is the 16 percent.

Now next question we have to answer is and we want to answer the next question.

(Refer Slide Time: 19:52)

What is the next question that what happens to the average cost of capital of the company if it
employs Rs 100 million of debt to finance a project which earns an operating income of Rs 20
million? Assume that the net operating income approach applies and there are no taxes. Now let
us find out how much is now, the weighted average cost of capital once company employs

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another 100 million rupees by way of borrowing it from the market or as a debt from the market
right.

So in this case, once Rs 100 million means borrowed from the market, cost of capital after say
borrowing, after borrowing Rs 100 million as debt from the market right. So we have to calculate
the revised weighted average cost of capital, cost of capital after borrowing, so cost of capital
after borrowing the Rs 100 million, Rs 100 million from the market.

So you can easily find out this is Rs 100 million after borrowing the Rs 100 million from the
market, so we can find out here. Now what will be the net operating income? Net operating
income will be how much? It will change now because when you are bringing in the (20) Rs 100
million of the debt in the market now in the new project and if we make investment, so your
income will become now what was your earlier income, Rs 40 million and this new investment is
going to give us an income, Rs 20 million. So this income will become as Rs 60 million.

So this is the net operating income, this is 60 million rupees. Net operating income is 60 million
rupees, right. Interest on debt, let us see now the interest on debt. What is the new interest on
debt because we are infusing the additional amount of debt of Rs 100 million, which is costing us
at say, something like 12 percent? So we will have to think there is cost interest on debt. How
much is the interest on debt now?

Total value of the debt, total value of the interest is earlier we had how much? Rs 10 million and
now we are borrowing Rs 100 million at the rate of 12 percent. So total interest on the debt will
become Rs 22 million and then we have got the equity earnings. We have to find out the equity
earnings. If we calculate the equity earnings how much, Rs 60 million is the total operating
income interest on debt is Rs 22. So equity earnings are only left with us is the Rs 38 million.
This amount will go to the equity shareholders, Rs 38 million right.

Now, let us see the market value of equity. So if we take the market value of equity, you can see
here what is the market value of the equity? Is there any change in the market value of the
equity? Yes, there is a (mark) change in the market value of the equity. And the market value of
the equity is now going to be how much? You can recalculate it. How we have calculated the
market value of the equity earlier because now the equity earnings have been increased from say,
whatever that amount was earlier 238 million.

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So market value of the equity can easily be calculated and if you calculate this how we
calculated previously same way if you do it, it will become Rs 211.11 million. This is the market
value of the equity and now similarly the market value of debt. If you calculate the market value
of debt, you can easily calculate the market value of the debt and this amount market value of the
debt will become is how much?

It is already given, earlier we had the debt component Rs 83.33 and now we are borrowing Rs
100 million more. So this amount will become as Rs 183.33 million. So this is going to be the
market value of the debt. This is the market value of the debt. So we have got everything now.
We have got the net operating income of Rs 60 million. We have got the interest on debt Rs 22
million. We have got the equity earnings Rs 38 million, Rs 38 means Rs 60 minus Rs 22 is Rs 38
million. So again, be revised the market value of the equity because now the equity earnings
have changed.

So we have to find it out 38 when you say upscale the market value of the equity. So it has gone
up. Earlier, it was Rs 166.67 million, but now it has become Rs 211.11 million. Market value of
the debt is same that is Rs 83.33 was earlier and Rs 100 million we have borrowed freshly from
the market. So this becomes Rs 183.33 million, so now market value of the firm as a whole, so if
you take the market value of the firm, market value of the firm as a whole if you take how much
it becomes? It becomes now this plus this right.

So this will be how much? This will become as Rs 394.44 million. This is the market value of
the firm and now on the basis of this information. Hence, you can calculate that the revised cost
of weighted average, cost of capital hence revised weighted average cost of capital, so you can
easily calculate it, the rate of interest cost is the same 12 percent, interest cost is, borrowing cost
is 12 percent into what is the market value of the debt, Rs 183.33 divided by Rs 394.44. So this is
the way you can calculate the cost of the debt composition.

So this is Rs 183.33 and we have similarly got the value of the debt. So this is Rs 183.33 and
total market value of the firm is Rs 394.44 plus you have to now calculate the cost of equity,
which is 18 percent into, what is the market value of the equity now? Rs 211.11, I am not writing
rupee, so it is in the rupees, millions. I can write here millions. It is millions. So this is Rs 394.44
right, the total amount.

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So this composition if you total it up Rs 183.33 plus Rs 211.11 million. If you sum it up, this
becomes as Rs 394.44. So finally if you calculate the WACC by this say solving this equation.
So WACC you can call it as the revised, revised WACC is how much? Revised WACC is 15.21
percent. Earlier how much was that weighted average cost of capital? 16 percent but now as we
have brought in the more amount of the debt in the firm additional 100 million we have brought
in the firm and that say amount has been brought by we have the borrowing from the market.

So in this case, the ultimate cost of the capital, revised weighted average cost of capital has gone
down because that is cheaper as compared to the equity cost of equity is given to us is 18
percent. And the cost of the debt is say 12 percent, which is there. There is a difference of clear
cut difference of 6 percent. So when you are going for the expansion and diversification or the
further investment in the firm we are making in the new project. We have decided to invest funds
by borrowing it from the market because cost of the borrowing is lesser by 6 percent as
compared to the equity and the effect of that we have seen in the revised capital structure.

And now the revised weighted average cost of capital has come down from 16 percent earlier to
15.21 percent. So you can see that the ultimate purpose of doing this problem was that whatever
we conceptually discussed, what different theories of the capital structure we discussed, how
means practically they are going to be helpful and we wanted to find it out that is the debt capital
truly cheaper as compared to the equity and looking at the in this case, we have assumed, for
example, that say there are no taxes.

But had the taxes been there? Either you assume that this 12 percent is the after tax cost but if
you say still feel that taxes are also there and this cost is tax deductible, so you can say the
overall cost of capital weighted average cost of capital of the firm will further go down. So you
can understand that by doing this problem, what was the capital structure we had seen the cost of
capital was 16 percent.

But when we expanded operations by borrowing funds from the market rather than say bringing
additional equity in the firm our overall cost of capital revised weighted average cost of capital
has gone down from 16 percent to 15.21 percent. So you can easily understand that whatever the
theory says though even today, we are not able to concretely conclude that yes, there is a

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standard formula of deciding the capital structure of the firms that you cannot say with that much
of conviction or that much of the say belief.

But still there is a indication and almost all the theories also say that debt is cheaper as compared
to the equity. But the limitation of the debt we have discussed is that say number one, it increases
the risk and risk comes in the form of that distressed cost. It comes in the form of the agency cost
right. So if you do not consider these limitations of the debt or especially the risk component,
which is brought in by the debt in the firm.

The moment you bring that amount of debt in the capital structure of the firm. So ultimately the
objective of minimizing the cost of capital can be attained by having the sufficient amount of the
debt in the capital structure of the firms and equity capital can be there has to be there in any
case, because debt equity ratio has to be something. So equity has to be there but if you have the
amount of debt at least equal to the equity or maybe little more than the equity.

So we are going to understand that risk profile of the firm is going to change, but the cost of
capital is significantly going to go down. And ultimate objective of the maximization of the
value of the firm is going to be achieved.

So with this discussion, I am going to close discussion on the capital structure. I hope you have
understood the things clearly and still if there is any doubt after listening to the lectures on the
capital structure. If you still have any kind of the doubt, you can refer to the book and all the
theories you can understand there.

You can say do some practical problems also. And finally, you can form your own opinion that
what is the capital structure? How it should be normally decided by the firms and how it impacts
the market value of the firm, right? So this is all about the capital structure. And I close the
discussion on the capital structure and the market value of the firm. Now, the next part is the next
topic is the last topic in this course plan, which I have given with regard to this say subject of the
financial management for the managers.

And the last topic is that is dividend decisions. We are going to now talk about the dividend
decisions in detail and whatever the leftover time is with me, I will be talking about the dividend
decisions. I will introduce you with the concept of the dividend decisions. What is the

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importance of the dividend decisions, how normally companies take the dividend decisions and
from the shareholders’ point of view, how important the dividend decisions are and from the
companys point of view, how relevant the dividend decisions are and what should be the say you
can call it as rational dividend policy?

How it is decided all about the dividend decisions I am going to discuss with you now in the say
subsequent discussion. So dividend decisions when we talk about, or we say talk about the term
dividend, you all understand or must be clear about the dividend is basically the reward of
investment by the equity and preference shareholders in the total capital structure of any
company.

The say amount of the borrowing which we bring in the firm, the cost of the debt is paid as the
first obligation, first of all. And means there is no second thought about that because it is a fixed
obligation on the part of the firm and first from the total revenue of the firm by way of sales or
any other source of income; we subtract the cost of debt in the profit and loss account itself.

And after that, whatever the profit is say left with us after paying the taxes and everything, the
profit available to us is called as the divisible profit and from that profit we normally divided it
into 2 parts or 3 parts sometimes. One part is paid as a dividend to the shareholders, both equity
and preference. Normally preference dividend is first paid but after this we pay the dividend to
the equity shareholders and then we say create some specific reserves.

For example, debenture redemption reserve we have to create or for any specific purpose which
is foreseeable purpose. We have to create some reserves from the profit after tax available with
us. And third component is that is retained earnings which are added into the existing capital of
the firm. So broadening the capital base of the firm, so dividend decisions are very-very
important decisions because if you want to keep the morale of the investors high in the firm and
even the overall reputation of the firm better high in the market.

So that people are all the times inclined to buy the shares of the company, not through IPOS or
FPOS. But even in the secondary market. So dividend plays a very important role. So companies
have to pay the dividend. There are the companies who are not paying the dividend at all or who
are paying a very lesser amount of dividend. But people are still satisfied with their dividend

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policy because they know it that whatever the, say profit is being earned by the company that is
being reinvested back.

That is being reinvested back in the business may broadening the capital base. So they may be
the shareholders who do not want the regular income as the dividend income. So they can get the
entire income by the way of the capital gains by selling the stock in the market when they feel
that now it is appropriate time to sell the stock in the secondary market. So net gain to any
investor comes in the two forms.

One is the dividend which is the annual return on the investment made in the companys equity.
Second is the capital gain. So we will talk here largely about the dividend decisions or the
dividend part how the dividend is decided. And what are the important reasons why the dividend
is given by the firms. So first question arises why firms pay dividend to the shareholders, why
firms pay dividend? If the firm not pay dividend to the shareholders, what will happen, right?

(Refer Slide Time: 35:13)

So we have divided the reasons into two parts. One is the plausible reasons, second is that
dubious reasons of paying the dividends? Plausible reasons and second is the dubious reason for
not paying the dividends and the plausible reasons which are clear cut reasons which are possible
reasons are investor preference for dividend and second is that information signaling.

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Investor preference is very clear that investors always prefer normally hardly there is any
investor in the market who is of the view that I do not want any dividend and whatever the total
profit is being earned by the firm that should be reinvested back into the business operations.
And only I want to get the return by way of the capital gains, nothing in the form of dividends.
Very few people there are the people in the market but very few people are there right. So largely
people expect dividends and if the firms do not pay the dividend, it sometimes creates the
problem.

So because of the investor preference for the dividend as a regular income on their investment in
the companies and stocks, companies declare dividend. Information signaling is a very-very
important information about the companys performance. Because if the company is not paying
any kind of dividend, it means it conveys a message in the market that maybe the shareholders
who are basically the agents of the sorry, not shareholders, but the managers who are basically
the agents of the shareholders.

They may be misappropriating with the say the profits available or they may be investing the
profits into that kind of the projects which are not worthy of investment. So why they are not
paying the dividend? Sometimes the say the signal may go in the market will not be a good
signal. So that information signaling you can divide into two parts, first is the clientele effect and
second is the agency cost.

So when you talk about the clientele effect, clientele effect is means that say investors choose
those kinds of companies which fulfill their investment requirements. So you can divide
normally the investors in the market into 3 broad categories. One is those kind of investors who
want the dividend and who want the capital gain also. Means largely first category is that who
want dividend.

Second category of the customers who want only capital gains and they do not want any kind of
the dividends right. And third category of investors could be who want both dividends also and
the part of the say, appreciation in the share prices also, so both. So it means when the investors
choose the companies for the investment of their surplus savings into the stocks of the
companies. They fit into the, the dividend policy of the company and they mean basically called
as the investor clients.

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They are called as basically the investor clients for the companies because all the investors are
not suitable for all the companies. So largely their choice of the company or companys choice of
their investors depends upon the dividend policy or the return policy on the investment of
shareholders. So the different type of clients go to the different type of the companies for the
subscription of the shares. So you have to pay the dividend and that is a clientele effect.

Second is agency cost. Agency cost is means as I told you, managers are the agents of the
shareholders. They are only agents and there is always a lack of trust between the managers and
shareholders right because shareholders, all the shareholders are not means involved into the
affairs of the company or managing the company.

So always there remains a say source of suspicion that if we do not ask for the dividend or we are
not being paid any dividend. I do not know or we do not know how the say surplus funds of the
company are being used by these managers because the shareholders themselves are not
managing the companies. Managers are managing their companies for shareholders. So it creates
the agency relationship and agency costs is say something which is sort of that they do not trust
their managers to the fullest possible extent.

So that creates the agency cost and agency costs becomes another reason that to satisfy their
investors. It becomes a prime duty of the say agents or the managers to pay the say regular
dividend to the shareholders. So information signaling goes out or the information signal goes in
the market that if the dividend is being paid, companies doing very well and all kinds of needs,
of this investors are going to be taken care of.

So two reasons are first being investors preference, prefer dividend. Second is it gives the
relevant information, very information, very important information signal in the market. So that
is the second reason for giving the clear cut reason for giving the dividend. Dubious reasons for
paying the dividends are bird in hand fallacy. People say that who knows, the company will grow
in the time to come. So whatever you have in your hands, normally we see that a bird is in hand
is better than two the bush.

So sometimes investors also that kind of the policy that who has seen the time to come that our
investment will grow and by say earning through capital gain will maximize our returns. First
you whatever is possible to be, say, pocketed by way of getting the liberal amount of dividend

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first to enjoy that and lateral on if some capital gain also comes. Fine, let it come and second is
temporary excess cash.

If there is some temporary excess cash available, so certainly means if you do not need that cash
within the firm, you not need the cash within the firm then it is better that means there is no
policy as such but sometime the firm may decide management of the firm, board of directors
may decide that let us use this cash, for paying the dividend to the shareholders. So it is not a
clear reason that we have to pay the dividend because we are going to pay the dividend because
we have the surplus cash.

So rather than using it somewhere else, we do not need it internally also. So let us use it for
paying the dividend to shareholders. So these are the two dubious reasons. So some total, there
are the four important reasons. Two are very clear reasons and two are means out of the
situation. Dubious means they are not doubtful. You cannot take the meaning as doubtful but out
of the situation dividend is paid by it is not the policy of the firm sometime. But out of the
situation, situation emerges something like this that dividend comes through the shareholders.

(Refer Slide Time: 41:37)

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Dividend policy payout ratio, so it means we will talk about the important things here, dividend
policy right. Dividend policy, so first is the dividend policy. How the dividend policy of the firm
is decided? It has two components. Number one is deciding about the average payout ratio. And
second thing is the stability of the dividend payout ratio. This is the second component. So
dividend policy when you talk about it has to be a stable policy.

And the other important component here is that is the average payout ratio. So dividend policy is
a very-very important thing for every firm to decide that how the dividend policy of the firm will
be there. And when they decide the dividend policy, they have two broad components. One
component is the payout ratio average payout ratio deciding the payout ratio. Second is the
stability of the dividend being paid that is the stability of the dividend payout ratio.

How much dividend payout ratio has to be there? And second thing is should be stable dividend
payout ratio so these are the two important components. So first part we will discuss and then we
will move towards the stability, the consideration relevant for determining the dividend payout
ratio what are the important considerations? These are 5-6 important consideration. First is the
funds requirement. If we want to pay regular dividend to our shareholders how much funds are
required? And I will be able to generate those funds from the profits.

Second, do we have the liquid funds available with us? Because in many cases it may be possible
firm is the profit making firm, firm is earning huge profits, but most of the sales being on credit,
the profit is also on the credit. And if the profit is also on the credit, it means there is a lack of

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liquidity. So profit is there, but not the cash profit is there. So you cannot pay the dividend or if
you want to pay the dividend from where the liquid cash will come.

Third is access with external sources of financing. How much access to external source your
financing is there? And even if we have access to external sources of financing, it will not be a
right approach that your internal funds you distribute as dividend and for your own investment
requirements, you go in search of the funds from external sources. That does not stand justified.

So consider it carefully that though the funds are available but should be say pay our own funds
as a dividend to the shareholders and then look for the funds from external sources for our needs.
That is an, another important consideration shareholders’ preference what the shareholders want.

Clientele effect we have discussed, in the clientele effect we have discussed that different type of
shareholders is there. So your shareholders are the clients kind of who want a regular dividend or
the clients are or the investors are or shareholders are who do not want regular dividend. Look at
that and consider it. Difference in the cost of external equity and retained earnings is a very-very
important consideration, right.

Think it clearly and issue of the control because if you issue your sorry, if you pay your profit as
a dividend to the shareholders, but for your own investment requirements, you issue the fresh
equity so what will happen? As a result of that, your control of the existing shareholders will be
diluted. And sometimes the existing shareholders may object to that. So they may allow the
company that you do not pay us the dividend, first you fulfill your reinvestment requirements.
And only if some amount is left after that, you pay us the dividend. So it is important
consideration.

And last one is the taxes. If the component of the taxes is very high on the firm’s profits then you
can think about, you can pay your own earnings as dividends. And you can borrow the funds
from the market by way of the debt. But taxes are to be seen in two ways. One is the taxes on the
yours say dividend. Second one is the taxes on the say, the funds going to be borrowed from the
market.

So enjoying that tax deductible advantage of the debt, when you talk about the taxes, for
example, in the case of India if you talk about, taxes impact the firm in two ways. Number one,

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when the firm pays the dividend to the shareholders right. So though the dividend up to 10 lakh
rupees, dividend income up to 10 lakh rupees is not taxable in the hands of shareholders, is not
taxable in the hands of shareholders but firm while declaring the dividend has to pay to the
government, a dividend distribution tax.

They have to pay the to the government the dividend distribution tax and when you talk about
the dividend distribution tax, that works out as somewhere around 17 percent. So whatever the
dividend is going in the hands of shareholders, that is exempted up to 10 lakh rupees of the
dividend income that is exempted. But company who is paying the dividend to the shareholders,
they have to pay the dividend distribution tax to the government and that works out as 15 percent
is the basic tax rate plus the surcharge plus the cess on that and total amount works out as
somewhere 15, 16.995.

So approximately 17 percent tax firm has to be pay to the government as dividend distribution
tax after that in the hands of equity shareholders, though, it is exempted but now the second tax
has also come in the picture. That is a long term capital gain tax and any long term capital gain,
which is the firm is, which the shareholders are getting beyond an amount of rupees 1 lakh that is
also taxable at 10 percent right.

So earlier there was a miss point of discussion that if the company declares a dividend, then the
company has to pay the dividend distribution tax at the rate of 17 percent. But if the company
allows the say, shareholders to enjoy or to have the appreciation of their investment by way of
the say reinvestment of the profit back into the say, the capital base of the company, and to enjoy
the appreciation of their investment, by way of the capital gain.

So capital gain was tax free but now that advantage is also gone. That any capital gain to any
long-term capital gain especially, short term was already taxed. But long-term capital gain,
which comes to the investor after say the one year’s period of time is also taxable now at the rate
of 10 percent but beyond an amount of 1 lakh rupees right.

So it means now in both the cases the say firms or the say the dividend on the dividend, firms
have to pay the tax. And on the, say in case of the capital gains, the individuals have to pay their
tax. So it is a very important consideration how you want to make use of it this tax part, how you
want to consider it, how you want to make use of it.

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Whether we should pay 17 percent dividend distribution tax and then pass on the dividend to the
shareholders or the shareholders should pay 10 percent long term capital gain tax and seek the
appreciation of their investment by way of the say your capital gains, long-term capital gains. So
that will be important consideration. Taxes are going to play a very-very important role and now
after that is the second part, which is called as the stability of the dividend payout ratio.

So when you talk about the stability of the dividend payout ratio, this discussion and some other
concepts with regard to the dividend decisions and dividend payout ratios, I will discuss with you
in the next class. And if the time permits, I will do one or two problems also. But first my
objective is to means clear you the different concepts of the dividend decisions and say how the
dividend is decided.

How the dividend policy is decided and what are the important relevant concepts? So in the next
remaining two classes I would try to cover on the dividend decisions as much as possible, till
then thank you very much.

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 Financial Management For Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 59
Dividend Decisions - Part I

Welcome all, so we will continue with the process of dividend policy further or the dividend
decisions further and in the previous class we just initiated the discussion on the last topic of this
course, the Dividend Decisions. And I just say began discussing about the dividend decisions
that how the firms take the dividend decisions and what are the important considerations while
taking the dividend decisions. We will be now continuing further with the say other parts and the
remaining part on the dividend decisions very relevant and important part of the dividend
decisions.

So, as in the previous class we were talking about the dividend policy, so I talked to you in
previous class itself that dividend policy, a good dividend policy has the 2 broad components.
One is the average payout ratio and second one is the stability. Average payout ratio and second
one is the stability.

1003
(Refer Slide Time: 01:30)

So, in the average payout ratio, we discussed number of the points that the consideration which
are relevant for the dividend payout ratio are like fund requirement, liquidity, access to external
sources of financing, shareholder preference, difference in the cost of external equity and
retained earnings, control and taxes.

So, taxes we discussed, till taxes we discussed in the previous class that how the taxes impact, so
I told you that there is a dividend distribution tax at the rate of 15 percent plus assess on that plus
surcharge on that, plus assess on that, so it works out somewhere about say 17 percent
approximately 17 percent of the dividend distribution tax although it is free in the hands of say
shareholders up to 10 lakh rupees dividend income is tax free.

But, dividend distribution tax the company has to pay who is going to pay the dividend to the
shareholders.

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(Refer Slide Time: 03:30)

And the second part is the say capital gains. Earlier the long term capital gains were exempted
but since 2018 onwards now even the LTCGR also taxable beyond rupees 1 lakh rupees per year.
So, it means if there is LTC Long Term Capital gains income also and long term capital gains
also so they will be and if they are more than 1 lakh rupees per year, so they will be taxable at
the rate of 10 percent.

So, it means when you talk about the say dividend policy and the payout ratio, taxes are very
important considerations that should we pay dividend and pay the about 17 percent of the tax or
should we means not pay the dividend and let the people enjoy by way of capital gains. But
earlier, the capital gains were free of the tax but as I told you now they are also subject to tax
more than 1 lakh rupees of the long term capital gain.

Short term capital gains were already taxable but the long term capital gains are also now taxable
and the tax has to be paid on any gain beyond rupees 1 lakh at the rate of 10 percent. So, taxes
are the important consideration while deciding the payout ratio. So, first part of the dividend
policy is the average payout ratio and the second part is the stability of the dividend, second part
is the stability of the dividend. And if you talk about the stability of the dividend part so here we
talk about the stable dividend payout ratio.

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Stable dividend payout ratio, so it means stable dividend payout ratio has to be related to the
earnings, has to be related to the earnings. So, how it can be stable? Means there can be the two
ways of deciding the policy. One way is that for example it is directly linked to the profitability
of firms, it is directly linked to the say after tax incomes earnings of the profit after tax or
earnings after tax of the firm.

And the way the earnings behave the dividend will also behave the ratio will remain the fixed but
only means it will be paid as per the earnings behaviour. So, for example, if you look at this
structure say thick line depicting the earnings and the dotted line is depicting the dividends. So
you see that as the earnings are going up, dividend is also going up and for example this is a
relationship here it is a relationship.

Here it is a relationship and here it is a relationship, so it means the dividend payout ratio directly
depends upon or is directly linked to the, the earnings capacity of the firm or the profitability of
the firm. So it means sometimes if higher the profits or higher the earnings higher will be the
dividend but if sometimes the lower the earnings, lower the profits, lower will be the dividends.

So this is one way say deciding the dividend policy with regards to the stability. So, you can say
that dividend will be paid for sure certainly but it will be depending upon or it will depend upon
the profitability or earning of the company and directly linking to the earning of the company, so
sometime more dividend will be paid, sometime lesser dividend will be paid but dividend will be
paid for sure.

So, policy is stable but the say amount of dividend, percentage is also stable or the payout ratio is
also stable but the absolute amount of the dividend is not stable. Sometime it goes up; sometime
it comes down.

1006
(Refer Slide Time: 05:36)

And second version of the stability can be something like this or trend something like this that
when your earnings are whatever the trend they are following like, this is the trend of the earning
if you look at this, this is the trend of the earning these are fallings.

But, dividend is rather more stable, there is no change in the dividend company not changing the
dividend for a certain period of time after that they are changing the dividend again it remains
stable for more number of years and after that they are changing but its again changing upwards
and further remains a stable for a number of years.

So, it is not linked to the earnings at all the standard payout ratio is used or standard fixed
amount of the dividend is used and it is not as a percentage or payout ratio of say the earnings
but a standard that for example per share this much of the dividend will be paid. So for example,
you talked about the years here 1, 2, 3, 4 for the first 4 years’ dividend will be this much from
this to this, dividend will be this much whatever that amount.

It may be for example, 20 rupees per share the dividend is in being paid or 2 rupees per share the
dividend is being paid but it is stable for the 4 years. After that it continues and remains the
stable for the another 3 years, right it is 1, 2, 3, so its again stable for the another 3 years. So
dividend is like this and whatever the profits, profits are fluctuating like the previous structure

1007
profits are not changing, profits are like that but the dividend is say means profits are fluctuating
going up, coming down.

But the dividend is stable for the certain number of years. I think this is a better say way of
stabilizing the dividends so that the shareholders can predict that how much dividend they are
going to get in the next say number of years or at least the predictable number of years so that
they can understand that this much of the return is sure for them.

Otherwise if it is like the previous structure, if it is linked to the profitability like this then means
people will not come to know what is going to be the return in their investment. So, normally
companies follow this structure where the dividend largely remains a stable and that is not linked
to the earnings of the company. Yes, the dividend has to be paid out of the profits only if the
company is into loss, no dividend can be paid. But the dividend remains a stable under this
policy for certain number of years it is not linked to the say fluctuations in the earnings or the
profitability.

Rather its say link to the number of years therefore the this much number of years, this much of
the dividend will be paid, this much is the number of years and this much of the percentage of
the dividend will be paid and their percentage will be worked out on the basis of the equity
investment not on the basis of earnings.

(Refer Slide Time: 08:09)

1008
Now for example, this say structure or these calculations predict the different type of the
policies. These calculations predict the different type of the policies say for example dividend
stream under the different policies So for example, in the we are given the total number of years
here 1 to 6 years total is just given like this and first column says earning, earning for the year
T,right, Et earning for the year t.

For example, in this year if we talk about it is Rs 1,50,000 you can say right or Rs 150 million
this is earning after tax which is available for now to be provided to the shareholders or maybe
for any purpose. Investment budget is 137000 right for example we assume it is thousands, Rs
137000 out of this it is estimated that equity investment will come 68 to the tune of 68.5
thousand and pure residual dividend will be the balance amount.

Now, they are the 3 policies policy number 1, policy number 2 and policy number 3, right. These
are the 3 policies, so first is a pure residual policy under the pure residual policy from the total
earnings whatever the say investment budget is there that is taken into account and part of the
earnings is provided for investment into the say investment part of the firm and then remaining
amount which is called as the pure residual, remaining amount which is called as a pure residual
that amount is distributed to the equity share holders.

So, for example in this case 150 is the earning right and the total investment which the firm is
going to make in this year in the year number 1 is to the tune of Rs 1,37,000 right but in this Rs
1,37,000 it is assumed there 68.5 thousand will come from the equity, from the external equity

1009
and from the retained earnings only the say in this case for example not, not equity we can say
that investment is going to be 137.

Total earnings are 150 in this year 1 and the investment is, investment budget is 137 and equity
investment means part of the earnings which are going to be invested into this capital
expenditure is 68.5. So it means remaining amount is going to be there that is 81.5 is going to be
distributed to the shareholders as the dividend, right.

So, this total amount becomes equal to this, so in this total process we can, you can find out that
pure residual means after making the investment into the capital projects whatever the amount is
left that is called as the pure residual and the pure residual in this case is 81.5 percent, Rs 81.5
thousands and this amount is available for paying the dividend to the equity share holders. Under
the fixed dividend payout ratio, the amount is 82.5 percent.

But this dividend payout ratio is here, this is 0.55, so that you can say 55 percent will be
distributed, 55 percent of this 150 will be distributed as the dividend and only the remaining
amount that is 82.5 thousand is available for paying the dividend to the shareholders. And under
the smoothed residual dividends which we saw in the structure, which we saw in this structure
this is called as basically the smoothed residual dividends.

So, in this case what is happening? For the 3 years, first 3 is the dividend is same for the next 3
years the dividend is same and then it is going to change in the sorry, say the total dividend is
676.5. So, in this case for example, if you look at this, this is a same structure says for the first 4
years the dividend is same, for the next 3 years the dividend is same and the remaining time the
dividend is same its going to go up upwards but it is not directly linked to the earning of the firm.

So it means same is a thing done here, we are taking first of all, I am repeating, I am just
explaining it again to you earnings are 150, investment budget is Rs 1,37,000, right, so out of Rs
1,37,000 say out of 150 earnings 68.5 percent will be, 68.5 thousands will be invested for the
capital investment and remaining amount is called as a pure residual amount out of the earnings
which is 81.5.

So, fix dividend payouts mean this 81.5 will be available as a dividend under this policy that is a
pure residual dividend policy under this. Fix dividend payout ratio for example, the second

1010
policy will follow fixed dividend payout ratio, so it means in this case the dividend amount will
be a fix ratio, payout ratio that is 0.55. So 150 is the earnings and 0.55 will be the dividend which
works out as 82.5 thousand.

And under the smoothed residual policy, residual dividend policy the dividend will be paid at a
certain amount which will remain fix for certain number of years and after that it will change, its
not changing every year. For example, in this case, if it is 55 percent is the dividend payout ratio
so it means it is directly linked to the profitability, how it is linked? For example, here the profit
is or the earning is 150 your fixed dividend is 82 as per this ratio the dividend amount is 82.5.

When the profit has gone up the, this amount is 104 but when the profit is come down from 150
to 140 dividend also has come down to 77. In this case when the profit has further gone up it has
gone up also in this case it has gone up and in this again it has come down. So it is directly
linked to profitability if there is a fixed dividend payout ratio. And in case of the residual also,
pure residual dividends also it will depend upon the capital expenditure, how much capital
expenditure the firm is going to make?

And in that total capital expenditure what part of the capital expenditure is going to be provided
from the equity investment in the form of retained earnings, right. So in this case for example,
the pure residual equity investment for example in this case is 68.5 in the second case it is 80,
right. So, the total earnings are 190 equity investment in that total capital investment is going to
be, total investment is in the second year it is how much? Rs 1,60,000, so equity investment in
that is going to be 80.

So out of 190, 80 will be provided for the capital investment and 110 will be available as the, as
a pure residual amount it will be available as for paying the dividends. Third year if you go about
140 is the earning, investment budget is 180 it is decided that Rs 90,000 will be coming from the
equity earnings or maybe the retained earnings. So it means out of this amount 140 of the
earnings 90 will go towards the capital investment and 50 are available to be paid as the dividend
which is called as the residual dividend.

And as per the fixed dividend payout ratio which is 0.55, so of this Rs 1,40,000, 0.55 will be
available as to be paid as a dividend which works as Rs 77,000, so this as per the fixed dividend
payout ratio. But under the third smoothed residual dividend means there is no fluctuations and

1011
there is no linking of dividend with the profits there is a standard amount which is fixed by the
company that for the first 3 years 1,05,000 will be paid total amount will be paid as a dividend in
the next 3 years 1,20,000 will be paid as a dividend and then so on and so forth.

So, we have shown it that how the 3 different dividend policies pure residual dividend, fixed
dividend payout ratio and as per the smoothed residual dividends how the dividends are
calculated and pay to the equity share holders. So, I think this is a best policy which is called as a
smoothed residual dividend policy and which is the say the presentation of the policy is in this
structure where you can say that for the certain number of years up to this your dividend is fixed.

Then up to this the dividend is fixed and up to this the dividend is fixed. So, I think that is better
that its predictable by the investor that how much dividend they are going to get on their say
investment in the companys stocks if it is linked to the profitability like the previous structure, so
means it will be depending upon that if the profits go up dividend will also be go up, profit go
down dividend will also go down.

So people cannot predict their dividend income and they cannot plan of say making use of that
income for any other purpose. So, means the smoothed residual policy, smoothed residual
dividend policy is the best policy and practically also I will discuss with you at the end of the
discussion that it has been found that the firms are falling largely the firms are falling smoothed
residual dividend policy who do not link the dividend payment with the profitability and do not
fluctuate the dividend payment every now and then, right.

So, this is the way the dividend is decided under the different policies largely 3 policies and the
best one is the third policy. Now we will quickly go for the key considerations in formulating the
dividend policy. What are the key considerations in formulating the dividend policy?

1012
(Refer Slide Time: 17:25)

So the key considerations are number 1, investment decisions have the greatest impact on the
value creation. Certainly investment decisions have the say greatest impact on the value creation.
If you are making investment into the profit making projects, then certainly the dividend will be
high because value of the firm will be going up because of the increased earnings. So, certainly
yours say profitability will increase, earnings will increase, profitability will increase and value
of the firm as your whole will increase so dividends will also increase.

External equity is more expensive than internal equity retained earnings because of the issue cost
and the underpricing, right. So or because of flotation cost also issue cost or you call it as the say
into this you can include the flotation cost as sometime the underpricing cost is also there, their
companys stocks maybe underpriced or maybe say not properly subscribed, so they have to sell it
less than the normal price.

So the cost is high in issuing the external equity, so it is always better that we should say first
make use of the internal equity and if the firm plans like that then the dividend to be paid to the
shareholders will certainly come down because larger part of the earnings after tax will be used
for investment into the new projects.

Third point is most promoters are averse to dilute their stake in the equity and hence are reluctant
to issue the external equity. So, certainly they want that their larger part of their earning should

1013
be reinvested back into the business because if the new equity is issued by the company then
their stake will be diluted. So they are also and if the people are of so this kind of the view as per
the third point then certainly you can make out dividend will go down.

There is a limit beyond which a firm would have the real difficulty in raising debt financing.
Because normal ratio of the debt capital is debt to equity is 2:1, right. So there may be the ratio
which can be more than that also depending upon the credit worthiness of the firm but in the
normal term the ratio 2:1. So, when it is not possible to raise the funds with the help of debt then
the only way out left is the retained earnings.

And if that is the case then certainly the dividend will be impacted. And the last point is the
dividend decision of the firm is an important means by which the management conveys
information about the prospects of the firm. So it is also true, higher the amount of the dividend
the firm is paying, it conveys a good feeling, good gesture, it gives a good signal also in the
market.

So people will be inclined to buy the share of the company and the stock price may go up but
there so many limitations also of paying the higher amount of dividend and dividend can
ultimately be paid as the say liberal amount of the dividend only if the say requirement of the
retained earnings is not much in the company or within in the firm and sufficient surplus funds
are available, sufficient profitability surplus funds are available for the payment of the dividend.

So there are the positives of declaring liberal dividend, negative is also declaring say liberal
dividend but the dividend largely will depend upon the internal financing requirements of the
company and the available of the funds to the company from the different sources of the funds.

1014
(Refer Slide Time: 20:39)

Now we take into account the next some important guidelines, guidelines for the dividend policy.
When the firms decide their dividend policy what are the important guidelines which is take into
account. Number 1, do not pay dividends at the expense of positive NPV projects, so this is a
first guideline. If there is a possibility of investing the surplus savings or maybe say as the profits
earned by the firm into the positive NPV projects.

Then certainly first use of the earning after the tax should be in making the investment into the
companys projects and not into the say paying the dividends. It should not be something that you
have the NPV projects for which you are looking for funds from the external sources and for the
dividend requirements means for the external sources and your own internal say retained
earnings, your own internal profits you are distributing as dividends, it should not be the case
right.

So, do not pay dividends at the expense of the positive NPV projects if you have the positive
NPV projects first requirement of the company should be, the policy of the company should be
that the retained earnings, larger part of the retained earnings will be invested into the positive
NPV projects. So means it should not be the situation that for your own investments, you are
looking the external sources of the finance and your own internal retained earnings which is
internal free source of finance, right.

1015
Free in the sense of that there is no cost of issuing the retained earnings so you are paying it as a
dividend and for your own investments you are looking towards outside that should not be the
policy. Minimize the need to sell external equity. External equity as I told you there are so many
cost associated, right. There is an issuing cost, there is a flotation cost, there is an underpricing
cost so if the sufficient funds are internally available by way of the earnings after profit or the
earnings after tax.

Earnings after tax or profits after tax then the larger part of the retained earnings should be
invested into the companys projects and dividend should be maybe it will be affected negatively
but it will create a value of the firm in the long run. Reliance industry is the one case; classical
case were now they have started paying the dividend but in the past when they were requiring the
funds in the larger amount for the reinvestment in the business they have been paying the
dividend at very-very lesser rate.

Define a target dividend payout ratio along with target debt equity ratio. Define a dividend
payout ratio, dividend payout ratio along with the target debt equity ratio taking into account the
investment needs, managerial preferences, capital market norms and tax code, right. So it should
be very properly, clearly defined the dividend payout ratio will be this much and that will be
according to the debt equity ratio.

Because if the if you do not want to raise much amount with the help of debt because debt brings
means so many problems with it, though it come as a cheaper source of finance but it comes with
so many problems financial distress is the one out of the many. So if the internal funds are
available, so you would stipulate that this much of the debt will be raised for our future
investment requirements largely we will say, say bring the funds from the retained earnings so
that is important consideration.

Accept temporary departures from the target dividend payout ratio and the target debt equity
ratio. Means you should not deviate from the target debt equity ratio, there should not be any
departure, right. If it is there it has to be only a temporary but not in the say on the regular basis
debt equity ratio should be the basis that this is going to be our maximum debt equity ratio
remaining amount is going to come.

1016
If there has to be any departure, then it can be temporary but not in the long term. So, largely
you, you again focus upon more funds will come from the internal sources not through external
equity or neither through borrowings. Avoid the dividend cuts, yes, that I mean discuss with you
that we should follow the largely the smoothed residual dividends. If dividend remains the stable
for the next number of years’ people are at least able to say predict that what is going to be their
income from dividend or from this source as dividend.

So, dividend cuts can be avoided if it is for example linked to the profitability. So if you are
paying say for example 55 percent dividend or out of that say total your profitability if somebody
is getting 1 rupee as a dividend per share and next time it goes 2 rupees per share then third year
comes down to 50 paisa per share, so lot of fluctuations are there and you are applying a severe
cut on the dividend also. So that should be avoided, right.

So, lastly it is written in essence the above guidelines imply that a firm should pursue a smoothed
look at this I just was telling you that a firm should pursue a smoothed residual dividend policy
and not a pure residual dividend policy or a fixed dividend payout policy. Smooth residual
dividend policy a pure not a pure dividend policy or the fixed dividend payout policy because
smoothed means (pick) people remain sure about that for the next 3 years, next 4 years this much
of the dividend is going to be available to them.

And this much of the income they are going to receive from the dividend for their investment
into the equity of this company or different companies so that they can plan of that investment or
that amount coming to them as investment somewhere or fulfilling some of the requirements. So
out of the 3 policies looking at these guidelines, these guidelines should be followed in such a
way that ultimately a smooth residual dividend policy is followed and we are not fluctuating the
dividend.

We are not applying the cut on dividend and we are not linking it to the profitability also
otherwise means the dividend does not remains the smooth and people are not able to predict
how much income they are going to get and it does not give a good reflection in the market also
with regards to the companies say overall financial performance and how they are treating their
say the equity share holders. Next part is the conference board survey.

1017
(Refer Slide Time: 27:04)

Here are some of the say reporting means a findings of the survey which was conducted in US,
the survey was conducted in US and this survey has a very important implication on the dividend
policy of the firms all around the globe. So they have come out with the important say guidelines
means the important points which are here which have come out after the survey.

They can help many companies to form means they connect as some guidelines to many
companies to form their dividend policies. So what is written here? A survey of the dividend
policies and practice conducted by the conference board in US revealed that 5 considerations or
guidelines were dominant in the minds of the dividend decision makers and these guidelines
these important points are not only linked to the companies in US they can help the companies in
framing their dividend policies all around the globe.

So, what are these important points? First point is the companys earnings record and its future
prospects, the companys earnings record and its future prospects, that how much is your earning
today? How much they were in the past and how much of the total earnings you want to invest in
to the future investment projects? So, that will be the first thing that your earning record and your
future investment prospects they are important consideration.

Second is the companys record of continuity or regularity of the dividend payments, the
companys record of continuity or regularity of dividend payments is a second point. Third point

1018
is the need to maintain a stable rate of dividends per share of the stock, the need to maintain a
stable rate of dividend per share of the stock. Fourth point is the companys cash flow, present
cash position and the anticipated need for funds and the anticipated need for the funds.

And the last important point is the needs and expectations of the owners of the common stock.
These are the five important points which have come out after survey conducted in US by the
conference board in US and they have means this is a practical experience how the people feel
about and how these important 5 points can help the companies in devising there dividend
policies.

So, they have to be taken into consideration and I as I told you these points are not important
only for the companies in US but all around the globe that for forming their dividend policy they
should take into consideration these 5 important points where the companys earnings and the
future earnings prospects are to be properly evaluated. The companys record of continuity or
regularity of dividend payments is the important consideration.

If you are continuously regularly paying the dividends you are considered as the better manager
of the peoples’ equity or the stock or the shares which are held by the equity share holders. The
need to maintain a stable rate of a dividend, a stable rate of a dividend also gives a clear cut
feeling in the market of the feeling of say belongingness.

It creates the belongingness amongst the shareholders that, yes, if we make investment in this
company we are going to gain out of it. Companys cash flow, yes, very important of you are
selling in the market for example and larger part of your shares are on credit, so your cash flows
will get affected because your profit is there but profit is a noncash profit, right. So your cash
flow will get affected so the companys cash flow, present cash position and the anticipated need
for the funds they are important considerations.

Last point is the needs and expectations of the owners of the common stock always bear in your
mind as the say director finance or CF of the company because the director finance or CF of the
company will be playing the major role in influencing the dividend policy and there the
expectations of the shareholders, equity share holders should also be kept in mind that what they
expect from us, how we are managing their funds, what they expect from us and how there
expectation should be factored in to the dividend policy of the firm.

1019
So, these are the important 5 points which have come out after a survey in US and are very
helpful, very useful for framing the dividend policies by the firms, not in India but anywhere or
not in US but anywhere in the globe they can be helpful. Now, we talk about the corporate
dividend behaviour and here we will discuss one important model, the model which is called as
the Linter’s model of deciding the dividend.

With the help of Linter’s model we can learn practically how we can say calculate or how the
dividend per share can be calculated, this model is very-very helpful model and many people
have tested this model later on. This means Linter’s was American professor he tested this model
and say he develop this model and tested and it has a proved as a full proof model for deciding
the amount of the dividend to be paid to the shareholders.

Where you can say that it takes into consider not the dividend to be paid in the current year but
the dividend paid in the previous years. So, it is basically you can call it as it is based upon the
model is based upon the weighted average of the dividend over the years and not on the current
year only. So, current year’s dividend I mean to say here if you see this model if you understand
this model current years dividend will depend upon the dividend paid in the previous year.

It will depend upon number of other factors also earning per share is a important consideration
but the dividend paid in the previous years is also an important consideration that is also taken
into account while deciding the dividend for the current year. So what is a dividends model given
to us by Linter and how this model has been developed lets discuss this model and learn about
this model.

So that you can also practically work out if you work in some company or if you or if you
happen to work tomorrow in some company maybe the CF of the director finance or in the
finance department you can also contribute that how the dividend amount can be worked out.

1020
(Refer Slide Time: 33:31)

So, first of all he has developed this model after conducting a survey of many companies and this
survey is called as Linter’s survey of corporate dividend and say this is a survey is Linter’s
survey of the corporate dividend. And on the basis of that he has said that the behaviour of the
companies is means he has narrated under the different points and what is the behaviour of the
cooperate dividend behaviour of the companies. After conducting the survey on many companies
Linter’s has observed that number 1, firms set long term target payout ratios, firms set long term
target payout ratios they do not change it every day, they do not change the say payout ratio
every year or every now and then. They set the payout ratios on the long term basis.

Number 2 point, managers are concerned more about the change in the dividend than the
absolute level of the dividend. Third important point is dividends tend to follow earnings but
dividends follows, dividend tends to follow earnings but dividends follow a smoother path than
the earnings. Earnings are taken into account but normally the smoothed residual policy is
followed by the firms.

Fourth point is, dividends are sticky in nature because manager have a reluctance to effect
dividend changes that may have to be reversed, dividends are sticky in nature because manager
have a reluctance to effect dividend changes that may have to be reversed. So any change which
you want to means the reverse in the coming years or you want to reverse your old existing

1021
decisions or the old decisions people do not want to managers especially do not like to say go for
this kind of the decisions.

So, four important points first point is, firms set long term target payout ratios. Second point,
managers are concerned more about the change in the dividend than the absolute level of the
dividend. Third point, dividends need dividends tends to follow earnings, but dividends follow a
smoother path than the earnings, they are following earnings fluctuations in earnings they are
also taken into account. But normally the dividend is not affected by earnings that remains
smooth.

Fourth point is, dividends are sticky in nature because managers have a reluctance to effect
dividend changes that may have to be reversed. So, these are the four important points given to
us by a survey which was conducted by Mr. Linter.

(Refer Slide Time: 36:11)

And on the basis of that he has developed a model which we is called as a Linter’s model of
dividend declaration or Linter’s model of find out the amount of dividend. And if you look at this
model how this model works, so you can say that these are the important components. The model
is very simple how he has done it Linter expressed corporate dividend behaviour in the form of
the following model, he has expressed the corporate dividend behaviour in the form the

1022
following model. He has said Dt is equal to crEPS for the year t, plus 1 minus c multiplied by the
Dt-1. What are these important components of this model now?

Where Dt is the dividend per share for the year t means the year, current year in the question, c is
the adjustment rate, c is the adjustment rate as compared to the previous years and other
important factors, r is a target payout ratio, how much you want to pay as a target payout ratio,
EPS is EPS for the year t is a earnings per year for the year t, means the current year for which
the dividend is going to be decided and Dt-1 is equal to dividend per share for the previous year t
minus 1 is the previous year.

So it means while deciding as I told you, while deciding the dividend to be paid in the current
year Linter has taken into a consideration important factors where adjustment rate is important,
target payout ratio is important, earning per share in the current year is important and dividend
paid in the previous year is important so it is not a simple way of deciding the dividend rather it
is a weighted average of the dividend which we have used.

And say it is the weighted value of the dividend which we are going to calculate or the Linter has
a say suggested to calculate and this model as I told you that is a very-very say useful model
many people have tested and tried this model in the industry after this model was coined up by
Linter and this model has been found as a full proof model very useful model, wonderful model
and many people have use it afterwards.

1023
(Refer Slide Time: 38:26)

]
So, let us take some examples here and with the help of this example we can learn the how the
dividend amount can be calculated by factoring the different important components which are
suggested to be factor by Linter in his model. So what is a problem given here?

Mohan Limited has earnings per share of rupees 4 for the year t, for the year t means the current
year Mohan Limited has earnings per share of rupees 4 for year t its dividend per share for the
year t minus 1, previous year, year t-1 was rupees 1.5. Assume that target payout ratio and the
adjustment rate for this year for this firm are 0.6 and 0.5 respectively. What would be the
dividend per share for Mohan Limited for year t, if the Linter’s model applies to it, right.

And looking at this now if you apply this model, so you can understand Mohan’s dividend as per
the dividend per share, dividend per share for the year t, t means the current year would be if you
see this has been calculated so same model is applied here this model has been applied in this to
solve this particular problem, so this model is applied here and we have seen that the dividend
amount to be paid will be rupees 1 and 95 paisa, 1.95 rupees.

1.95 rupees will be paid as the dividend and what is the earning per share? That is 4 rupees, so
out of 4 rupees earned per share by the company what is the total number of shares means
comparing to that the companys earnings per share EPS is 4 rupees per share right, out of that
earning per share of the 4 rupees 1.95 almost you can say half of the amount will be distributed,

1024
you can calculate that should be as the dividend as per the Linter’s model and remaining amount
can be used for the reinvestment into the positive NPV projects.

Remaining amount can be reinvested into the say, can be invested into the positive NPV projects.
So, with the help of this model which is scientific more useful, more smoothed model the
dividend can be worked out or the dividend say payout can be worked out in the absolute value,
this is further more useful that in the absolute value you can work out the dividend to be, to be
paid to the equity share holders per share dividend to be paid to the equity share holders which is
otherwise very difficult.

Even calculating in terms of percentage, proportions or anything sometime it is not that way
very-very convincing or clear but in by using this model which is very simple that per share
dividend amount has been calculated that if the company is earning per share EPS is 4 rupees
then by applying this model by taking into consideration the say important factors you can find
out easily that dividend out of the 4 rupees earning per share, dividend amount will be rupees
1.95, rupees 1.95.

So this amount has been worked out with the help of this model. So, finally it is remarked here
dividend can be described in terms of a weighted average of the past earnings. It is the weighted
average of the past earnings it is not only based calculator only on the basis of the EPS earning
per share in the year t or in the current year but it is a weighted average of the past earnings and
that is more wonderful thing that he is linking this model is linking.

The payment of the dividend in any year in the current year with the previous year’s earnings
and that is a wonderful thing that he has means maintained the sequence that how much is the
earning in the previous year and how much is the dividend paid in the previous year same way
they are taking into account and the dividend for the current year and the future year is going to
be future year is going to be decided with the help of this model.

So, for this particular discussion, I will stop here and some more relevant concepts with regard to
the dividend policy of the firms and some if, the time permits in the next class then I will discuss
I would like to discuss 1 or 2 problems also practical problems also which can be means useful in
learning about the dividend decisions of the firm. But say that all I will discuss in the next class
till then I will stop here and thank you very much.

1025
1026
 Financial Management For Managers
Professor Anil K. Sharma
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 60
Dividend Decisions - Part II

Welcome all, so we are starting now the last and the final lecture of this course 60th lecture and I
am discussing with you as I discussed in the previous class also the dividend decisions that how
the firms take the dividend decisions. So after this completing discussion, conceptual discussion
on the dividend decision so I will close discussion on the dividend decisions as a whole and even
the course as a whole.

So, let us learn about the remaining parts, important parts which are concerning the dividend
decision of the firms. How different other important say aspects affect the dividend decision of
the firm. So, one another important aspect is apart from the things we have discussed so far, so
the one important aspect here is the legal aspects. So, there are some say legal components also
because dividend is paid by the joint stock companies which are under the preview of the
Ministry of Company Affairs or the corporate affairs you can say.

And companies act also applies on the companies even the say income tax also applies on the
companies. So, there are certain provisions of the Indian Companies Act 1956 and later on
amended from time to time. Major amendments were recently done say in the companys act in
2013. So, I will like to give you a snapshot of the important things, a snapshot of the important
legal aspects which affect the dividend decisions. But I will not take more time in discussing of
this because this is something where you cannot add any value. You will have to reproduce these
provisions or so simply you should be learning it about.

1027
(Refer Slide Time: 02:04)

So, the key provisions of the company law pertaining to the dividend decisions are first point is
dividends can, companies can pay the say only cash dividends. Companies can pay only the cash
dividends. Sometimes the bonus shares can also be given, but largely the dividend has to be paid
as the cash dividend. And next important point is as per the Section 123 of the Companies Act
2013 dividends can be declared for any financial year only out of the profits, only out of the
profits of the company.

For that year arrived at after providing for depreciation in accordance with the provisions of the
schedule two of the act or out of the profits of the company for any previous financial year or
years arrived at after providing for the depreciation in accordance with the Schedule 2 of the act
and the remaining undistributed profit or both of that. Either from the profit of the current year or
from profit, undistributed profit of the previous year or from the sum total of the both the profits.

But after providing for the depreciation, it should not happen that you have not provided the
sufficient amount for the depreciation for the fixed assets and you are distributing the entire
profit as a dividend to the shareholders. So, the problem will come when the assets have to be
replaced. We not have the any sufficient amount available with us. So, that is the reason that is
the say important say consideration here that under the legal aspects, this provision for the
depreciation has been necessitated.

1028
That first of all depreciation provision has to be made after that whatever the residual profits are
left with you. You can distribute part of that as a dividend. So and the dividend has to be paid
from the profits only maybe the profits of the current year or maybe the undistributed profit of
the previous year or maybe from the sum total of the profit of the both of the year.

Next important legal aspect is the Companies Transfer to Reserves Rules 1975 provide that
before dividend declaration a specified percentage of the profit should be transferred to the
reserves of the company. Some amount of the profit should also be transferred to the reserves
and surpluses of the company in the form of the retained earnings, so that in the event of non-
availability of the funds for meeting any kind of the exigencies or for any kind of contingencies,
we have the sufficient funds available with us. So, these are the major legal aspects.

One thing is that it can be paid as a cash dividend. Second thing is as it can be paid say from the
profits of the current year or from the previous year, but after providing for the say depreciation.
And another important aspect is that out of the total profits, some part of the profits should be
transferred to the reserves and surpluses we must create some reserves and surplus and then only
the remaining part or part of the profit can be distributed as dividend.

(Refer Slide Time: 05:16)

Procedural aspects, there are the four points involved in the procedural aspects. Number one is
the board resolution. Board of directors have to pass a resolution and they have to say ultimately

1029
it is their prerogative. How much dividend they want to pay? They want to pay any dividend or
do not want to pay any dividend. It may be possible that there is a profit in the company, but
BOD feels that entire profit is required for reinvestment in the company. So, they will not declare
any dividend.

So, first of all board resolution is important. Second thing is a shareholders’ approval. So, it has
to be got approved in the shareholders meeting, annual general meeting of the shareholders. So
their approval is also must and record date. Record date is that date means on the date of paying
the (dividend) on the date of the declaration of the dividend not paying on the date of the
declaration of the dividend, the number of shareholders whose names are appearing in the
register of the company will be entitled to receive the amount of the dividend declared by the
company.

But the shareholders whose name is not appearing on the date of the declaration of the dividend
in the register of the company will not be titled for the dividend for that year. So, record date is
basically the date on which the dividend is declared and the shareholders name is appearing in
the register of the company. And dividend payment, finally the dividend has to be paid within 30
days.

Within 30 days it has to be transferred, dividend warrant has to be sent within a period of 30 days
from the date of declaration of the dividend. And if there is any amount of the dividend left
unpaid maybe because of some reasons, sometimes what happens that we send the dividend
warrant but the address of the shareholder is not correct. So, it is not reaching at the proper time.
Or maybe some details of the shareholders are not available with the company.

So, it is not clear to whom to send the dividend or maybe when to send the dividend. So, it may
be possible that out of the total declared dividend as per the number of shares shareholders name
appearing in the companys registered. Some of the shareholders are not locatable, so their
dividend remains undistributed or unsent.

So, that amount of the dividend has to be say deposited in a special account to be opened in a
scheduled bank within the 7 days from the last date of the payment of the dividend. That is after
the completion of 30 days period of time, within which the dividend warrant has to be sent to the

1030
shareholders within the next 7 days the undistributed dividend has to be deposited in a special
account, open in a scheduled bank.

So that that I amount can be later on transfer to the shareholders when their details will be
locatable. And then finally, that amount in that special account becomes a zero because total
undistributed amount has been passed on to the shareholders as an even their details were
available.

(Refer Slide Time: 08:17)

Now, we discussed some other important concepts like bonus shares. And then we will discuss
some buyback issues and some other things which are again linked to the dividend decisions. So
what is a bonus share? Bonus issued represent capitalization of the free reserves, bonus issued to
represent capitalization of the free reserves. It is just basically that capitalization of the free
reserves. In the balance sheet of the company there are certain free reserves.

Sometimes the company feels that entire amount of these reserves and surpluses is not required
all the times. So why not to capitalize it? And why not to say transfer it to the account of the
shareholders and say the benefit of which can be passed on to the shareholders. So capitalization
of the free reserves build out of the genuine profits or the share premium collected in cash only.
A bonus issue represents capitalization of free reserves built out of the genuine profits or that
shared premium collected in cash only.

1031
In the wake of the bonus issue, number 1, what happens now? Shareholders proportional
ownership remains unchanged. Proportional ownership means in the percentage wise, if you talk
about the ownership of the shareholders that remains unchanged because every shareholder is
getting the bonus share in the proportion of the shares he or she is holding. So, ultimate
proportional remains the same total number goes up. But the ultimate proportion remains the
same.

Second is the book value per share, earning per share, and the market price per share decrease.
The book value per share, earning because number of shares has increased total capital amount
remaining the same that is equity paid up capital plus pre-reserves. Total amount is remaining the
same. Earlier for example, there were 1000 shares now there are 1500 shares. So what will
happen?

Value per share and earning per share because number of shares you have increased, so value per
share, earning per share and the market price per share will decrease. But the number of shares
increase but the number of shares is increase and it is only because of increasing the number of
shares other things decrease, right. So this is the bonus shares, which is issued to the existing
shareholders out of the say free reserves which were built out of the genuine profits on the share
premium collected in the cash by the company.

Then we talk about the stock split. Stock split is a very important concept sometimes. What
happens, companies say they split their stocks into the smaller amounts. One share will be
divided into 2 shares or one share will be divided into 5 shares. So, something like that, why it is
done? Sometimes largely the objective remains that when the share price or the when the
companys share is trading in the stock market at a very high price, when it is trading at a very
high price in the stock exchange.

So, sometimes it goes out reaches beyond the reach of a common man. Everybody cannot think
of purchasing that share from the market, from the stock exchange. So, what the companies do to
increase the trading of the share of the company they split into the smaller number of means into
the multiple number of shares. So the price per share comes down and it becomes within the
reach of a common man.

1032
So the trading for the shares increases because trading is the only mechanism which helps to
reflect the true price of the share, right. So, stock split is many times used. So what normally we
do, let us understand and then we will understand the difference between the bonus issue and the
stock split.

(Refer Slide Time: 11:50)

In a stock split the par value per share is reduced, the par value share reduced and the number of
shares is increased proportionately. In a stock split the par value because again same thing you
are doing, in the bonus share also number of shares is increasing and in the stock split also
number of shares is increasing. So what will happen? The par value per share is reduced and the
number of shares is increased proportionately. A comparison between the bonus issue and the
stock split is given to below. Between the two is given below so what happens?

In both the cases number of shares goes up, right. So, share price goes down in case of the bonus
share also, in case of that split of the shares also. So, what is a bonus issue and what is a stock
split, this table is given quickly let us have a glance on it. You can read it later on also but let us
discuss the important points. Bonus issue, the par value of the share is unchanged and stock split
the par value of the share is reduced.

Number 2, a part of the reserve is capitalized, there is no capitalization of the reserve. Only the
existing shares are bifurcated into the smaller number of shares. And yes, the par value does not

1033
change because total common stock remains the same paid up capital plus the pre-reserves are
same right. So par value is not going to change, it remains unchanged. And in this case, the par
value changes.

A part of the reserves is capitalized. And in this case, there is no question of capitalization of
reserves. The shareholders’ proportional ownership remains unchanged. As I told you,
percentage ownership remains unchanged. The shareholders’ proportional ownership remains
again unchanged in this case also. One share divided into 2 so proportional ownerships is the
same. The book value per share, the earning per share and the market price per share decline.

The book value per share, earnings per share and the market price per share decline, in this case,
the book value per share the earnings per share and the market price per share declines. So same
thing happened in both the cases and number four, the market price per share is brought within a
popular trading range. That is why the say bonus shares are issued so that the per share price
goes down and it number of shares increase means you can say by increasing the number of
shares in the market.

It comes with the within the popular trading range and the market price per share is brought with
within a more popular trading range. So, here the number of shares is increased. So, it comes
within the more trading range. And in this case price per share is reduced so that it also comes
within the range of say more trading range.

So more popular trading range and in both cases when there is more trading of any company
shares taking takes place in the stock market. So what happens? It comes in the reach of the
common man trading increases and when the trading of any share in the stock market increases, I
repeat that the true price of the share can be reflected. It is the only mechanism, not CAPM, not
any other mechanism, but only the trading frequency of any company share in the market helps
to reflect the true price of share that what is the worth of the share, how much price people are
ready to pay, that all depends upon the trading volumes.

1034
(Refer Slide Time: 15:22)

Now, we discussed some next important concept and that is called the share buybacks. Share
buybacks is again a very-very important concept, which is also linked to the say dividend
decisions because when share buyback will happen dividend will also change. Dividend
decisions will also be affected. So whether it is a bonus issue, whether it is a stock split or
whether it is a share buyback all the three are say affecting your dividend policy. That is why we
are discussing these important concepts here.

First point, share buyback referred to as equity repurchase or stock repurchase in the US in the
US had become possible since 1998 in India also. This process of share buyback originated in
the US, came from the US to other economies and in India also this was allowed in 1998 and
buyback is governed by the SEBI guidelines issued in 1998, right. So, SEBI guidelines are
important for the first time. Buyback was allowed in India in 1998 and SEBI formed the
guidelines that how the buyback of the shares will be done by the different companies.

After that, many companies Reliance Industries, Bajaj Auto Limited and many other bigger
companies they have gone for the share buyback. And this process has been means very-very
facilitating for many companies who wanted to buy back their shares from the market, because
sometimes what happens the company is overcapitalized, the company is overcapitalized they
are not justifying, their investment in the company and the total capital invested in the company
is more than the say requirement, real requirement of the capital in the company.

1035
So, in that case, sometime the company feels that if the part of the capital means the same level
of operations, if they can be carried over with 1000 rupees. So why should we invest 2000 rupees
for carrying on that kind of operations. So if Rs 1000 is returned back to the investors, only Rs
1000, which is really required, if it is retained in the firm, then I think it improves the overall
financial health of the company, capitalization of the company and dividend to be paid to the
shareholders also to the of the company.

Section 78 brought in by the Companies Amendment Act of 1999, has caused this a structural
change in the theme and philosophy of the company law that is subject to the restrictions and
envisaged in the section. A company may buy back its own shares subject to the restrictions and
envisaged in the Section 77A.

Company may buy back its own shares. In India Corporates generally choose the open market.
There are basically two methods of purchasing the, rebuying the or repurchasing the shares from
the market or buying back the shares from the market. One is the tender method; second one is
the open market purchase method. Under the tender method company who want to buy back its
own shares, they fix up a price, right?

They prefix price and that price is normally which is a fixed price remains more than the normal
market price. So, they give the allurement, they give the reasons, they give the allurement to the
shareholder. That if you want to sell off your shares or return it back to the company, you can
and they normally fix a price which more than the normal market price. Now for example, a
company whose shares are more than the genuine requirements of the company.

So naturally, the demand for the shares of that company will be very less in the market because
dividend paid is also very less because companys earnings are not justifying that amount of the
say shares. So, it means the price which is available at which the share is available in the market
must be comparatively lesser. So, if the company want to buy back the shares from the market by
following a tender method they have to fix up a price, offer it to the people by way of advertising
it in the newspaper that we are ready to buy this much number of shares at this much of the price.

If anybody want to sell it back, return it back to the company, then it can be done. So, that is a
tender method and open market purchase method is that when the company purchases it shares

1036
from the open market stock exchange with the help of or through the brokers. This is called as
the open market purchase method and broker is told the maximum price he can pay for buying
the share from the market and maximum number of the shares he can purchase from the market.

That is told to the broker and with the help of the broker the shares are purchase at the open
market price from the market but the maximum price to be paid is told to the broker. And on that
say prefixed price which is communicated to the broker, the broker tries to buy the shares of the
company for the company from the open market.

So, in India corporates generally choose the open market purchase method under this method. A
company buys a shares from the secondary market over a period of 1 year, over a period of 1-
year subject to a maximum price fixed by board or shareholders in their annual general meeting.
A company that chooses to buy back has to appoint a merchant banker and make a public
announcement of the offer 7 days before the commencement of the buyback.

The buyback has to be completed in a period of 12 months from the date of passing the special
resolution by the board of the company or board of directors of the company. So, these are some
of the important provisions. It was initiated buyback was allowed in 1998, SEBI guidelines for
the first time were issued in 1998 and open market purchase method is used. There are two
methods tender method and the open market purchase methods.

So, open market purchase method is used in India and section 77A of the Companies
Amendment Act 1999 deals with the provisions of the buyback of the shares.

1037
(Refer Slide Time: 21:43)

Why the companies want to go for buyback of the shares or why the government has allowed,
you can look at that from this angle. Number 1, efficient allocation of the resources. Sometimes
the companies are overcapitalized, right. So, if you are using if you have invested 2000 rupees at
the place of Rs 1000, if the Rs 1000 is actually required and we are say investing 2000 rupees.
So, the companies overcapitalized, nowhere it will be justified by the operations of the company
that this company required 2000 rupees, right. So, that 1000 can be withdrawn can be invested
elsewhere. Second, price stability because if the say number of shares are optimum, which are
justified by the companys overall net worth, performance, operations, everything, then price will
be more stable.

Otherwise, if the large number of shares are say floating in the market. Then price may not be
stable sometime depending upon the performance of the company. The price may go up, but
largely the price will remain lower because dividend is also affected in case of the over
capitalization. So, price stability is another important objective.

Tax advantage, right, tax advantage is in terms of that for example, you want to talk about let say
by way of the capital gain. People should earn more as compared to buy way of the dividend
because dividend is taxable. It is not taxable at the hands of the shareholders, but it is taxable at
the hands of the company when the company declares dividend, right. But if the company
declares a dividend so tax will have to be paid.

1038
But if the people want to earn or a company want the people to earn more through the capital
gains, right. So, in that case they should be able to sell the share at a price which is substantially
higher than their purchase price. But that will not happen because price of the share will not
change or especially change upwards because company is already overcapitalized control, right.
So, buyback is that shareholders (())(23:45) means the promoting shareholders.

The major shareholders of the company want to increase strength and their control up on the
companys ownership so they buyback most of the shares from the market if it is possible and
then overall control comes within the say within the hands of the few major owners of the
company or shareholders of the company. Voluntary character, so, it is up to the shareholders. It
is not compulsory for the shareholder to sell back their shares to the company.

If they want to, company can offer to buy it back, but if they want to sell it back to the company
then it is up to them. If they do not want to sell it back to the company nobody can force them.
So, it is a voluntary character. No implied commitment, (one) once the buyback is done by the
company do not expect in future also it will be done. It is only a one-time commitment. It may be
done once. It may not be done in future or it may be done again also but no commitment.

Capital structure changes, certainly the capital structure will change because debt equity ratio
will change. Your capital will come down; your debt will remain the same. Equity will come
down. So your capital structure will change. Certainly it will impact the capital structure and
debt equity ratio will be certainly changing. Objections to buy back.

1039
(Refer Slide Time: 25:01)

There are 3 objections, first is unfair advantage, second is the manipulation, third is excessive
payments. Unfair advantage is basically sometimes what happens that it may be blamed that the
major shareholders who have the controlling stake in the company, they would like to increase
their stake in the company and enjoy the maximum dividend or the returns on their investment.
So to have that unfair advantage in the favour of the majority shareholders the shares are bought
back from the minority shareholders. This is one important point of a criticism.

Manipulation, sometime by manipulating or maybe artificially increasing or decreasing the price

of the shares in the stock market or increasing the fluctuation in the share price the minority
shareholders or retail shareholders may be compelled to sell back the shares to the company so
that the major shareholders gain the maximum control. So this way they can do the manipulation

And third one is excessive payment, sometime to meet this objective of maximizing the control
they want to buy back the shares from the retail shareholders by hook or by crook at any cost,
right. So, sometimes they make the extra payment also, which affects the reserves of the
company. So excessive payment is being made through the management of the company by the
majority shareholders to compel the say minority shareholders or retail investors to sell off their
shares back to the company.

1040
Ultimate objective is strengthening the control but the payment is going from the accounts of the
company and the reserves of the company are getting affected. So these are the 3 points of
criticism, but largely it is means a very-very carefully done exercise. SEBI also remains in the
picture company, law is there and the provisions of the company law are also there. So, taking
into consideration keeping into consideration many important components, the final decision is
taken.

But still, we should be careful about that if any company is offering to buy back its shares as a
investor we have to be careful whether we would like to sell the shares back to the company or
not would like to sell the shares because basic character of the buyback is voluntary, it is not a
compulsion on the shareholders. It is only offer if they want to accept it, fine. If they do not want
to accept it nobody can compel them.

(Refer Slide Time: 27:24)

So, there was a survey conducted in US by two people. Survey there why the say the buyback is
done, which was I told you earlier this buyback process initiated in US, so why companies go for
the buyback of the shares? A survey was conducted by two people Mr S.G Badrinath and Nikhil
Varaiya who suggested 5 basic reasons for equity repurchase. Survey of the equity purchase in
US. See what is written here.

1041
A survey off equity repurchase is in the US conducted by S.G. Badrinath and Nikhil Varaiya
suggested 5 basic reasons for equity repurchase, why the companies go for the equity repurchase.
First one is, to boost the stock price. As I told you when the number of shares trading in the
market at too large not justified by the companys net worth. Then it is better to reduce the
number of shares by proportionately buying it back from the market, so that price of the
remaining shares goes up.

Second is to rationalize the companys capital structure, to rationalize that companys capital
structure sometime yours say equity is too much in the market as compared to the debt and that
larger part of the capital which is available with the company is not justified and company is
overcapitalized right. So, to bring it equal to that 2:1 of the debt equity ratio or just to keep their
entire capital structure within control this buyback is done. This is a second finding of the survey
done by these two people.

Number three, to substitute for cash dividends. Sometimes what happens, the companies are not
able to pay the cash dividend to their shareholders because their reinvestment needs are very
high. So, how they substitute the shareholders that they return the cash back to the shareholders
by buying back the shares. So, any person whose say investment is blocked into the stocks of the
company and the share price is not going up in the market. Share price is very low in the market.
So, he is caught in the net that he is not able to retain the share.

He is not able to sell the share, the price which you want to sell, the share at in the market that is
not available and the say the price which is available in the market. He does not want to sell the
shares. So, neither he is getting the desired amount of dividend. Nor he is able to sell the shares
back in the market. So, to compensate those kind of the shareholders this buyback is offered by
the companies.

Fourth important point or outcome of the survey is to prevent dilution from the stock market
grants that say to prevent the dilution. That how means when I told you when the share is trading
in the market the price comes down. There is a dilution in the price of the shares because number
of shares trading in the market are too many and they are not justifying. The companys earnings
are not justifying, dividends are not justifying, companys operations not justifying. So, prices
coming down, dilution in the prices there in the stock market.

1042
And number five, last point of finding was to give excessive cash back to the shareholders.
Sometime company has excessive reserves; they are not required within the company.
Reinvestment needs are not there. And company do not does not look forward that any
investment needs are there where these excessive funds can be used. Reserves surpluses are
mounting they are too much.

And in a way they are taking the company from the optimum capital structure towards the over
capitalization, so to avoid that particular situation. When you have the excessive cash available
that is not required within the firm. So what you can do is you can distribute the excessive cash
back to the shareholders that way you can rationalize the capital structure of the company. You
can deal with the over capitalization problems and you can even say improve the companys share
price in the stock market also the optimum price of the share can be attained in the market.

So, people while trading in the market, they might feel that yes now this is optimum price. We
should re-pay to buy the shares of a company and if they buy the stock of the company from the
market the desired amount of the dividend will also be available. So, these are the findings of a
survey which is conducted by the two people about the buyback of the shares in the US market
from where this concept of the buyback was started in the beginning.

1043
(Refer Slide Time: 32:02)

Now quickly let us go for the points of the regulation of the buybacks. There are the again
important points of the regulations because buyback is regulated by SEBI also and the Indian
companys act also. So what are the important points of regulation? You can read them yourself
also, but I will just means discuss quickly with you. First point, a company can buy back 10
percent of its shares annually with the board resolution.

Beyond that a special resolution of the shareholders is required which is passed in the annual
general meeting of the company, special resolution of the shareholders up to 10 percent, normal
resolution will help which will be passed by the board. Post buyback debt equity ratio should not
exceed 2:1. The standard debt equity ratio 2:1. If you invest 1 rupee from the pocket, 2 rupees
can be borrowed from the market.

So, buyback should not affect this ratio, post buy back your debt equity ratio should be 2:1. The
buyback should not exceed 25 percent of the total paid up capital and the free reserves another
important provision, 25 percent of that total paid up capital and free reserves. After completing a
buyback program, a company should not make a further issue of the equity securities. It is a very
important point.

After completing a buyback program, a company should not make a further issue of the equity
securities or equity shares within a period of 24 months, except in certain cases. These cases are

1044
so many lined up in the say is clearly depicted in the say different say books also, for example,
they want to redeem the adventures or they want to say go for an investment with a special new
projects. Then it can be done.

But normally new equity cannot be issued within a period of 2 years, 24 months from the process
of completing the buyback process by any company. A buyback cannot be done through
negotiated deals, no, it has to be either by the means say two methods. Tender method and the
open market method, right. Under the tender method the price has to be prefixed, which will be
little more than the normal price of the share.

And on the open market, the price at which the company is willing to buy the share has to be
communicated to the broker and broker if that price, if the share is available in the market or
from the market broker will buy it back for the company otherwise not. No negotiated deals
between the company and the shareholders can be done nothing, it has to be crystal clear and as
per the provisions of the SEBI guidelines.

The buyback process has to be handled by a merchant banker duly appointed by the company.
Merchant banker’s assistance is also important and when the merchant banker’s existence is
there in any buyback process, then the negotiated deals are impossible to happen. Negotiated
deals cannot take place.

1045
(Refer Slide Time: 35:04)

And then is the we talk about the say last part here. And this last part is regarding the dividend
policies in practice in India. Three important points are available here. So from where of these 3
important points have come up with regard to the dividend policies in practice in India. A survey
was conducted actually, a survey was conducted by Professor Prasanna Chandra, who has
authored the book Financial Management, very popular book financial management, which I
been referring during my discussion of this course here all the delivery of my lectures here I have
been referring to that book.

The author of the same book Financial Management by Prasanna Chandra, he conducted a
survey of the large 20 large sized Indian companies, 20 large sized Indian companies in the
belonging to the different industries, different sectors, right. And on the basis of the survey
which he conducted himself on the 20 large sized the Indian companies, he has found out that
how the dividend policies are in practice in India.

So, he has given all those findings of his survey. Industry wise that, if he went to the chemical
industry what the people said or the CFO of the company he has in tribute basically. He has
conducted the survey with the CFOs of the different companies, 20 large sized companies who
were belonging to different industries and different sectors. So in that in his own book itself, he
has given he has reported those findings in a detailed manner.

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For example, he has written that when he went to the chemical industry or companies belonging
to a chemical industry, what was the response of the CFO, when he went to any other
manufacturing sector what was the response of the CFO and even to the automobile sector what
was the response of CFO, that what dividend policy they follow?

So, on the basis of his survey of the 20 large sized Indian companies he has which the detailed
say findings of the surveys are available in his book. If you want to see the detailed findings, you
can refer to his book. Chapter number 22 is there, which is on the dividend decisions, so you can
refer to that. But the crux of his survey, his findings is given here in the 3 points. Crux is given
here in the 3 points.

Number 1, generous dividend and the bonus policy. Companies in India follow a generous
dividend bonus and the bonus policy. They are quite generous. They want to take care of the
shareholders and they want to pay as much as possible the dividends the return back to the equity
shareholders in the form of the dividend and in the form of the bonus issues.

Second, important finding is more or less fixed dividend policy. The companies follow more or
less the fixed dividend policy. They do not change it means every year, fixed dividend policy is
followed. And erratic dividend policies, erratic dividend policies means sometime when the
profit is there dividend is paid, but when the profit is not there dividend is not paid right. When
the profit is there dividend is paid when the profit is not there dividend is not paid.

So, certainly profit is the major source from where the dividend has to be paid so precondition
also that the dividend will be paid from the profits of the company. Maybe the profit of the
current year or the profit of the previous year, undistributed profit of the previous year. So if
there is a profit yes. The dividend is paid. There is no profit. No dividend is paid. But more or
less dividend say fixed dividend policy is followed by the companies. And generous dividend
and the bonus policies are in practice or these policies are in bouge.

So we have found out the 3 major points with regard to the dividend policies in practice in India.
First one is which is on the basis of the survey conducted by the Prasanna Chandra have come up
and we have been able to understand that how the companies say have their dividend policies in

1047
India. So, first point says the companys pay generous dividend and their policy with regard to
the, their policy with regard to the dividend and the say bonus issue is quite generous.

More or less fixed dividend policy they follow, an erratic dividend policy because sometime in
the say event of non-availability of the profit, dividends are not paid, right. So, this is a
conceptual discussion. I could do or I could complete till now. And now in the next 5 to 10
minutes’ time I will discuss 1 or 2 problems with you that how the dividend means can be
calculated by following number one, following the Linter’s model.

And second thing is when there is a say earnings available with the company. So how those
earnings will be say bifurcated into that capital expenditure and the dividend and how finally
practically that earning will be used or that amount of the earnings will be used by the company
that I will discuss with you.

So, the first part here is which is very simple and the first problem which is here, that is very
simple problem.

(Refer Slide Time: 40:14)

What will be the dividend per share? The first problem, what will be the dividend per share of
Rama Industries for the year 2018 given the following information about the company. This is a
first problem that relating to the dividend decisions where given the EPS for the current year,

1048
2018 and that is rupees 3. That is earning per share, dividend per share for the previous year
2017 that is rupee's 1.2.

Target pay-out ratio that is 0.6 and then is the adjustment rate that is 0.7 so, now you look at
whatever the information is given to us nowhere it is written that you have to apply the Linter’s
model and calculate the dividend amount to be paid. What will be the dividend per share? So you
have to means nothing is mentioned here that by applying the Linter’s model, you calculate the
dividend to be paid by the Rama Industries.

But you see depending upon the input information given to us, we are given the EPS for the
current year, we are given the DPS for the previous year. We are given the target pay-out ratio
for the say which is the companys target pay-out ratio and we are given that adjustment rate,
right. So, looking at these 4 inputs it is a clear indication that you can find out the amount of the
dividend to be paid per share by the Rama Industries by following or by using the Linter’s
model. So if you use the Linter’s model here, so how you can calculate the model is very simple,
right?

(Refer Slide Time: 41:44)

Lintners model is very simple. So, with the help of Linter model they are going to make use of
the Linter model and by using this model Linter model, you can try to find out that is the amount
of the dividend that will be paid by the company and the models says here. Dt is equal to cr small

1049
cr EPS for the year t plus 1 minus C into Dt minus 1, right, cr so c is a small here it is not a
capital c you have to take it as a small c.

So this is cr EPSt EPS for the year t plus 1 minus c into Dt minus 1 and what is a Dt here? Dt is
basically the dividend payable by the company for the current year from the say earning per
share available for the current year and keeping into consideration the dividend per share paid in
the previous year or during the previous year target pay-out ratio and the adjustment rate, right.

So in this case if you apply if you put all these values. So what these values are given to us,
adjustment rate is given to us is 0.7, right. And what is the pay-out ratio is 0.6. And what is the
earning per share? Earning per share is 3 plus you are given 1 minus c so c is again the amount
that is 0.7 and the dividend for the previous year is 1.2.

So, we have put all the values which were available with us that is 0.7 into 0.6 into 3 plus 1
minus 0.7 into 1.2. And if you solve this equation, you will find out that Dt is equal to 1.62
rupees. So, you can easily understand what this amount is, Dt is equal to rupees 1.62. It means it
is a dividend. What we wanted to find out? What will be the dividend per share, so dividend per
share will be 1.62 rupees to be paid. What was the dividend paid by the Rama Industries in the
previous year? 1.2, right.

1 rupees 20 paisa was paid the dividend in the previous year and this is going to be increased in
the current year for 1.2 rupees to 1.62 rupees in the current year depending upon the EPS of the
company, depending upon the target pay-out ratio and depending upon the adjustment rate of the
company. So, this is the way we can solve this very simple problem and apply the Lintners
model for calculating the dividend to be paid per share.

In the current year where the different factors which are to be generated first of all as input
factors and if they are available, you can apply the Lintner model and calculate the dividend
payable in the absolute amount. This is the beauty of the model that in the absolute amount per
share dividend payable by the company in the current year can be calculated. Now we do one
more problem here quickly. And the second problem is a little lengthier. So, I will do the one
part of it and the remaining I will give you the hints so you can do it yourself.

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(Refer Slide Time: 45:27)

The problem is Raja Limited expects that it is net income and the capital expenditure over the
next 4 years will be as follows. We are given the 4 years, right? First year the net income will be
10000 rupees and Cap-ex, capital expenditure will be 8000 rupees. Second year the net income
will be 12000 rupees; Cap-ex will be 7000 rupees. Third year net income will be 9000 rupees.
Cap-ex will be 10000 rupees. And fourth year the net income will be 15000 rupees, Cap-ex will
be 8000 rupees.

Company has 5000 outstanding shares currently or which it pays a dividend of 1 rupee per share
dividend of 1 rupee per share. What is now required to be done? First point, what will be the
dividend per share if the company follows a pure residual policy, what will be the dividend per
share if the company follows a pure residual policy. B, what external financing is required if the
company plans to raise dividend by 1 percent.

What external financing is required if the company plans to raise dividend by 10 percent. Every
2 years. And c, what will be the dividend per share and external financing requirements if the
company follows a policy of a constant 60 percent pay-out ratio. So, these are the three
requirements which you have to work out with the help of this information which is with regard
to the net income and the Cap-ex, right.

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So, let us do the first part here quickly and then we will understand that how the others two part
can be done and how the different requirements of this problem can be answered here. So first, is
that is the under the pure residual dividend policy, pure residual dividend policy means out of the
total earnings first of all, you have to deal with the capital expenditure. And after that, whatever
the amount is left with us that will be used for paying the dividend to the shareholders.

(Refer Slide Time: 47:32)

So, under the pure residual policy, you can call it as DPS Dividend Per Share under a pure
residual policy. So here you can take the particulates and here you can take the years, right. Here
you can take the years because we are given the information in terms of the years. So here you
can take the years and years are 1, 2, 3 and it is 4 right, years are 1, 2, 3 and 4. So first thing is
the earnings EPS or total amount of the earnings.

It is not earnings but EPS but the total amounts of earnings. So, total amount of earning given is
to us is how much? Total amount of earnings given to us we have to find it out from this. And
earnings are given year wise 10000 rupees, then we are given the next earning is that Rs12000,
then we are given the earnings is Rs 9000 and then we are given the earnings is Rs 15000, right.
So what is a cap-ex? Capital expenditure, it is also given to us Capital expenditure in this case,
we first take the Rs 8000, right.

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Second is Rs 7,000, then we are to take Rs 10,000 which is given to us, these two informations
are given to us, right. And then is the now out of this, for example, earnings are Rs 10000, capital
expenditure we want to make is 8000, right. Now in this case we assume that equity investment
is done is equity investment which comes or which say has to be made here is that is for example
we assumed equity investment.

Equity investment has to be done here is the, we assume that Rs 4000 rupees, the companys
policy is that equity investment will be Rs 4000 here. In this case, it will be Rs 3500. In this case,
it will be Rs 5000 and in this case, it will be Rs 4000, right. Equity investment has to be made is
Rs 4000 and Rs 5000 and this amount that is the equity investment. So, equity investment will
come from where, from the retained earnings.

So from this means this is a total expenditure Rs 8000 that is a capital expenditure, which we
want to make in year 1, this in the year 2, this in the year 3, this in the year 4 right. And it is
decided by the company and that equity investment will be Rs 4000 only, remaining amount in
this case, Rs 4000 will come from the borrowings. In this case, the remaining amount will come
from the borrowings. In this case, Rs 5000 will come from the borrowings. In this case 4000 will
come from the borrowings, right.

So in this case, what is a pure residual amount? If you talk about the pure residual dividend this
will be, so it means out of Rs 10000 if Rs 4000 is invested into the capital expenditure, so pure
residual dividend left with us is Rs 6000. In this case it will be Rs 8500. In this case, it will be Rs
8500. And in this case will be how much? 4000, and in this case, it will be Rs 11000, right. So,
you can easily calculate what is a dividend per share, how many total number of shares are there?

Total number of shares are Rs 5000 shares on which dividend of 1 rupee the company pays
normally, but depending upon the amount available here, now the pure residual dividend
available here. Rs 6000 is available in the first year, Rs 8500 is available in the second year,
4000 is available in the third year and Rs 11000 is available in the fourth year. So, you can
calculate the dividend per share.

If you calculate the dividend per share, how much it is going to be? It is going to be 1.20 because
6000 will be divided by 5000 shares. So, it is 1.20, 1.70. It is 0.8 and in this case it will be

1053
maximum 2.20, it will be 2.20. So, this is the dividend per share under the pure residual policy.
And why we call it as a pure residual policy, that out of the total earnings, first of all we will
decide the capital expenditure.

And in that capital expenditure, how much part will come from the equity investment that is
from the retained earnings, that is from the earnings and amount which is remaining after making
investment for meeting the capital expenditure requirement. The remaining amount will be paid
will be distributed as a dividend. That is why it is called as a pure residual amount, pure residual
dividend. And this amount is called as the in this case, this amount has worked up as the 6000
rupees. And total number of shares are 5000.

So if you divide this 6000 by the 5000 so in the first year, the dividend per share is 1.2 rupees. It
is in the absolute value rupees 1.20. In the second case rupees 1.70, in the third case is rupees
0.80. And in the fourth, here it is rupees 2.20. So, similarly you have to say answer the other two
questions, which I leave it to you. You can do it yourself. And for example, in this case, what is
the second question?

(Refer Slide Time: 53:27)

Second question is what external financing is required if the company plans to raise dividend by
10 percent every 2 years? So, you can simply understand that out of the. But you have to do in
this case is. So, if you want to find out that how much is the, the question here is that external

1054
financing required, right. So, for example in this case say how much external financing is
required. So first of all, you take in the second question to answer the second question first step
process I am explaining. And other you can do to yourself.

(Refer Slide Time: 53:58)

So, it is 10000, DPS is for example. Dividend Per Share is 1, so total dividend paid will be how
much? Multiplied by 5000, right. So it will be total dividend will be how much? Total dividend
will be rupees 5000. I am explaining it to you. You can do it yourself, 5000, right. What is the
retained earnings? Retained earnings are now we are left with 5000 only, so how it is, that is
10000 minus 5000.

So it is 5000 retained earnings and what is the cap-ex? Cap-ex is going to be how much, 8000?
So, external financing requirement in the first year will be equal to 3000 rupees, right. So this
way you can solve other problems means the other years also you can do it yourself. And in the
other case, for example, now the next question is that it is asked here us is, what will be the
dividend per share and external financing requirements, if the company follows a policy of a
constant 60 percent pay-out ratio?

So there you can change the dividend up to 60 percent of the earnings, the dividend amount will
become 60 percent. So, from the earnings 60 percent, dividend amount will be first subtracted
whatever the balance is left. That will be available for the capital expenditure meeting

1055
requirement. And the balance amount that is the amount total required as a capital expenditure
and available from the earnings.

After paying the dividend the amount available from the earnings that will be used for the capital
expenditure plus the balance amount will be generated from the external financing. So, this is
how the dividend decisions are means taken or they affect the overall financing requirements as
well as the overall financial performance of the company and how means important
considerations of the dividend decisions are born in mind while framing the dividend policies by
the companies.

So, with this discussion for the past to say 60 lectures, including todays lecture, I could discuss
some important relevant concepts of the financial management. We started with the basic
introduction f the financial management and then we moved to the financial planning. Then we
discussed some other important concepts like capital budgeting. Then say cash flow analysis
with regard to the capital budgeting projects.

Then the risk analysis we did then we went forward with the cost of capital then we say carried
forward the process with the process of learning of the capital structure. And finally this dividend
decision. So, whatever the important possible topics were there with regard to this subject or
which would be pertaining to this subject to pass on you or share with you the complete
knowledge on the financial management, I have tried to do and say I hope that this course will be
very useful to you.

You will find it quite interesting and means whatever the doubts queries are there will be
meeting on the discussion forum also when the course will be starting. So you attend this course,
you become the part of this course, try to listen to the video lectures very carefully. If there are
any kind of the improvement or any suggestions please, we will discuss on the discussion forum
and in the end I would like to say conclude the discussion on this say.

This the course as a whole with my observations that whatever possible was to be done, I have
done and I have tried to bring in the best possible topics and the most suitable topics which are
very useful in our day to day knowledge. And I am sure that if you become a part of this course

1056
and if you enrol for this course, you will be really finding this course very useful. Thank you
very much. See you on the discussion forum. After you joined the course. Thank you very much.

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