Financial

Management
FAC202: August – December 2022

Debarati Basu
Wednesday
debarati.basu@snu.edu.in
(11am -
12pm)
Office: B 220E
Module 3
Capital Budgeting
 What is Capital Budgeting?
Increase
Diversify Buy a Invest in
volume of
product line company mutual funds
production

• Multiple long-term investment options

• Fixed amount of resources

• Capital Budgeting: deciding where to invest!

Basu, SME-SNU
 Time Value of Money
• A Rupee today or a Rupee next year?

• Interest rates and inflation 100 * (1+5%)

• Value today = 100

100 105
• Rate of interest = 5% p.a.
105 / (1+5%)
• Future Value at the end of the year = 105

Basu, SME-SNU
 Variations
• Single vs Multiple period

• Multiple cash flows

• Frequency of compounding

• Perpetuities

• Annuities

• Growth rate
Basu, SME-SNU
 Investment Options?
Increase
Diversify Buy a Invest in
volume of
product line company mutual funds
production

Basu, SME-SNU
 Invest in a Mutual Fund?
1. Investment today = 350 mn NPV =
-350 + 364 =
2. Horizon = 1 year
14
3. Forecasted value at the end of the year = 400 mn IRR =
14.28%
4. Opportunity cost of capital?

 If I buy a company instead, estimated return in 1 year = 10%

• PV = 400 / (1.1) = 364

Basu, SME-SNU
 NPV vs IRR
• NPV:

 If NPV > 0 then invest

 If NPVA > NPVB then invest in A

• Similarly, IRR:

 If IRR > Hurdle rate / Discount rate then invest

 If IRRA > IRRB then invest in A

Basu, SME-SNU
 But
12% A B C D E F G H
0 -100 100 -200 -100 -100 100 -100 -100
1 150 -150 280 130 260 -300 150 50
2         -165 250 25 150
NPV ₹ 33.93 ₹ -33.93 ₹ 50.00 ₹ 16.07 ₹ 0.61 ₹ 31.44 ₹ 53.86 ₹ 64.22
IRR 50% 50% 40% 30% 10%/50% #NUM! 65% 50%

• E: Multiple IRRs • Scale: A vs C?

• Time: G vs H?
• F: No IRR

• Conflict: A vs B?
Basu, SME-SNU
 NPV
• So, NPV a better tool

• Other tools: payback period, profitability index, etc.

• Most decision-makers use multiple tools for same decision

• Risk and PV

 Higher risk -> requires higher rate of return

 Higher required rate of return -> lower PV of cash flows

• Accept investments with rate of return > opportunity cost of capital

Basu, SME-SNU
Hurdle Rate?
 Cost of Capital

Weighted Average Cost of Capital

(WACC) =

(Proportion of Debt)* rdebt + (Proportion

of Equity)* requity

Basu, SME-SNU
 Cost of Debt
• Effective interest rate paid on debt obligations

 Bonds, loans, etc. Eg: Annual Interest = 10;

Total Debt = 250; Marginal
 Tax implications: interest expense is deductible! Tax Rate = 30%

• Useful when assessing liquidity and solvency

rdebt = (10/250)% * (1-30%)
 1000 @ 3% vs 500 @ 7% = 2.8%

 Size and cost important

Basu, SME-SNU
 Bond Basics
• Face value / par value / principal

• Maturity Date

• Coupon rate

• Covenants

• Secured vs unsecured – collateral

• Seniority
Basu, SME-SNU
 Valuing Bonds
• An XYZ Bond pays 100 every March for 5 years. It’ll pay the principal 1000 at
maturity. The bond is rated AAA and the market rate of interest is 5%.

Bond Value = PV of cash flows

= 100 / (1.05) + 100 / (1.05)2 + 100 / (1.05)3 + 100 / (1.05)4 +

100 / (1.05)5 + 1000 / (1.05)5

= 1216.47
Basu, SME-SNU
 Coupon vs Yield
• Issued:

 At par or face value (coupon = yield)

 At a discount or below face value (coupon < yield)

 At premium or above face value (coupon > yield)

Basu, SME-SNU
 Debentures
• Most corporate bonds -> debentures

• Debentures are bonds without collateral

Basu, SME-SNU
 The Global Bond Markets
• Large debt markets globally

• India still struggling to develop its debt market

• Financing in India

 Bank-led
 Private placement
 Internally generated

Basu, SME-SNU