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Financial Management Unit 3 Investment Decision
Financial Management Unit 3 Investment Decision Notes cover all the exercise questions in UGC Syllabus. Financial Management Unit 3 Investment Decision provided here ensures a smooth and easy understanding of all the concepts. Understand the concepts behind every Unit and score well in the board exams.
Investment Decision
FINANCIAL MANAGEMENT
| VERY SHORT TYPES QUESTION & ANSWERS |
A. State whether the following statements are true or false:
1. Pay back period method measures the true profitability of a project.
Ans: False.
2. Internal Rate of Return and Time Adjusted Rate of Return are the same.
Ans: True.
3. Capital rationing and capital budgeting mean the same thing.
Ans: False.
4. Rate of Return method takes into account the time value of money.
Ans: True.
5. Net present value method take into account the earning over the entire life of the project.
Ans: True.
6. Risk is a characteristic inherent in all business.
Ans: True.
7. Futurity does not refer to the timing of cash flows.
Ans: False.
8. Operating and financial leverage are not interdependent.
Ans: False.
9. Fixed charges leverages indicates the extent to which changes in operating income affect earnings before taxes.
Ans: True.
10. Financial leverage exists whenever a firm has debts or other sources of funds that carry fixed charges.
Ans: True.
11. There is no direct relation between operating profit and break-even point.
Ans: False.
12. If a firm has a high degrees of operating leverage, small changes in sales will have large effect on operating income.
Ans: True.
13. Operating leverage does not exist when changes in revenue produce greater changes in EBIT.
Ans: False.
14. Operating leverage means the extents to which fixed costs are used in the activities of a firm.
Ans: True.
15. The Contribution margin implies sales minus variable cost.
Ans: True.
16. Financial leverage means earning before interest and taxes (EBIT).
Ans: False.
17. Financial leverage relates with liabilities side of the balance sheet.
Ans: True.
B. Fill up the blanks:
1. Capital budgeting is also known as ________ and ________.
Ans: Investment decision making, planning capital Expenditure.
2. Capital Investment decisions are generally of _________ nature.
Ans: Irreversible.
3. Profitability index is also known as _________ ratio.
Ans: Benefit/cost.
4. The simplest capital budgeting technique is ________.
Ans: Payback period method.
5. The Net Present Value of Inflows is calculated by deducting _______ from the total ______.
Ans: Cost of investment, present value of cash inflows.
6. Certainty is always expressed as ________ and impossibility as ______.
Ans: One, zero.
7. The point at which shareholders feel that there is a trade off between risk and return is known as the _________ point.
Ans: Optimum.
8. __________ is a graphic display of the relationship between the present decision and a possible future event, future decisions and that consequences.
Ans: Decision free.
9. _________ shows how the basic forecast or results in a decision will be affected by changes in the critical data imputes that influence those results.
Ans: Sensitivity Analysis.
10. The leverage of a firm is essentially related to ________ measure.
Ans: Profit.
11. The term ________ describes the ratio between the stock and the fixed interest bearing securities of a company.
Ans: Capital gearing.
12. The product of asset turnover and profit margin is known as ________ leverage.
Ans: Return on investment.
13. The asset turnover is the same as ________ leverage.
Ans: Asset.
14. ________ Leverage indicates the impact of changes in sales on operating income.
Ans: Operating.
15. If a firm can obtain debt funds at an interest rate lower than its internal rate of return, this should tend to in cease the rate of return on its equity capital. This is known as the principle of _________.
Ans: Combined.
16. Financial leverage is also known as ______.
Ans: Trading on Equity.
17. A firm will have favourable leverage if its _________ are more than the debt cost.
Ans: Earnings.
18. Operating leverage × financial leverage = __________.
Ans: Composite leverage.
19. Degree of financial leverage = _______.
Ans: %Change in EPS/ % Change in EBIT.
20. Operating leverage = ______.
Ans: Contributi on/ Operating profit.
SHORT TYPE QUESTIONS & ANSWERS
1. What is cost of capital?
Ans: The cost of capital is the minimum rate of return that the company must earn on its investments to fulfil the expectations of the investors. If a company can raise long-term funds from the market at 10%, then 10% can be used as cut-off rate as the management gains only when the project gives return higher than 10%. Hence 10% is the discount rate or cut-off rate. In other words, it is the minimum rate of return required on the investment project to keep the market value per share unchanged. In order to maximise the shareholders’ wealth through increased price of shares, a company has to earn more than the cost of capital. The firm’s cost of capital can be determined by working out weighted average of the different costs of raising different sources of capital.
2. Mention the merits of pay back period. Mention five merits of pay back method.
Ans: Merits of pay back period method: The pay back period method is quite an easy method for evaluation of capital expenditure projects.
The merits of this method are as follows:
(i) Simple: This method is quite simple to understand as well as easy to calculate.
(ii) Saves time, cost and labour: It saves in cost, it requires lesser time and labour as compared to other methods of capital budgeting.
(iii) More accurate estimates: In this method we do not consider entire life of the project but only the period of pay back it taken into consideration. Therefore estimates are more accurate and real.
(iv) Risk of obsolescence: In this method, as a project with a shorter payback period is preferred to the one having a longer pay back period, it reduces the loss through obsolescence. This method is more suited to the developing countries, like India, which are in the process of development and have quick obsolescence.
Five merits of pay back method are:
(i) It is easy to calculate and simple to understand.
(ii) It is preferred by executive who like answers for the selection of the proposal.
(iii) It is useful where the firm is suffering from each deficiency.
(iv) It reduces the possibility of loss through obsolescence.
(v) It is a handy device for evaluating investment proposals, whose precision in estimates of profitability is not important.
3. Define Capital Budgeting. Mention the various kind or technique of capital budgeting.
Ans: The planning and control of capital expenditure is termed as ‘Capital Budgeting’. In the words of Charles T. Horngreen: “Capital Budgeting is long term planning for making and financing proposed capital outlays”.
According to R.M. Lynch, “Capital Budgeting consists in planning the development of available capital for the purpose of maximising the long- term profitability (return on investment) of the firm”.
The various kind or technique of capital budgeting:
(i) Pay back period method.
(ii) Unadjusted Rate of Return Method.
(iii) Present value Method.
(iv) Time adjusted Rate of Return method.
(v) Net present value method.
4. Write fine factors influencing the size of receivables.
Ans: The size of receivables are:
(i) Size of credit sales.
(ii) Credit policies.
(iii) Terms of trade.
(iv) Expansion plans.
(v) Relation with Profits.
5. Mention four problems associated with the cash management.
Ans: The cash management are:
(i) Controlling of level of cash.
(ii) Controlling inflow of cash.
(iii) Controlling outflow of cash.
(iv) Optimal Investment of surplus cash.
6. Mention fine functions or advantages of cash budget.
Ans: The functions or advantages of cash budget are:
(i) Helpful in planning.
(ii) Forecasting the future needs of funds.
(iii) Maintenance of ample each balance.
(iv) Controlling cash Expenditure.
(v) Evaluation of performance.
7. Write the demerits of pay back period?
Ans: Demerits of pay-back period method:
(i) More importance to pay back of invested funds: There is more importance to liquidity rather than to the profitability which is not right too much emphasis is given on payback of original investment.
(ii) Does not consider the income received after pay back period: In this method only the pay back of original investment is considered and the income after that period is not considered. The objective of any business firm to invest money in capital projects is not only to get the investment back but to earn profit, therefore earnings in the entire life of the project should be considered.
(iii) Does not measure risks: This method does not measure risks in the project. If a project has shorter pay back period but more risk can also be accepted which is not good.
(iv) Ignores cost of capital: The cost of capital is the strong basis for investment decisions but this method ignores cost of capital.
8. Write the merit of Average Rate of Return Method?
Ans: Merits of average rate of return method:
(i) Simple: This method is quite simple.
(ii) Considers whole life of the project: This method considers the income of whole life of the project.
(iii) Test of profitability: In this method profitability of different projects is evaluated; so comparison of different projects is possible.
(iv) More useful for analysis of long term projects: This method is quite useful for the analysis of long term projects because it considers the whole life of the project.
9. What do you mean by Capital Rationing?
Ans: Capital rationing is a situation where a firm is not in a situation to invest in all profitable projects due to the constraints on availability of funds. The resources are always limited and the demand for them far exceeds their availability. So the firm cannot take up all the projects though profitable, and has to select the combination of proposal that will yield the greatest profitability. The capital rationing is proper allocation of capital between various projects, those projects are left in which the expected profitability rate is lower than the cost of capital.
10. Write the demerits of Rate of Return Method?
Ans: Demerits of average rate of return method:
(i) Does not consider time value of money: It does not consider time value of money. The comparative study is essential for the evaluation of different projects and for this purpose the calculation of present value of cash inflow of different projects is necessary. But this is not done in this method.
(ii) Profits affected by micro factors are not tested: In this method the profits affected by micro factors are not measured and only average annual profits are considered.
(iii) Concepts of investment and income are vague: In this method, the income and investment words are used which have got many meanings so there is uncertainty.
11. Mention the Net Present Value Method?
Ans: Merits of the net present value method:
(i) Recognises the time value of money and is suitable to be applied in a situation with uniform cash outflow and uneven cash inflows or cash flows at different periods of time.
(ii) Considers the whole life of the project: It takes into account the earnings over the entire life of the project and the true profitability of the investment proposal can be evaluated.
(iii) Considers the objective of profitability: It takes into consideration the objective of maximum profitability.
12. Write the demerits of the Net Present Value Method?
Ans: Demerits of the net present value method:
(i) Difficult to understand and operate: As compared to traditional methods, the net present value method is more difficult to understand and operate.
(ii) Does not give good results: It may not give good results while comparing projects with unequal investment of funds.
(iii) Difficult to determine discount rates: It is not easy to determine an appropriate discount rate.
(iv) Internal rate of return: The internal rate of return method is also a technique of capital budgeting that takes into account the time value of money. It is also known as time adjusted rate of return, discounted rate of return, yield method and trial and error yield method. It is the rate at which the sum total of cash inflow after discounting equals to the discounted cash outflow. The IRR of a project is the discount rate which makes NPV of the project equal to zero.
Mathematically, IRR = A + PVA-C/ PVA-PVB. (B-A)
Where, A = Lower trial rate.
B = Higher trial rate.
C = Initial investment.
PVA = Present value of cash inflows with lower trial rate.
PVB = Present value of cash inflows with higher trial rate.
13. Write the Merits of Internal Rate of Return Method?
Ans: Merits of internal rate of return method:
(i) Uses the concept of time value of money: It takes into account the time value of money and can be usefully applied in situations with even as well as uneven cash flow at different periods of time.
(ii) Easier: The determination of cost of capital is not a prerequisite for the use of this method and hence it is better than net present value method where the cost of capital cannot be determined easily.
(iii) Considers entire economic life: It considers the profitability of the project for its entire economic life and hence enables evaluation of true profitability.
(iv) Uniform ranking: It provides for uniform ranking of various proposals due to the percentage rate of return.
14. Write the demerit of Rate of Return Method?
Ans: Demerits of internal rate of return method:
(i) Difficult to understand as well as evaluate: It is difficult to understand and is the most difficult method of evaluation of investment proposals.
(ii) Unjustified assumption: This method is based upon the assumption that the earnings are reinvested at the internal rate of return for the remaining life of the project, which is not a justified assumption particularly when the average rate of return earned by the firm is not close to the internal rate of return.
(iii) Profitability index or benefit cost ratio: It is also a time-adjusted method of evaluating the investment proposals. The proposal is accepted if the profitability index is more than one and is rejected in case the profitability index is less than one. Profitability index also called as ‘Benefit Cost Ratio’ or desirability factor is the relationship between present value of cash inflows and the present value of cash outflows. Thus,
Profitability index = Present value of cash inflows/ Present value of cash outflows.
The method is a slight modification of the net present value method. The net present value method has one major drawback that it is not easy to rank projects on the basis of this method particularly when the costs of the projects differ significantly. To evaluate such projects the profitability index method is most suitable. The other merits and demerits of this method are the same as those of net present value method.
15. What do you mean by the term leverage? What are the types of leverage?
Ans: The term leverage refers to the ability of a firm in employing long- term fund having fixed cost, to enhance returns to the owners. James Horne has defined leverage as “The employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return”. The fixed cost (also called fixed operating cost) and fixed return (called financial cost) remains constant irrespective of the change in volume of output or sales.
There are three types of leverage:
(a) Operating/operative leverage.
(b) Financial leverage.
(c) Composite or combined operating and financial leverage.
16. Write about combined operating and Financial Leverage or Composite Leverage.
Ans: The combined leverage may be defined as the potential use of fixed cost, both operating and financial, which magnifies the effect of sales volume change on the earnings per share (EPS) of the firm. Operating leverage affects the income which is the result of production. On the other hand, the financial leverage is the result of financial decisions. The composite leverage focuses attention on the entire income of the concern. The risk factor should be properly assessed by the management before using the composite leverage. The high financial leverage may be offset against low operating leverage or vice-versa.
The degree of composite leverage may be calculated as follows:
Degree of composite leverage (DCL) = Percentage Change in EPS/ Percentage Change in sales.
Or, composite leverage = Operating leverage × Financial leverage.
= C/OP × OP/ PBT = C /PBT.
Where,
C = Contribution (Sales-Variable Cost).
OP = Operating Profits or EBIT (Earning before Interest and Tax).
PBT = Profit Before Tax but after Interest.
17. Write a note on Importance of Financial Leverage.
Ans: Leverage is an important technique that helps the management to take sound and prudent financing and investing decisions. The task of choosing most suitable combinations of different securities for financing fund requirements in the light of the firm’s anticipated earnings is facilitated by it. In matters relating to investment also, leverage technique is immensely helpful. It acts as a useful guideline in setting the maximum limit by which business of the firm should be expanded. For example, management is advised to stop expanding business the moment anticipated return on additional investment falls short of fixed charges of debt.
18. What are the benefits of financial leverage? What are the limitations of financial leverage?
Ans: The benefits of using financial leverage include:
(i) Borrowers may make a relatively small upfront investment.
(ii) Borrowers may be able to purchase more assets through debt financing with the extra funds.
(iii) Under favourable conditions, financial leverage can lead to higher returns than an individual or business may otherwise see.
A finance manager must be acquainted with the following limitations of the leverage technique:
(i) The leverage technique fails to take cognizance of implicit costs of debt. According to this technique, so long as the future earnings of the firm exceed the interest cost of debt (explicit cost), debt should be relied upon to raise additional funds as it seems to be the cheapest means of financing.
However, this course of action may not always help maximise shareholders’ wealth. Implicit cost resulting from a decline in the market-price of the common stock because of increased financial risk due to induction of higher doses of debt is altogether ignored in this technique. Implicit costs may partially or wholly offset the earnings per share of using debt. In view of this it would be erroneous to decide as to what extent a firm should take recourse to debt financing unless’ implicit cost of debt is calculated.
(ii) Financial leverage technique is based on the premise that costs of debt remain constant regardless of degree of leverage in the firm. This assumption is unrealistic. With successive increase of doses of debt interest rate on debt tends to rise correspondingly because of increased risk in the firm.
In view of these limitations, finance manager should not base financing and investing decisions solely upon this analysis. It can at best be employed as a supplement to other financial techniques.
(iii) There is a chance that assets decline in value quickly, and the financial losses may increase with financial leverage.
(iv) Financial leverage comes with a greater operational risk for companies in industries like automobile manufacturing, construction and oil production.
(v) The abuse of financial leverage can force companies out of business.
19. How leverage can arise?
Ans: Leverage can arise in a number of situations, such as:
(i) Securities like options and futures are effectively bets between parties where the principal is implicitly borrowed/lent at interest rates of very short treasury bills.
(ii) Equity owners of businesses leverage their investment by having the business borrow a portion of its needed financing. The more it borrows, the less equity it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result.
(iii) Businesses leverage their operations by using fixed cost inputs when revenues are expected to be variable. An increase in revenue will result in a larger increase in operating profit.
(iv) Hedge funds may leverage their assets by financing a portion of their portfolios with the cash proceeds from the short sale of other positions.
20. What are the Measures of Financial Leverage?
Ans: There are various measures of Financial Leverage:
(i) Debt Ratio: It is the ratio of debt to total assets of the firm which means what percentage of total assets is financed by debt.
(ii) Debt Equity Ratio: It is the ratio of debt to the equity that signifies how many dollars of debt is taken per dollar of equity.
(iii) Interest Coverage Ratio: It is the ratio of profits to interest. This ratio is also represented in times. It represents how many times of the interest is the available profit to pay it off. The higher such ratio, the higher is the interest-paying capacity. The reciprocal of it is income gearing.
LONG TYPE QUESTIONS & ANSWERS
1. Explain the Significance of Cost of Capital. Discuss the various techniques of Investment Decision.
Or
Explain the Significance of Cost of Capital. Discuss various methods of Capital Budgeting.
Ans: The significance or importance of cost of capital may be stated in the following ways:
(i) Maximisation of the Value of the Firm: For the purpose of maximisation of value of the firm, a firm tries to minimise the average cost of capital. There should be judicious mix of debt and equity in the capital structure of a firm so that the business does not to bear undue financial risk.
(ii) Capital Budgeting Decisions: Proper estimate of cost of capital is important for a firm in taking capital budgeting decisions. Generally cost of capital is the discount rate used in evaluating the desirability of the investment project. In the internal rate of return method, the project will be accepted if it has a rate of return greater than the cost of capital. In calculating the net present value of the expected future cash flows from the project, the cost of capital is used as the rate of discounting. Therefore, cost of capital acts as a standard for allocating the firm’s investible funds in the most optimum manner. For this reason, cost of capital is also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return etc.
(iii) Decisions Regarding Leasing: Estimation of cost of capital is necessary in taking leasing decisions of business concern.
(iv) Management of Working Capital: In management of working capital the cost of capital may be used to calculate the cost of carrying investment in receivables and to evaluate alternative policies regarding receivables. It is also used in inventory management also.
(v) Dividend Decisions: Cost of capital is significant factor in taking dividend decisions. The dividend policy of a firm should be formulated according to the nature of the firm – whether it is a growth firm, normal firm or declining firm. However, the nature of the firm is determined by comparing the internal rate of return (r) and the cost of capital (k) i.e., r> k, r = k, or r< k which indicate growth firm, normal firm and decline firm, respectively.
(vi) Determination of Capital Structure: Cost of capital influences the capital structure of a firm. In designing optimum capital structure that is the proportion of debt and equity, due importance is given to the overall or weighted average cost of capital of the firm. The objective of the firm should be to choose such a mix of debt and equity so that the overall cost of capital is minimised.
(vii) Evaluation of Financial Performance: The concept of cost of capital can be used to evaluate the financial performance of top management. This can be done by comparing the actual profitability of the investment project undertaken by the firm with the overall cost of capital.
The various methods used for the evaluation of investment or capital expenditure decisions may be grouped into the following two categories, which are discussed below:
(i) Pay back period method: The period in which we get the invested amount back is called pay-back period. The annual income received from the invested capital or whatever savings are there, they are called ‘cash earning’ or ‘net cash inflows’.
A project is accepted if its pay back period is less than the maximum pay back period set up by the top management. A ranking of various projects is done keeping the project of least pay back period on the top. If the management has to choose one project between two mutually exclusive projects, the project with shortest pay back period will be chosen.
Pay-back period = Initial Investment/ Annual cash inflow.
(ii) Average rate of return method: This method takes into account the earnings expected from the investment over their whole life. It is also known as accounting rate of return method. According to this method various projects are ranked in order of the rate of earnings or return. The project with the higher rate of return is selected as compared to the one with lower rate of return. This method can also be used to make decision as to accepting or rejecting a proposal.
(iii) Accounting rate of return on initial investment: The accounting rate of return on initial investment is the ratio between initial investment and estimated net average annual income.
The calculation is done by the following formula: Accounting rate of return = Estimated average net annual income.
after depreciation & tax/ Initial Investment ×100.
(iv) Rate of return on average investment: In this method also the average net income is calculated. The average net income is divided not by the initial investment but by average investment. Average investment is calculated by dividing initial investment + scrap value by two. This can be explained with the following formula:
ARR = Average annual income after tax and depreciation/ Average investment ×100.
Or
ARR = Average annual cash inflow-annual depreciation/Average investment ×100.
Annual depreciation = Initial investment-scrap value/ Life of the project.
Average investment = Initial investment + scrap value / 2.
ARR = Average annual (Initial investment value / life of the project) 1/2 (Initial investment + scrap value).
(v) Net present value method: It is quite important for the analysis of capital expenditure and it is based on time adjusted rate of return. This is also known as excess present value method or net gain method. The present value of the project can be known quite easily. First of all, the present value of cash inflows is calculated by the required rate of discount. The initial investment is deducted from the present value of cash inflows to find out the net present value.
This can be expressed in the following equation:
NPV = PV – C
Where NPV = net present value.
PV = present value of cash inflows.
C = Initial investment.
(vi) Internal rate of return: The internal rate of return method is also a technique of capital budgeting that takes into account the time value of money. It is also known as time adjusted rate of return, discounted rate of return, yield method and trial and error yield method. It is the rate at which the sum total of cash inflow after discounting equals to the discounted cash outflow. The IRR of a project is the discount rate which makes NPV of the project equal to zero. Mathematically,
IRR = A+ PVA-C/ PVA-PVB (B – A).
Where, A = Lower trial rate.
B = Higher trial rate.
C = Initial investment.
PVA = Present value of cash inflows with lower trial rate.
PVB = Present value of cash inflows with higher trial rate.
2. What are the Factors Affecting The Cost Of Capital Of A Firm? What are the methods of measurement of cost of capital? Explain.
Ans: Factors affecting the cost of capital of a firm are:
(i) Risk Free Interest Rate: The risk free interest rate, If, is the interest rate on the risk free and default- free securities. Theoretically speaking, the risk free interest rate depends upon the supply and demand consideration in financial market for long term funds. The market sources of demand and supply determines the If, which is consisting of two components:
(a) Real interest Rate: The real interest rate is the interest rate payable to the lender for supplying the funds or in other words, for surrendering the funds for a particular period.
(b) Purchasing power risk premium: Investors, in general, like to maintain their purchasing power and therefore, like to be compensated for the loss in purchasing power over the period of lending or supply of funds. So, over and above the real interest rate, the purchasing power risk premium is added to find out the risk free interest rate. Higher the expected rate of inflation, greater would be the purchasing power risk premium and consequently higher would be the risk free interest rate.
(ii) Business Risk: Another factor affecting the cost of capital is the risk associated with the firm’s promise to pay interest and dividends to its investors. The business risk is related to the response of the firm’s Earnings Before Interest and Taxes, EBIT, to change in sa less revenue. Every project has its effect on the business risk of the firm. If a firm accepts a proposal which is more risky than average present risk, the investors will probably raise the cost of funds so as to be compensated for the increased risk. This premium is added for the business risk compensation is also known as Business Risk Premium.
(iii) Financial Risk: The financial risk is a type of risk which can affect the cost of capital of the firm. The particular composition and mixing of different sources of finance, known as the financial plan or the capital structure, can affect the return available to the investors. The financial risk is affected by the capital structure or the financial plan of the firm. Higher the proportion of fixed cost securities in the overall capital structure, greater would be the financial risk.
(iv) Other Consideration: The investors may also like to add a premium with reference to other factors. One such factor may be the liquidity or marketability of the investment. Higher the liquidity available with an investment, lower would be the premium demanded by the investor. If the investment is not easily marketable, then the investors may add a premium for this also and consequently demand a higher rate of return.
The measurement of cost of capital of different sources of capital structure is discussed:
(a) Cost of Debentures: The capital structure of a firm normally includes the debt capital. Debt may be in the form of debentures bonds, term loans from financial institutions and banks etc. The amount of interest payable for issuing debenture is considered to be the cost of debenture or debt capital (Kd). Cost of debt capital is much cheaper than the cost of capital raised from other sources, because interest paid on debt capital is tax deductible.
The cost of debenture is calculated in the following ways:
(i) When the debentures are issued and redeemable at par. Kd = r(1-t)
Where Kd = Cost of debenture.
r = Fixed interest rate.
t = Tax rate.
(ii) When the debentures are issued at a premium or discount but redeemable at par.
Kd = I/NP (1- t).
where, Kd= Cost of debenture.
I = Annual interest payment.
t = Tax rate.
Np = Net proceeds from the issue of debenture.
(iii) When the debentures are redeemable at a premium or discount and are redeemable after ‘n’ period:
Kd
I(1-t)+1/N(Rv-NP)/ ½ (RV-NP).
where, Kd = Cost of debenture.
I = Annual interest payment.
t = Tax rate.
NP = Net proceeds from the issue of debentures.
Ry = Redeemable value of debenture at the time of maturity.
(b) Cost of Preference Share Capital: For preference shares, the dividend rate can be considered as its cost, since it is this amount which the company wants to pay against the preference shares. Like debentures, the issue expenses or the discount/premium on issue/redemption are also to be taken into account.
(i) The cost of preference shares (KP) = DP/NP.
Where, DP = Preference dividend per share.
NP = Net proceeds from the issue of preference shares.
(ii) If the preference shares are redeemable after a period of ‘n’,the cost of preference shares (KP) will be:
Kp = Dp + 1/n ( Rv-Np)/ ½ ( Rv + NP).
where, NP = Net proceeds from the issue of preference shares.
RV = Net amount required for redemption of preference shares.
DP = Annual dividend amount.
There is no tax advantage for cost of preference shares, as its dividend is not allowed deduction from income for income tax purposes. The students should note that both in the case of debt and preference shares, the cost of capital is computed with reference to the obligations incurred and proceeds received. The net proceeds received must be taken into account while computing cost of capital.
(c) Cost of Equity or Ordinary Shares: The funds required for a project may be raised by the issue of equity shares which are of permanent nature. These funds need not be repayable during the lifetime of the organisation. Calculation of the cost of equity shares is complicated because, unlike debt and preference shares, there is no fixed rate of interest or dividend payment.
Cost of equity share is calculated by considering the earnings of the company, market value of the shares, dividend per share and the growth rate of dividend or earnings.
(i) Dividend/Price Ratio Method: An investors buys equity shares of a particular company as he expects a certain return (i.e. dividend). The expected rate of dividend per share on the current market price per share is the cost of equity share capital. Thus the cost of equity share capital is computed on the basis of the present value of the expected future stream of dividends.
Thus, the cost of equity share capital (Ke) is measured by:
Ke = where D = Dividend per share.
P = Current market price per share.
If dividends are expected to grow at a constant rate of ‘g’ then cost of equity share capital.
(Ke) will be Ke = D/P + g.
This method is suitable for those entities where growth rate in dividend is relatively stable. But this method ignores the capital appreciation in the value of shares. A company which declares a higher amount of dividend out of given quantum of earnings will be placed at a premium as compared to a company which earns the same amount of profits but utilises a major part of it in financing its expansion programme.
(ii) Earnings/Price Ratio Method: This method takes into consideration the earnings per share (EPS) and the market price of share. Thus, the cost of equity share capital will be based upon the expected rate of earnings of a company. The argument is that each investor expects a certain amount of earnings whether distributed or not, from the company in whose shares he invests.
If the earnings are not distributed as dividends, it is kept in the retained earnings and it causes future growth in the earnings of the company as well as the increase in market price of the share.
Thus, the cost of equity capital (Ke) is measured by:
Ke = E/P where E = Current earnings per share.
P = Market price per share.
If the future earnings per share will grow at a constant rate ‘g’ then cost of equity share capital (Ke) will be.
Ke = E/P + g.
This method is similar to dividend/price method. But it ignores the factor of capital appreciation or depreciation in the market value of shares. Adjustment of Floatation Cost There are costs of floating shares in market and include brokerage, underwriting commission etc. paid to brokers, underwriters etc.
These costs are to be adjusted with the current market price of the share at the time of computing cost of equity share capital since the full market value per share cannot be realised. So the market price per share will be adjusted by (1— f) where ‘f’ stands for the rate of floatation cost.
Thus, using the Earnings growth model the cost of equity share capital will be:
Ke = E/P(1— f) + g.
(d) Cost of Retained Earnings: The profits retained by a company for using in the expansion of the business also entail cost. When earnings are retained in the business, shareholders are forced to forego dividends. The dividends forgone by the equity shareholders are, in fact, an opportunity cost. Thus retained earnings involve opportunity cost.
If earnings are not retained they are passed on to the equity shareholders who, in turn, invest the same in new equity shares and earn a return on it. In such a case, the cost of retained earnings (Kr) would be adjusted by the personal tax rate and applicable brokerage, commission etc. if any.
Therefore, Kp = ke (1— t) (1— f).
Where,
Ke = D/p + g.
t = shareholders personal tax rate.
f = rate of floatation cost.
Many accountants consider the cost of retained earnings as the same as that of the cost of equity share capital. However, if the cost of equity share capital is computed on the basis of dividend growth model (ie., D/P + g), a separate cost of retained earnings need not be computed since the cost of retained earnings is automatically included in the cost of equity share capital.
Therefore, Kr = Ke = D/P + g.
(e) Overall or Weighted Average Cost of Capital: A firm may procure long-term funds from various sources like equity share capital, preference share capital, debentures, term loans, retained earnings etc. at different costs depending on the risk perceived by the investors. When all these costs of different forms of long-term funds are weighted by their relative proportions to get overall cost of capital it is termed as weighted average cost of capital. It is also known as composite cost of capital. While taking financial decisions, the weighted or composite cost of capital is considered.
3. Discuss the Importance of optimal capital structure?
Ans: Importance of Optimal Capital Structure are as follows:
(i) Minimized Cost: The primary objective of a company is to maximize the shareholder’s wealth through minimization of cost. A well-advised capital structure enables a company to raise the requisite funds from various sources at the lowest possible cost in terms of market rate of interest, earning rate expected by prospective investors, expense of issue etc. The optimal capital structure is achieved when a firm’s cost of capital (WACC) is minimized and its firm value is maximized.
(ii) Maximized Return: The primary objective of every corporation is to promote the shareholders interest. By minimizing the cost of capital, a company can increase its earnings per share and return on equity. This, in turn, can lead to an increase in the company’s stock price, which benefits shareholders.
(iii) Minimize Risks: A sound capital structure serves as an insurance against various business risks, such as interest in costs, interest rates, taxes and reduction in prices. These risks are minimized by making suitable adjustments in the components of capital structure. An optimal capital structure is a critical element of a company’s risk management strategy. By finding the right balance between debt and equity financing a company can mitigate financial risks and provide its shareholders with a more stable return on investment.
(iv) Controlled: An optimal capital structure maintains the owners’ rights and control. It is also flexible and gives scope for future borrowing whenever necessary, without losing control.Though the management of a company is apparently in the hands of the directors, indirectly, a company is controlled by equity shareholders carry limited voting rights and debentures holders do not have any voting right, a well-devised capital structure ensures the retention of control over the affairs of the company with in the hands of the existing equity shareholders by maintaining a proper balance between voting right and non-moving right capital.
(v) Liquid: If asset liquidity increases the optimal leverage when the assets are tied up as collateral, firms with greater asset liquidity should issue more secured debt. An object of a balanced capital structure is to maintain proper liquidity which is necessary for the solvency of the company. A sound capital structure enables a company to maintain a proper balance between fixed and liquid assets and avoid the various financial and managerial difficulties.
(vi) Optimum Utilization: Optimum utilization of the available financial resources is an important objective of a balanced financial structure. An ideal financial structure enables the company to make full utilization of available capital by establishing a proper co-ordination between the quantum of capital and the financial requirements of the business. An optimal capital structure is the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital.
(vii) Simple: A balanced capital structure is aimed at limiting the number of issues and types of securities, thus, making the capital structure as simple as possible.
(viii) Flexible: Flexibility or capital structure enables the company to raise additional capital at the time of need, or redeem the surplus capital. Maintain control An optimal capital structure maintains the owners’ rights and control. It is also flexible and gives scope for future borrowing whenever necessary, without losing control. it not only helps is fuller utilization of the available capital but also eliminates the two undesirable states of over-capitalization and under – capitalization.
4. Explain some examples of measuring cost of capital.
Ans: Some examples of measuring cost of capital are:
(i) Cost of Debt Measurement: B Ltd. issues $ 1,00,000 9% debentures at a premium of 10%. The cost of flotation are 2%. The tax rate applicable is 60%. Measure cost of debt capital.
Kda = Interest /NP X (1-t).
NP = (1,00,000 +10,000) – (1,10,000 X 2/100) = 1,10,000 – 2,200 = 1,07,800
t = Tax rate.
= 1,00,000 X 9%/ 1,07,800 X (1-0.6) = 3.34%.
(ii) Cost of Preference Share Capital Measurement: A company issues 1000 7% preference shares of $ 100 each at a premium of 10% redeemable after 5 years at par. Measure the cost of preference capital.
Kpr = D +1/n (MV-NP)/ 1/2 (MV + NP) × 100.
D = 100,000×7% =7,00.
MV = 1,00,000.
NP = 1,00,000 + 1,00,000 × 10% = 1,10,000
n = 5 years.
= 7,000+1/5(1,00,000 -1,10,000).
(iii) Cost of Equity Share Capital Measurement: A company is considering an expenditure of $ 60 lakhs for expanding its operations. The relevant information is as follows.
Number of existing equity shares = 10 Lakhs.
Market Value of existing share = $ 60.
Net Earnings = $ 90 Lakhs.
Measure the cost of existing equity share capital of new equity capital assuming that new shares will be issued at a price of $ 52 per share and the cost of new issue will be $ 2 per share.
Cost of existing equity share capital.
Ke = EPS/MP.
EPS = Earning per share.
= $90/10 = $9.
Ke = 9/60 × 100 = 15\%.
Cost of New Equity Share Capital.
Ke = EPS/NP.
= 9/ (52 – 2) × 100 = 18\%.
(iv) Cost of Retained Earning Measurement: A company’s return available to shareholders is 15%. The average tax rate of shareholders is 40% and it is expected that 2% is brokerage cost that shareholders will have to pay while investing their dividends in alternative securities. What is the cost of retained earnings?
Cost of Retained Earnings = Kr = Ke (1– t) (1— b).
Ke = rate of return available to shareholders.
t = tax rate.
b = brokerage cost.
Kr = 15% (1– 0.4) (1— 0.02).
= 15% × 0.6 x 0.98.
= 8.82%.
5. Explain the advantages and disadvantages of Financial Leverage. What are the Factors Affecting Financial Leverage? Explain.
Ans: The financial leverage has various advantages to the company, management, investors and financial companies. The following are some such benefits:
(i) Economies of Scale: The financial leverage helps the organizations to expand its production unit and manufacture, goods on a large scale, reducing the fixed cost drastically.
(ii) Improves Credit Rating: If the company take debts and can pay off these debts on time by generating a good profit from the funds availed, it secures a high credit rating and considered reliable by the lenders.
(iii) Favourable Cash Flow Position: This additional capital provides an opportunity to increase the earning power of the company and hence to improve the cash flow position of the company.
(iv) Increases Shareholders’ Profitability: As the company expands its business through financial leverage, the scope for profitability also increases.
(v) Tax Relaxation: When the debts and liabilities burden the company, the government allows tax exemptions and benefits to it.
(vi) Expansion of Business Ventures: The need for financial leverage arises when the company plans for growth and development, which is a positive step.
Limitations of Financial Leverage: There are certain drawbacks of the financial leverage which are mainly related to borrowings through debts. These are as follows:
(i) High Risk: There is always a risk of loss or failure in generating the expected returns along with the burden of paying interest on debts.
(ii) Adverse Results: The outcome of such borrowings may be harmful at times if the business plan goes wrong.
(iii) Restrictions from Financial Institutions: The lending financial institution usually restricts and controls the business operations to some extent.
(iv) High Rate of Interest: The interest rates on the borrowed sum is generally high, which creates a burden on the company.
(v) Benefits Limited to Stable Companies: The financial leverage is a suitable option for only those companies which are stable and possess a sound financial position.
(vi) May Lead to Bankruptcy: In case of unexpected loss or poor returns and huge debts or liabilities, the company may face the situation of bankruptcy.
Financial leverage is more about the borrowings from external sources and needs to be repaid sooner or later. To understand more about financial leverage, let us go through the following factors:
(i) Second Stage Leverage: The financial leverage is considered as second stage leverage because it is dependant upon the degree of operating leverage. If the operating risk is high, the company will plan for low financial leverage and vice-versa.
(ii) Financial Liability: The borrowings in the form of debts create financial liability on the company.
(iii) Financing Decision: The financial leverage decision is a part of the company’s financing strategy planned by the directors.
(iv) Interest Rates: These borrowings are usually payable with interest which is quite high.
(v) Stability of the Firm: The most important factor considered by the management while taking the financing decision is the firm’s position and balance, to bear the risk.
(vi) Return on Assets: The returns which the additional capital needs to be estimated to find out whether the company will be able to generate higher profits on the capital employed or not.
(vii) Fixed Financial Cost: The debts create a fixed financial burden in the form of interest over the company.
6. Discuss effect of financial leverage on capital structure/ relationship between leverage and capital structure?
Ans: Leverage can be defined as the amount of debt a firm uses to finance its assets. Leverage refers to debt that is taken to acquire long term assets which are necessary to produce goods and services. Common types of source of funds to acquire fixed assets include debt such as bank loan, debentures and bonds issued by the company and these sources are part of capital structure. There are two types of leverage that namely operating and financial leverage that have a connection to a company’s balance sheet as the items provide capital for repaying bonds or debt. Operating leverage is basically sales revenue less cost of goods sold and less operating expenses, with the result being earnings before interest and taxes (EBIT). Financial leverage is EBIT less interest expenses, taxes, and preference dividend, which result in earnings available for equity share holders, or earnings per share. A high leveraged company means a company whose debt is more than its equity which results in higher financial risk and a low leveraged company means a company whose equity is more than its debt which represents less financial risk.
The term capital structure refers to the relationship between the various long terms sources of financing such as debt and shares. In capital structure, a company most likely prefers to avoid the use of bonds and other debt because high ratio of debt in capital structure increases the financial risk of the company. Equity shares and preference shares more attractive than debt because these are unsecured and there in no compulsory payment of dividends. The use of debt and preference shares capital along with equity shares is called financial leverage. Leverage and capital structure are closely related to each other. Both affects the operating results and financial position of a company. The relation between leverage and capital structure is that companies use a mix of debt and equity to finance its operations. A high ratio of debt in capital structure of a company results in higher amount of interest payment which increases financial leverage and reduces EPS. On the other hand, a low ratio of debt in capital structure of a company reduces financial leverage and increases EPS. Financial leverage is very good for the company who is growing or managing good profits, but in case of economic crises or adverse situation of company this fixed expense make situation more adverse. From the above discussion, we can say that leverage and capital structure are closely related to each other.
Impact of financial leverage on capital structure: The use of long term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity. The use of long-term debt increases, magnifies the earnings per share if the firm yields a return higher than the cost of debt. The earnings per share also increase with the use of preference share capital but due to the fact that interest is allowed to be deducted while computing tax, the leverage impact of debt is much more. However, leverage can operate adversely also if the rate of interest on long-term loan is more than the expected rate of earnings of the firm. Therefore, it needs caution to plan the capital structure of a firm.
Factors affecting financial leverage: (VVVI Section)
Financial leverage is PBIT/ PBT. Therefore as interest increases, financial leverage will increase. Interest, in turn, being the cost of borrowed funds, will increase with increase in the proportion of debt used for financing assets. That is why, the ratio of borrowings to assets is also called financial leverage. The higher the degree of financial leverage of a firm, the greater is the sensitivity of its profits before tax to changes in PBIT.
The combined leverage factor which is the product of operating leverage and financial leverage determines the overall sensitivity of profits before tax to change in sales. As income taxes are calculated as a percentage of profit before tax, the net profit will normally be proportionate to the profit before tax. Therefore, fluctuations in profit before tax will bring about corresponding fluctuations in net profits which in turn will bring about fluctuations in earnings per share (EPS) as EPS equals net profit divided by the number of equity shares. Therefore, the combined leverage factor influences the extent to which net profits and EPS will fluctuate for a given fluctuation in sales.
It is important to remember that additional benefits will accrue only when the return on assets is higher than the cost of borrowings. If however, the cost of borrowings is higher than the return on assets; the return on net worth will be even less than the return on assets.
7. What are the Measures of Financial Leverage?
Ans: After employing additional capital into the business, the management uses various financial ratios to the performance of the company.
The four most crucial financial leverage ratios or measures are given below:
(i) Debt-Equity Ratio: The debt-equity ratio is the proportion of the funds which the company has borrowed to the fund raised from shareholders. In short, it is the ratio of the borrowings to the owner’s fund.
Debt Equity Ratio = Total Debt/ Shareholder’s Equity.
Analysis: The higher the debt-equity ratio is, the weaker is the financial position of the company. Therefore, this ratio should always be less to avoid the risk of bankruptcy and insolvency.
(ii) Debt Ratio: The debt ratio determines the company’s asset position or strength to meet its liabilities.
Debt Ratio = Liabilities Assets.
Analysis: Lower is the debt ratio of the company; the sounder is its financial position, indicating that the company has sufficient assets to pay of the liabilities at the time of downfall.
(iii) Interest Coverage Ratio: The interest coverage ratio emphasizes the company’s ability to pay off the interest with the profits earned.
Interest Coverage Ratio = EBIT /Interest Expenses.
Analysis: If the ratio is high, it signifies that the company can make enough profit to pay the interest due and vice-versa.
(iv) Degree of Financial Leverage (DFL): The degree of financial leverage (DFL) signifies the level of volatility in the earning per share (EPS) with the change in operating income as a result of the capital restructuring, i.e., acquisition of debts, issuing of shares and debentures and leasing out assets.
Degree of Financial Leverage (DFL) = Percentage Change in EPS/ Percentage Change in EBIT.
Where,
Percentage Change in EPS = [(New EPS – Old EPS) /Old EPS].
EPS stands for earning per share.
Percentage Change in EBIT = [(New EBIT — Old EBIT) /Old EBIT].
EBIT stands for earnings before interests and taxes.
Analysis: A higher DFL indicates that the company is more sensitive to the change in operating income, ultimately showing its unstable earnings per share.
8. Discuss the various importance’s of Capital Budgeting. Describe the characteristics and Procedure of Capital Budgeting.
Ans: Following are the importance of capital budgeting:
(i) Long term Complications: Capital budgeting decisions have long term implications for the firm because they affect the future profitability of the firm and the cost structure. It influences the rate and function of firm’s growth. A wrong decision may bead the firm to a disastrous future and may endanger the very survival of the firm. Unwanted investment is fixed assets will result in unnecessary heavy operating costs to the firm. On the other hand, inadequate investment in assets would make it difficult for the firm to complete successfully and to stop the loss of its potion of the market share. Long term commitment of funds may also change the risk elements of the firm. If adoption of an investment proposal increases firms’ average carryings but simultaneously causes frequent functions in its earnings, the firm will become more risky. Thus Capital budgeting decisions have long term implications and therefore need serious considerations.
(ii) Irreversible Decisions: The capital investment decisions a heavy amount of funds. In most of the cases, the capital budgeting decisions are in eversible and the amount invested cannot be taken back without censing a substantial loss because it is very difficult to find market for the second hand capital goods and their conversion into other uses may not be financially feasible.
(iii) It affects Company’s future cost — structure: By taking a capital structure expenditure decision, a firm commits itself of a seeable amount of fixed costs in terms of labour, supervisor’s salary insurance, rent of the building and so on. If the investment in future terms out to be unsuccessful or yield less than the burden of fixed cost unless the assets is completely written off. In short firms future costs, break-even points, sales and profits will all be determined by the firms selection of assets.
(iv) Bearing on Competitive Position of the Firm: The Capital investment in fixed assets decisions also have a bearing on the competitive position of the firm because the fixed assets, represent in a souse, true earning assets of the firm. They enable the firm to generate finished good that can ultimately be sold for profit. As we have discussed in the earntieier point that it also determines the cost structure of the company’s product. In other words capital investment decisions determine the future profits and cost for the firm that ultimately affects the competitive positions of the firm.
(v) Cash Forecast: Capital Investment requires substantially large amount of funds which can only be arranged by making determined efforts to ensure their availability at the right time. Thus, it facilitates cash forecasts to plan the investment programmers carefully, So that the firm can meet its long term obligations without any difficulty.
(vi) Worth Maximization of Shareholders: The impact of long term capital investment decision is far reaching. It protects the interests of the shareholders and of the enterprise because it avoids over investment and under investment in fixed assets. By selecting the most profitable projects, the management facilitates the wealth maximization of equity shareholders.
Following are the characteristics of capital budgeting:
(i) Capital expenditure plans involve a huge investment in fixed assets.
(ii) Capital expenditure once approved represents long-term investment that cannot be reserved or withdrawn with out sustaining a loss.
(iii) Preparation of capital budget plans involve forecasting of several years profits in advance in order judge the profitability of projects.
(iv) In view of the investment of large amount for a family long period of time, any error in the evaluation of investment project may lead do serious consequences, financially and otherwise may adversely affect the other future plans of the organization.
(v) Capital budgeting decisions involve the exchange of current for the benefits to be achieved in future.
(vi) The future benefits are expected to be real used over a series of years.
(vii) The funds are invested in non flexible and long term activities.
(viii) They have a long term and term and significance effect on the profitability of the business.
Procedure of Capital budgeting: The following procedure may bad opted in preparing capital budget:
(i) Origination investment Proposals: The first step in capital budgeting process is the conception of profit idea. The proposals may come from rank and file worker of any department or from any line. The department head collects collects all the investment proposals and reviews than in the light of financial and risk polices of the organization in order to send then to the capital expenditure planning committee for consideration. The idea may originate from the top management level taking a long view in the interest of the company. It may be the result of periodic assessment of facilities, surveys of comparative position in the industries, research on the development of new product and new markets and similar investigations.
(ⅱ) Screening the Proposals: In large organizations a capital expenditure planning committee is established for the heads of various departments and the line offices of the company or by the top executives. The committee sources the various proposals within the long range policy framework of the organization. It is to be ascertained by the committee whether the proposals are within the selection criterion of the firm, or they do not lead to department ambulates or they are profitable. The committee consolidates the proposals and sends then to the Board of Directors for its final approval.
(iii) Evaluation of projects: The next step in capital budgeting process is to evaluate the different proposals in terms of the cost of capital the expected returns from alternative investment opportunities and the life of the assets with any of the following evaluation techniques.
(a) Degree of urgency method.
(b) Pay back method.
(c) Return on Investment Method.
(d) Discounted cash flow method.
Establishing Priorities: After proper sieving of the proposals uneconomic or unprofitable proposals are dropped out rightly. The profitable projects or in other words acceptable projects are then put in priority. It facilitates their acquisition or construction according to the somas available and avoids unnecessary and costly delays and serious cost-over runs.
Generally, priority is fixed in the following order:
(a) Current and incomplete projects are given first priority.
(b) Safety projects and projects necessary to carry on the legislative requirements.
(c) Projects or maintaining the percent efficiency of the firm.
(d) Projects for supplementing the income and.
(e) Projects for the expansion of new product.
(iv) Final Approval: Proposals finally recommended by the committee are sent to the top management along with the deleted report both the capital expenditure and of somas of funds to meet then. The management affirms its final real proposals taking in view the urgency, profitability of the projects and the availability of financial resources. Projects are then sent to the budget committee for incorporating then in the capital budget.
(v) Evaluation: Last but not the least important step in the capital budgeting process is an evaluation of the programme after it has been fully implemented. Budget proposals and the Net investment in the projects are compared periodically and on the basis of such evaluation the budget figures may be seemed and presented in a more realistic way.
9. Discuss the various kinds of Capital Budgeting proposal or decisions.
Ans: The main objective of capital budgeting is to maximize the profitability of a firm or the return on investment. This objective can be achieved either by increasing the revenues or by reducing costs. Thus, capital budgeting decisions can be broadly classified into two categories.
(a) Those which increase revenue. and
(b) Those which reduce costs.
The first category of capital budgeting decisions are expected to increase revenue of the firm through expansion of the production line. The second category increases the earnings of the firm by reducing costs and includes decisions relating to replacement of obsolete, out molded or work out assets. In such cases, a firm has to decide whether to continue with the same assets or replace it. Such a decision is taken by the firm by evaluating the benefits from replacement of the asset in the form of reduction in operating costs and the cost cash outlay needed for replacement of the assets. Both categories of above decisions involve investment in fixed assets decisions involve difference between the two decisions this in the fact that in creasing revenue. Investment decisions are subject to more uncertainty as compared to cost reducing investment decisions.
Moreover, capital budgeting decisions or proposal can be classified as follows:
(a) Accept Reject Decisions: Accept Reject Decisions relate to independent projects which do not compete with one another. Such decisions are generally taken on the basis of minimum return on investment. All those proposals which yield a rate of return higher than the minimum required rate of return or the cost of capital are accepted and the rest are rejected. If the proposal is accepted the firm makes investment in it and if it is rejected the firm does not invest in the same.
(b) Mutually Exclusive project Decisions: such decisions relate to proposals which compete with one another in such way that acceptance of one automatically exclusive the acceptance of the other. Thus, one of the proposals is selected at the cost of the option of a new machine, or second hand machine as taking an old machine on tire or selecting a machine out of more than one brands available in the market. In such a case, the company may select one best alternative out of the various options by adopting some suitable technique or method of capital budgeting One alternative is selected the other are automatically rejected.
(c) Capital Rationing Decisions: A firm may have several profitable investment proposals but only limited funds to invest. In such a case, these various investments proposals comet, for limited funds, and thus the firm has to ration then. The firm selects the combination of proposals that will yield the greatest profitability by ranking them in descending order of their profitability.
10. How does financial leverage magnify shareholders’ earnings? Explain.
Ans: How financial leverage magnify shareholder’s earning Financial leverage is also known as Trading on Equity. Trading on Equity refers to the practice of using borrowed funds, carrying a fixed charge, to obtain a higher return to the Equity Shareholders. With a larger proportion of the debt in the financial structure, the earnings, available to the owners would increase more than the proportionately with an increase in the operating profits of the firm. This is because the debt carries a fixed rate of return and if the firm is able to earn, on the borrowed funds, a rate higher than the fixed charges on loans, the benefit will go the shareholders. This is referred to as “Trading on Equity”
The concept of trading on equity is the financial process of using debt to produce gain for the residual owners or the equity shareholders. The term owes its name also to the fact that the equity supplied by the owners, when the amount of borrowing is relatively large in relation to capital stock, a company is said to be trading on equity, but where borrowing is comparatively small in relation to capital stock, the company is said to be trading on thick equity. Capital gearing ratio can be used to judge as to whether the company is trading on thin or thick equity.
Impact of Financial leverage on EPS: The EPS is affected by the degree of financial leverage. If the profitability of the concern in increasing then fixed cost funds will help in increasing the availability of profits for equity shareholders. Therefore, financial leverage is important for profit planning. The level of sales and resultant profitability is helpful in profit planning. An important tool of profit planning is break-even analysis. The concept of break-even analysis is used to understand financial leverage. So, financial leverage is very important for profit planning.
11. What is Cash Budget? Mention the Various Functions or importance of Cash Budget.
Ans: Cash budget is an analytical device to estimate the flow of cash in any business over a future period of time. It presents an estimate of cash inflows and receipts and cash of the firm over various intervals of time. It reveals to the financial manager the timing and amount of expected cash inflows and outflows over the period studied.
According to games C. von Horne. A cash budget is a forecast of future cash receipts and cash disbursements over various intervals of time. In the words of bushman and Doug all, Cash budget is an estimate of cash receipts and disbursements for a future period of time.
Functions or Importance of cash Budget: The importance’s of cash budget are discussed fellow:
(i) Helpful in planning: Cash budget help planning for the most efficient for the most efficient use of cash. It points out cash surplus or deficiency at selected point of time and enables the management to arrange for the deficiency before time or to plan for investing the surplus money as profitably as possible without and throat to the liquidity.
(ii) Fore casting the future needs of funds: Cash budget forecasts the future needs of funds, its time and the amount well in advance. It thus, helps planning for raising the funds through the most profitable source at reasonable terms and costs.
(iii) Maintenance of Ample cash Balance: Cash is the basis of liquidity of the enterprise. Cash budget helps maintaining the liquidity. It suggests adequate cash balance for retiring the obligations and a fair margin for the predictable and unpredictable contingences.
(iv) Controlling Cash Expenditure: Cash budget acts as a controlling device. The expense of various departments in the firm can best be controlled so as not to exceed the budgeted limit.
(v) Evaluation of Performance: Cash Budget acts as a standard for evaluating the financial performance by comparing the actual performance with the budgeted figures. If deviations are positive, the performance may be regarded as good.
(vi) Testing the Influence of Proposed Expansion programmed: Cash budget forecasts the inflows from a proposed expansion as investment programme and testify its impact an cash position.
(vii) Sound Dividend Policy: Cash Budget plans for cash dividend to shareholders consistent with the liquid position of the firm. It helps in following a consistent dividend policy.
Basis of Long term Planning and Coordination: Cash budget helps in coordinating the various finance functions, such as sales credit, investment, working capital etc. It is an important basis of long term financial planning and helpful in the study of long term financing with respect to probable amount, timing forms of security and methods of repayment.
12. What is operating leverage? What are its Characteristics?
Ans: Operating leverage is concerned with the operating of any firm. This leverage relates to the sales and profit variations. Any increase in sales, fixed cost remaining same, will magnify the operating revenue. This occurrence is known as operating leverage.
According to John Hampton, “Operating leverage exists when changes in revenue produce greater changes in EBIT.”
In the words of Solomon Ezra, “Operating leverage is the tendency of the operating profit to vary disproportionately with sales”.
Measure of operating leverage:
Operating leverage = Contribution/ Operating Profit.
Where,
Contribution = Sales – Variable cost.
Operating profit = Sales – Variable cost – Fixed cost.
Degree of operating leverage = Percentage Change in profits/ Percentage Change in sales.
The chief characteristic of operating leverage are as under:
(i) Related to fixed costs: If there are fixed costs in the firm there will be operating leverage and it tells us that the change in sales will bring more change in operating profits or EBIT.
(ii) Highest operating leverage near break-even point: There is a direct relation between operating profit and break-even point. At break- even point there is no profit no less. The degree of operating leverage is highest near BEP.
(iii) Business risks: On the one side the operating leverage raises operating profits but on the other side it raises business risks of increasing losses. Because if operating leverage is high a small fall in sales will result in very high reduction in operating profit.
13. What is financial leverage? What are its Characteristics?
Ans: Financial leverage means increasing the profitability of the firm by using fixed cost bearing finance. The use of the fixed charges sources of funds, such as debt and preference capital along with the owner’s equity in the capital structure is described as financial leverage or trading on equity.
According to James C. Vane Horn “Financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to common stockholders”.
According to Hampton “Financial leverage exists whenever a firm has debts or other sources of funds that carry fixed charges.”
The financial leverage may be calculated as:
Degree of financial leverage = EBIT/ EBIT- I = EBIT/ EBT= OP/ PBT.
Where,
EBIT = Earning before interest and tax or operating profit (OP).
EBT = Earning before tax or profit before tax (PBT).
I = Interest.
The main characteristics of financial leverage are:
(i) Related to fixed cost capital: If there is no fixed cost capital then there will be no financial leverage.
(ii) Related with liabilities side of the balance sheet: It is concerned with the liabilities side of the balance sheet where different type of sources of capital are shown.
(iii) Shows effects of changes in fixed charges on EPS: Financial leverage shows the effects of changes in fixed costs of EPS of the firm.
(iv) Financial risk: The presence of financial leverage increases the financial risk of the firm.
14. What does Optimal Capital Structure Mean? What are the Features of an Optimum Capital Structure? Explain.
Ans: In general, the optimal capital structure is a mix of debt and equity that seeks to lower the cost of capital and maximize the value of the firm. To calculate the optimal capital structure of a firm, analysts calculate the weighted average cost of capital (WACC) to determine the level of risk that makes the expected return on capital greater than the cost of capital. By calculating the cost of debt and the cost of equity, analysts multiply the cost of debt by the weighted average cost of debt and the cost of equity by the weighted average cost of equity and add up the results from each security involved in the total capital of the company.
The features of an optimum capital structure are:
(i) Simplicity: All businessmen are not educated. A complicated capital structure may not be understood by all; on the contrary it may raise suspicions and create confusion. A capital structure must be as simple as possible.
(ii) Profitability: An optimum capital structure is one which maximises earning per equity share and minimizes cost of financing.
(iii) Solvency: In a sound capital structure, content of debt will be a reasonable proportion of the total capital employed in the business. As a result, it has minimum risk of becoming insolvent.
(iv) Flexibility: The capital structure of a firm should be such that it can raise funds as when required.
(v) Conservatism: The debt content in the capital structure of a firm should be within its borrowing limits. It should be free from the risk of insolvency.
(vi) Control: The capital structure should be designed in a such a way that it involves minimum risk of loss of control of the firm.
(vii) Optimal debt-equity mix: Optimal debt-equity mix in the capital structure of a company would be that point where the weighted average cost of capital is minimum. Optimum debt-equity proportion establishes balance between owned capital and debt capital. The firm should be cautious about the financial risk associated with the maximum utilisation of debt.
(viii) Maximisation of the value of the firm: An optimum capital structure makes the value of the firm maximum.
15. What are the Key Points in Designing an Optimal Capital Structure? Write some factors determining capital structure.
Ans: Key Points in Designing an Optimal Capital Structure are:
(i) Maximise the company’s wealth An optimal capital structure will maximise the company’s net worth, wealth, and market value. The wealth of the company is calculated in terms of the present value of future cash flows. This is discounted by the WACC.
(ii) Minimise the cost of capital. The lower the cost of the capital, the lower is the risk of insolvency. Companies in industries that have uncertain future cash flows should keep their cost of financing minimal. The lower the cost of capital, the higher will be its present value of future cash flows.
(iii) Simplicity in structure It should be simple to structure and understand. A complicated capital structure will only create confusion.
(iv) Maintain control An optimal capital structure maintains the owners’ rights and control. It is also flexible and gives scope for future borrowing whenever necessary, without losing control.
Factors Determining Capital Structure:
(i) Trading on Equity: The word “equity” denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate of company’s earnings, equity shareholders are at advantage which means a company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high.
Degree of control – In a company, it is the directors who are so called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the company’s management policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares.
Flexibility of financial plan – In an enterprise, the capital structure should be such that there is both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order to make the capital structure possible, the company should go for issue of debentures and other loans.
Choice of investors –The company’s policy generally is to have different categories of investors for securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors.
Capital market condition – In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the company’s capital structure generally consists of debentures and loans. While in period of boons and inflation, the company’s capital should consist of share capital generally equity shares.
Period of financing – When company wants to raise finance for short period, it goes for loans from banks and other institutions; while for long period it goes for issue of shares and debentures.
Cost of financing- In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits.
Stability of sales – An established business which has a growing market and high sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases.
Sizes of a company – Small size business firms capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.
16. Explain the differences between operating and financial leverage.
Ans: Operating and financial leverage are as follows:
| Operating leverage | Financial leverage |
| (i) Related to fixed costsOperating leverage is present if there are fixed operating costs. | Related to fixed cost capitalFinancial leverage is present when There is fixed cost capital. |
| (ii) Operating risks Operating leverage raises increasesOperating profits but on the other side it raises business risks or operating risks. | Financial risks The financial risk of the firm. With the presence of financial leverage. |
| (iii) Effect on EBIT The operating leverage causes a change in sales revenue to have a magnified effect on EBIT. | Effect on EPSThe financial leverage produces change in EBIT to have magnified effect on EPS. |
| (iv) Not related with liabilities side of the balance sheetIt is not concerned with any side of the balance sheet. | Related with the liabilities side of the balance sheet It is concerned with the liabilities side of the balance sheet where different types of sources of capital are shown. |
| (v) Asset structureThe methods of production employed which are reflected in the asset structure of the firm, influence its operating leverage. | Capital structure The capital sources employedwhich are reflected in the capital structure of the firm influences its financial leverage. |
17. What is Capital Budgeting? Give four characteristics of Capital Budgeting. Write five importance of Capital Budgeting.
Ans: Capital Budgeting is a process of making decision regarding investments in fixed assets which are not meant for sale such as land, building, machinery or furniture. Budgeting is long term planning for making and financing proposed capital outlays. According to Robert N. Anthony. The capital budget is essentially a list of what management believes to be worth white projects for the acquisition of new capital assets gather with the estimated cost of each product.
Four characteristics of Capital budgeting are:
(i) Capital budgeting plans involve a huge investment in fixed assets.
(ii) Capital budgeting once approved represents long term investment that cannot be reserved or with drawn without subs tainting a loss.
(iii) Preparation of capital budget plans involve forecasting of several years profits in advance in order to judge the profitability of projects.
(iv) In view of the investment of large amount for a fairly long period of time, any error in the evaluation of investment projects, may lead to serious consequences, financially and otherwise and may adversely affect the other future plans of the organisation.
Five importance of capital Budgeting are:
(i) Long term implications.
(ii) Irreversible decisions.
(iii) If affects company’s future cost structure.
(iv) Bearing on competitive positions of the firm.
(v) Cash forecast.
18. Write short notes on:
(i) Optimal capital structure features.
Ans: Optimal capital structure features are as follow:-
(a) Profitability: The most profitable capital structure is one that tends to minimise financing cost and maximise of earnings per equity share.
(b) Flexibility: The capitals structure should be such that the company is able to raise funds whenever needed.
(c) Conservation: Debt content in capital structure should not exceed the limit which the company can bear.
(d) Solvency: capital structure should be such that the business does not run the risk of insolvency.
(e) Control: capital structure should be devised in such a manner that it involves minimum risk of loss of control over the company.
(ii) Uses of Financial leverage.
Ans: Uses of Financial Leverage:
(a) Financial leverage helps to examine the relationship between EBIT and EPS.
(b) Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT.
(c) Financial leverage locates the correct profitable financial decision regarding capital structure of the company.
(d) Financial leverage is one of the important devices which are used to measure the fixed cost proportion with the total capital of the company.
(e) If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets, the earning per share and return on equity capital will decrease.
(iii) Operating leverage.
Ans: The leverage associated with investment activities is called operating leverages. It is caused due to fixed operating expenses in the company. Operating leverage may be defined as the company’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Operating leverage consists of two important costs viz, fixed cost and variable cost. When the company is said to have a high degree of operating leverage if it employs a great amount of fixed cost and smaller amount of variable cost. Thus, the degree of operating leverage depends upon the amount of various cost structure. Operating leverage can be determined with the help of a break even analysis. Operating leverage can be calculated with the help of the following formula:
OL = operating leverage
C = contribution
OP = operating profits
Degree of operating leverage: The degree of operating leverage may be defined as percentage change in the profits resulting from a percentage change in the sales. It can be calculated with the help of the following formula:
DOL = percentage change in profits/ percentage change in sales.
(iv) Capital budgeting decisions.
Ans: A capital budgeting decision is both a financial commitment and an investment. By taking on a project, the business is making a financial commitment, but it is also investing in its longer-term direction that will likely have an influence on future projects the company considers. A capital budgeting decision is typically a go or no-go decision on a product, service, facility, or activity of the firm. That is, we either accept the business proposal or we reject it. A capital budgeting decision will require sound estimates of the timing and amount of cash flow for the proposal.There are several capital budgeting analysis methods that can be used to determine the economic feasibility of a capital investment. They include the Payback Period, Discounted Payment Period, Net Present Value, Profitability Index, Internal Rate of Return, and Modified Internal Rate of Return.
Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project without understanding the risks and returns involved would be held as irresponsible by its owners or shareholders. Furthermore, if a business has no way of measuring the effectiveness of its investment decisions, chances are the business would have little chance of surviving in the competitive marketplace.When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether or not the project will prove to be profitable. The payback period (PB), internal rate of return (IRR) and net present value (NPV) methods are the most common approaches to project selection.
(v) Techniques of capital budgeting.
Ans: Techniques of Capital Budgeting, Most commonly used technique in investment decision making are given below:
(a) Payback period Method: It is one of the simplest methods to calculate period within which entire cost of project would be completely recovered. It is the period within which total cash inflows from project would be equal to total cash outflow of project. It is calculated by dividing initial investments in project by annual cash inflows. The payback period is the time you need to recover the cost of your investment. In simple terms, it is time an investment takes to reach the break-even point. It would help if you retrieved the investment costs of a project as soon as possible to make a profit. The payback period shows you the time taken to recover the cost of the project. The payback period helps you to evaluate the associated risks of an investment. An investment may have a short or a long payback period.
(b) Accounting rate of return (Average rate of return – ARR): ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. Accounting Rate of Return (ARR) is the average net income an asset is expected to generate divided by its average capital cost, expressed as an annual percentage. The ARR is a formula used to make capital budgeting decisions. It is used in situations where companies are deciding on whether or not to invest in an asset. Based on the future net earnings expected compared to the capital cost. When comparing investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects. It is calculated with the help of the following formula:
ARR=Average Profit / Investment.
(c) Net present value (NPV) method: The best method for evaluation of investment proposal is net present value method or discounted cash flow technique. Net present value (NPV) is used to calculate the current value of a future stream of payments from a company, project, or investment. To calculate NPV, you need to estimate the timing and amount of future cash flows and pick a discount rate equal to the minimum acceptable rate of return.This method takes into account the time value of money. The net present value of investment proposal may be defined as sum of the present values of all cash inflows as reduced by the present values of all cash outflows associated with the proposal. Each project involves certain investments and commitment of cash at certain point of time. This is known as cash outflows. Cash inflows can be calculated by adding depreciation to profit after tax arising out of that particular project.
(d) Internal rate of return (IRR): IRR, or internal rate of return, is a metric used in financial analysis to estimate the profitability of potential investments. IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis. The internal rate of return method is also a modern technique of capital budgeting that takes into account the time value of money. It is also known as ‘time adjusted rate of return’ discounted cash flow’ ‘discounted rate of return,’ ‘yield method,’ and ‘trial and error yield method’. In the net present value method the net present value is determined by discounting the future cash flows of a project at a predetermined or specified rate called the cut-off rate. But under the internal rate of return method, the cash flows of a project are discounted at a suitable rate by hit and trial method, which equates the net present value so calculated to the amount of the investment. Under this method, since the discount rate is determined internally, this method is called as the internal rate of return method. The internal rate of return can be defined as that rate of discount at which the present value of cash-inflows is equal to the present value of cash outflows.
(e) Profitability Index (PI): It is also a time-adjusted method of evaluating the investment proposals. Profitability index also called as Benefit-Cost Ratio (B/C) or ‘Desirability factor’ is the relationship between present value of cash inflows and the present value of cash outflows.The profitability index (PI) is a measure of a project’s or investment’s attractiveness. The PI is calculated by dividing the present value of future expected cash flows by the initial investment amount in the project.
19. “Capital budgeting is long-term planning for making and financing proposed capital outlay.” Explain. What are the limitations of capital budgeting?
Ans: Capital budgeting or capital expenditure management is concerned with planning and control of capital expenditure. Budgeting of capital expenditure is an important factor in the management of a business. The term capital budgeting refers to long term planning for proposed capital outlays and their financing. It includes both raising of long term funds as well as their utilisation. It may thus be defined as “the firms formal process for the acquisition and investment of capital”. It is the decision-making process by which the firms evaluate the purchase of major fixed assets. It involves the firm’s decision to invest its current funds for addition, disposition, modification, and replacement of long term fixed assets. Decisions in this area should be based on carefully determined rate of return appraisals. Capital investment must be the result of capital budgeting and capital budgeting is a reconciliation between the marginal revenue and marginal cost. Marginal revenue represents the percentage rate of return on investment while marginal cost is the cost of capital to the business. Capital budgeting as a prelude for capital investment requires the management to have some highly objective and rational means of determining the size and content of the capital budget and to screen all proposals in order to select those which seem to be the most beneficial.
Limitations of Capital Budgeting:
(i) It has long term implementations which can’t be used in short term and it is used as operations of the business. A wrong decision in the early stages can affect the long-term survival of the company. The operating cost gets increased when the investment of fixed assets is more than required.
(ii) Inadequate investment makes it difficult for the company to increase it budget and the capital.
(iii) Capital budgeting involves large number of funds so the decision has to be taken carefully.
(iv) Decisions in capital budgeting are not modifiable as it is hard to locate the market for capital goods.
(v) The estimation can be in respect of cash outflow and the revenues/ saving and costs attached which are with projects.
(vi) All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not practically be true in some particular circumstances.
(vii) The techniques of capital budgeting require estimation of future cash inflows and outflows. The future is always uncertain and the data collected for future may not be exact. Obliviously the results based upon wrong data may not be good.
(viii) There are certain factors like morale of the employees, goodwill of the firm, etc., which cannot be correctly quantified but which otherwise substantially influence the capital decision.
