NTA NET PAPER 2 Accounting _ finance class 5 16th March 2021.pdf

NET

1. NTA NET PAPER 2 BY ABHI TUTORIALS
NTA NET PAPER 2
COMMERCE/MANAGEMENT
SUBJECT
ACCOUNTING & FINANCE
PREPARED BY,
PROF ABHILASHA N
ASSISTANT PROFESSOR CUM RESEARCH SCHOLAR
CONTACT NO: 9620925899
ABHI TUTORIAL -9620925899

2. DEFINITION OF CAPITAL BUDGET
Capital: Operating assets used forproduction.
Budget: A plan that details projected cash flows during someperiod.
Capital Budgeting: Process of analyzing projects and decidingwhich ones to include in
capitalbudget
“Itistheplanningprocessusedtodeterminewhetheranorganizationslongterm
investmentssuchasnewmachinery,newplants,newproductsandresearch
developmentsprojectsareworththefundingofcashthroughthefirmcapitalization
structure.
Insimple,capitalbudgetingreferstolongtermplanningforproposedoutlays.
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3. IMPORTANCE OF CAPITAL BUDGETING
➢Growth
➢LargeAmount
➢Irreversibility
➢Complexity
➢Risk
➢Long termimplications
BenefitsofCapitalBudgetingDecision:
CapitalBudgetingdecisionsevaluateaproposedprojecttoforecastreturnfromtheproject
anddeterminewhetherreturnfromtheProjectisadequate.
CapitalBudgetingdecisionsevaluateexpendituredecisionswhichinvolvecurrentoutflow
offundsbutarelikelytoproducebenefitsoveraperiodoftimemorethanoneyear.
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4. CAPITAL BUDGETING: PROJECTCATEGORIZATION
•Establishment of New Products &Services
•Replacement Projects: Maintenance or CostReduction
•Expansion of ExistingProjects
•Research and DevelopmentProjects
•Long TermCotracts
•Safety and/or EnvironmentalProjects
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5. STEPS IN CAPITAL BUDGETING
•Project Generation
•Project appraisal
•Project selection
•Project execution
•Follow up
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6. CASH FLOWS VS ACCOUNTING PROFIT
•Accountingprofitcoversthenoncashexpenseslikedepreciationaswelltocalculatethe
worthoftheproject
•Cashflowmethodisrelatedtotheinflowandoutflowofcashandexcludethenoncash
expenses
•Cashflowsapproachisbetterindicatorofcalculatingtheworthoftheprojectasitreflects
theactualcashtransactionassociatedwiththeproject.
•Cashflowapproachalsoconsiderstimevalueofmoneywhereastheaccountingapproach
ignoresit.
•Undertheaccountingmethod,revenueisrecognizedasbeinggeneratedwhenproductis
soldnotwhenthecashiscollectedfromthesale.
•Accountingcriteriaislessusefulwhenitcomestotakinginvestmentdecision.
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7. TYPES OF CAPITALEXPENDITURE
Capital Expenditure can be of twotypes:
•Capital expenditure increasesrevenue
•Capital expenditure reducescosts
Capital Expenditure Increases Revenue: It is the expenditure which brings more
revenue to the firm either by expanding the existing production facilities or development
of new productionline.
Capital Expenditure Reduces Costs: Such a capital expenditure reduces the cost of
present product and thereby increases the profitability of existing operations. It can be
done by replacement of old machine by a newone.
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8. TYPES OF CAPITAL BUDGETINGPROPOSALS
•A firm may have several investment proposals for its consideration. It may adopt after
considering the merits and demerits of each one of them. For this purpose capital
expenditure proposals may be classifiedinto:
1.IndependentProposals
2.Dependent Proposals or ContingentProposals
3.Mutually ExclusiveProposals
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9. •IndependentProposals:Theseproposalsaresaidbetoeconomicallyindependent
whichareacceptedorrejectedonthebasisofminimumreturnoninvestment
required.Independentproposalsdonotdependuponeachother.
•DependentProposalsorContingentProposals:Inthiscase,whentheacceptance
ofoneproposaliscontingentupontheacceptanceofotherproposals,itiscalledas
“DependentorContingentProposals.”Forexample;constructionofnewbuildingon
accountofinstallationofnewplantandmachinerydescribesit.
•MutuallyExclusiveProposals:MutuallyExclusiveProposalsrefertothe
acceptanceofoneproposalresultsintheautomaticrejectionoftheotherproposal.
Thenthetwoinvestmentsaremutuallyexclusive.Inotherwords,onecanberejected
andtheothercanbeaccepted.Itiseasierforafirmtotakecapitalbudgeting
decisionsonsuchprojects.
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10. Evaluation Criteria: Capital InvestmentProposal
EvaluationCriteria
Non-Discounting
Criteria
Pay-Back
Period
ARR
Discounting
criteria
NPV
Discounted
PBP
Profitability
Index
IRR
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11. NON DISCOUNTING: PAY-BACKPERIOD
1.Pay-BackPeriodMethod-Itisdefinedasthenumberofyearsrequiredto
recoveroriginalcostinvestedinaproject.Ithastwoconditions
➢Whencashinflowisconstanteveryyear
PBP=Cashoutflow/cashinflow(p.a.)
➢Whencashinflowarenotconstanteveryyear
PBP= *12
Requiredinflow
Completed years+
In flow of nextyear
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12. NON DISCOUNTING CRITERIA: ANNUAL RATE OFRETURN
2.AverageRateofReturnMethod-ARRmeanstheaverageannualearningonthe
project.Underthismethod,profitaftertaxanddepreciationisconsidered.Theaverage
rateofreturncanbecalculatedinthefollowingtwoways.
ARRonAverageinvestment=
ARR on Initialinvestment
*100
Average Profit AfterTax
AverageInvestment
*100
=Average Profit AfterTax
InitialInvestment
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13. DISCOUNTING CRITERIA: PAY-BACKPERIOD
3.DiscountedPay-BackPeriodMethod-Indiscountedpay-back
periodmethod,thecashinflowsarediscountedbyapplyingthepresent
valuefactorsfordifferenttimeperiods.Forthis,discountedcashinflows
arecalculatedbymultiplyingtheP.V.factorsintocashinflows.
*12
Requiredinflow
In flow of nextyear
Dis. PBP = Completed years +
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14. DISCOUNTING CRITERIA: NET PRESENTVALUE
4.NetPresentValueMethod:-Itisthebestmethodfor evaluation of investment
proposal. This method takes into account time value of money.
NPV= PV of inflows-PVof outflows
EvaluationofNetPresentValue Method:-Project with the higher NPV should be
selected.
Acceptif
Reject
May or may notaccept
NPV>0
NPV<0
NPV=0
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15. DISCOUNTING CRITERIA: PROFITABILITYINDEX
5.ProfitabilityIndexMethod-AstheNPVmethoditisalsoshows
thatprojectisacceptedornot.IfProfitabilityindexishigherthan1,the
proposalcanbeaccepted.
Accepted
Rejected
PI>1
PI<1
Profitabilityindex=
Total Cash Inflows
Total CashOutflows
ABHI TUTORIAL -9620925899

16. Discounting Criteria: Internal Rate ofReturn
5.InternalRateofReturnMethod:-IRRistherateofreturnthata
projectearns.Therateofdiscountcalculatedbytrialanderror,where
thepresentvalueoffuturecashflowsisequaltothepresentvalueof
outflows,isknownastheInternalRateofReturn.
*Difference inRate
NPV of HigherRate
Difference in cashflows
IRR=
*Difference inRate
NPV of LowerRate
Difference in cashflows
IRR=LowerRate+
Higher Rate-
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17. The expected cash flows of a projectare:-
The cash outflow is Rs.1,00,000 The cost of capital is 10% Calculate the
following:
b) ProfitabilityIndex
a)NPV
c)IRR
d)Pay-backperiod
e) Discounted Pay-backPeriod
Year Cash Flows (Rs.)
1 20,000
2 30,000
3 40,000
4 50,000
5 30,000
Example
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18. Computation ofNPV&PI
Year Cash Flows(Rs.)PVFactors@10% PV of Cash Flows(Rs.)
1 20,000 .909 18,180
2 30,000 .826 24,780
3 40,000 .751 30,040
4 50,000 .683 34,150
5 30,000 .620 18,600
Total CashInflow 1,25,750
Less:Cash
Outflows
1,00,000
NPV 25,750
P.I. 1.2575
Computation of NPV andPI
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19. pComutation ofNPV &PI
Computation ofIRR
Year Cash Flows
(Rs.)
PVFactors
@19%
PV of Cash
Flows(Rs.)
PVFactors
@18%
PV of Cash
Flows(Rs.)
1 20,000 .84 16,800 .847 16,940
2 30,000 .706 21,180 .718 21,540
3 40,000 .593 23,720 .609 24,360
4 50,000 .499 24,950 .516 25,800
5 30,000 .42 12,600 .437 13,110
Total CashInflow 99,250 1,01,750
LessCashOutflows 1,00,000 1,00,000
NPV (-)750 (+)1750
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20. COMPUTATION OF IRRCONTD..
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21. Computation of non discounting pay-backperiod
Year Cash Flows(Rs.) Cumulative CashFlow
1 20,000 20,000
2 30,000 50,000
3 40,000 90,000
4 50,000 1,40,000
5 30,000 1,70,000
PBP=
Completedyears+Required inflow*12
Inflow of Nextyear
=3years+ (1,00,000-90,000)*12
50,000
= 5.4years
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22. COMPUTATION OF DISCOUNTED PAY-BACKPERIOD
YearCashFlows
(Rs.)
PV
Factors@10%
PV ofCash
Flows(Rs.)
Cumulative
CashFlows
1 20,000 .909 18,180 18,180
2 30,000 .826 24,780 42,960
3 40,000 .751 30,040 73,000
4 50,000 .683 34,150 1,07,150
5 30,000 .620 18,600 1,25,750
Completed years+
Requiredinflow*12
Inflow of NextyearPBP=
=3years+(1,00,000-73,000)*12
34150
=12.48years ABHI TUTORIAL -9620925899

23. EXAMPLE-
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24. EXAMPLE-
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25. RISK
•Risk is defined as the variation of return from the expected return. Higher
the variation, more risky is thesecurity.
•An investment whose returns are fairly stable is considered to be a low-risk
investment, whereas an investment whose return fluctuates significantly is
considered to be a highly risky investment.
•The essence of risk in an investment is the variation in its return. This
variation in returns is caused by number offactors.
•These factors which produce variations in returns from an investment
constitute the elements ofrisk.
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26. The total variability in returns of a security is due to the total risk of that
security. Hence, Total risk = Systematic risk + Unsystematicrisk
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27. 1. SYSTEMATICRISK:
•Duetodynamicnatureofsocietythechangesoccurintheeconomic,politicalandsocialsystem
constantly.Thesechangeshaveaninfluenceontheperformanceofcompaniesandtherebyontheir
stockpricesbutinvaryingdegrees.
•Forexample,economicandpoliticalinstabilityadverselyaffectsallindustriesandcompanies.
Whenaneconomymovesintorecession,corporateprofitswillshiftdownwardsandstockpricesof
mostcompaniesmaydecline.
•Insimplewords,systematicriskisduetothosefactorsthataffectthemarketasawhole.For
ex.Changeineconomy,taxreformsetc
TYPESOFSYSTEMATICRISK:
MARKET RISK : Risk is caused by the herd mentality of investors i.ethe tendency of investors to
follow the direction ofmarket.
If market is falling even the good performing companies shares fall in prices. A general rise in share
prices is referred to as a bullish trend, whereas a general fall in share prices is referred to as a bearish
trend.
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28. TYPES OF SYSTEMATICRISK
INTERESTRATERISK:Thisarisesduetovariabilityintheinterestratesfromtimetotimeand
particularlyaffectsdebtssecuritieslikebondsanddebenturesastheycarryfixedcouponrateofinterest.
Achangeininterestratesestablishesaninverserelationshipinthepriceofsecurityi.e.priceof
securitiestendstomoveinverselywithchangeinrateofinterest.Longtermsecuritiesshowgreater
variabilityinthepricewithrespecttointerestratechangesthanshorttermsecurities.Whilecash
equivalentsarelessvulnerabletointerestraterisk,thelongtermbondsaremorevulnerabletointerest
raterisk.
PURCHASING POWER RISK : It is also known as inflation risk, as it also emanates from very
fact that inflation affects the purchasing poweradversely.
Inflation rates vary over time and investors are caught unaware when rate of inflation changes
unexpectedly causing erosion in value of realized rate of return and expectedreturn.
Purchasing power risk is more in inflationary conditions especially in respect of bonds and fixed
incomesecurities.
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29. UNSYSTEMATICRISK:-
Sometimes the return from a security of any company may vary because of certain factors
particular to thiscompany.Variability in returns of the security on account of these factors
(micro in nature), it is known as unsystematic risk(Diversifiable).Risk associated with the
companies issues related to management, assets, labour or capital.
TYPES OFUNSYSTEMATIC RISK:
•BUSINESSRISK:Business risk emanates from sale and purchase of securities affected by business
cycle, technological changesetc.Business cycle affect all types of securities viz. there is cheerful
movement in boom due to bullish trend in stock prices whereas bearish trend in depression brings
down fall in the prices of all types ofsecurities.
•FINANCIALRISK:Itarisesduetochangesincapitalstructureofthecompany.Itisalsoknownas
leveragedriskandexpressedintermofdebt-equityratio.Excessofdebtvis-à-visequityinthe
capitalstructureindicatesthatthecompanyishighlygeared.Althoughaleveragedcompany’searnings
persharearemorebutdependenceonborrowingsexposesittotheriskofwinding-upforitsinability
tohonorsitscommitmentstowardslenders/creditors.

30. DIVERSION OFRISK:
•Total risk of an individual security consists of two risks, systematic
risk and unsystematic risk.
•It should be noted that by combining many securities in a portfolio
the unsystematic risk can be avoided or cancelled out which is
attached to any particularsecurity.
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31. 1.Which one is not an important objective of Financial Management ?
(A) Profit Maximization
(B) Wealth Maximization
(C) Value Maximization
(D) Maximization of social benefits
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32. 2. The concept of present value is based on the :
(A)Principle of compounding
(B) Principle of discounting
(C) (A) and (B)
(D) None of the above
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33. 3. Match the following with most suitable option : (5)
List-I List-II
(a)Modigiliani-Miller Approach (i) Commercial papers
(b) Net Operating Income Approach (ii) Working Capital Management
(c) Short term Money Market Instrument (iii) Capital Structure
(d) Factoring (iv) Arbitrage
Codes:
(A)(iv) (iii) (i) (ii)
(B) (iii) (iv) (i) (ii)
(C) (iii) (ii) (i) (iv)
(D) (iii) (ii) (iv) (i)
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34. 4. The overall capitalization rate and the cost of debt remain constant for
all degrees of financial leverage is advocated by
(A)Traditional Approach
(B) Net Income Approach
(C) Net Operating Income Approach
(D) M-M-Approach
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35. 5. Which of the following is not included in the assumptions on which
Myron Gordon proposed a model on stock valuation ?
(A)Retained earnings, the only source of financing
(B) Finite life of the firm
(C) Taxes do not exist
(D) Constant rate of return on firm’s investment
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36. 6. Arrange the following steps involved in capital budgeting in order of their
occurrence: (13)
i.Project selection
ii. Project appraisal
iii Project Generation
iv. Follow up
v. Project execution
(A)ii, iii, i, v, iv
(B) iii, ii, i, v, iv
(C) i, iii, ii, v, iv
(D) i, ii, iii, v, iv
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37. 7. Which method does not consider the time value of money?
(A)Net Present Value
(B) Internal Rate of Return
(C) Average Rate of Return
(D) Profitability Index
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38. 8. Dividend irrelevance hypothesis is implied in the
(A)Traditional Model
(B)Walter Model
(C) Gordon Model
(D) M.M. Model
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39. 9. Who formulated the following model for estimating the market price of
equity share ?
(A)Modigliani-Miller
(B) Myron-Gordon
(C) James E. Walter
(D) Clarkson and Elliot
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40. 10. Which of the following techniques for appraisal of investment proposals are
based on time value of money?
(a) Accounting Rate of Return
(b) Internal Rate of Return
(c) Profitability Index Method
(d) Earnings Per Share
Codes :
(A)(a) and (b)
(B) (b) and (c)
(C) (a) and (d)
(D) (a), (b) and (d)
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