techniques of Capital Budgeting aND VARIOUS method of .pptx

theory on capital budgeting techniques

1. Risk & Uncertainly In Capital Budgeting Under traditional capital budgeting the project appraisal techniques were applied on the assumption that the project will generate a given set of cash flows. Risk arises in project evaluation because the firm cannot predict the occurrence of possible future events with certainty and hence, cannot make any correct forecast about the cash flows. The uncertain economic conditions are the sources of uncertainty in the cash flows.

2. Risk And Uncertainly In Capital Budgeting Various Evaluation Methods risk and uncertainty in capital budgeting Risk-adjusted cut off rate (or method of varying discount rate) Certainly Equivalent Method. Sensitivity Technique. Probability Technique Standard Deviation Method. Co-Efficient Of Variation Method. Decision Tree Analysis.

3. Various Evaluation Methods Risk & Uncertainty In Capital Budgeting Risk-adjusted cut off rate (or method of varying discount rate) This is one of the simplest method while calculating the risk in capital budgeting. The risk-adjusted discount rate is the total of the risk-free rate, i.e. the required return on risk-free investments, and the market premium, i.e. the required return of the market. Financial analysts use the risk-adjusted discount rate to discount a firm’s cash flows to their present value and determine the risk that investor should accept for a particular investment.

4. Certainly Equivalent Method This approach to incorporate risk in evaluating investment projects, overcomes weaknesses of the RADR approach. Under this approach riskiness of project is taken into consideration by adjusting the expected cash flows and not discount rate. Certainly equivalent are risk adjusted factors that represent the percent of estimated cash inflow that investors would be satisfied to receive for certain rather than the cash inflow that are possible/ uncertain for each year.

5. Decision Rule: For Certainly Equivalent Method If NPV method is used, the proposal would be accepted if NPV of CE cash flows is positive, otherwise it is rejected. If IRR is used, the internal rate of return which equates the present value of CE cash inflows with the present value of the cash outflows, would be compared with risk free discount rate. If IRR is greater than the risk free rate, the investment project would be accepted otherwise it would be rejected.

6. Sensitivity technique When cash inflows are sensitive under different circumstances more than one forecast of the future cash inflows may be made. These inflows may be regarded on ‘Optimistic’, ‘most likely’ and ‘pessimistic’. Further cash inflows may be discounted to find out the net present values under these three different situations. If the net present values under the three situations differ widely it implies that there is a great risk in the project and the investor’s is decision to accept or reject a project will depend upon his risk bearing activities.

7. Sensitivity technique The sensitivity analysis helps in identifying how sensitive are the various estimated variables of the project. It shows how sensitive is a project’s NPV or IRR for a given change in particular variables. The more sensitive the NPV, the more critical is the variables.

8. Decision Tree Analysis. In the modern business world, putting the investments are become more complex and taking decisions in the risky situations. So, the decision tree analysis helpful for taking risky and complex decisions, because it consider all the possible event’s and each possible events are assigned with the probability. Construction of Decision Tree 1. Defined the problem 2. Evaluate the different alternatives 3. Indicating the decision points 4. Assign the probabilities of the monetary values 5. Analysis the alternatives.

9. Decision Rule: For Decision Tree Analysis Accept/Reject criteria If the net present values are in positive the project may be accepted otherwise it is rejected.

10. Probability Technique Probability technique refers to the each event of future happenings are assigned with relative frequency probability. Probability means the likelihood of future event. The cash inflows of the future years further discounted with the probability. The higher present value may be accepted.

11. Unit II: Leasing, Hire-Purchase & Project Finance Lease financing is one of the popular and common methods of assets based finance, which is the alternative to the loan finance. A contract under which one party, the leaser (owner) of an asset agrees to grant the use of that asset to another leaser, in exchange for periodic rental payments. Lease is contractual agreement between the owner of the assets and user of the assets for a specific period by a periodical rent.

12. Elements of Leasing Parties: These are essentially two parties to a contract of lease financing, namely the owner and user of the assets. Leaser: Leaser is the owner of the assets that are being leased. Leasers may be individual partnership, joint stock companies, corporation or financial institutions. Lease: Lease is the receiver of the service of the assets under a lease contract Lease assets may be firms or companies.

13. Elements of Leasing Lease broker: Lease broker is an agent in between the leaser (owner) and lessee. He acts as an intermediary in arranging the lease deals. Lease assets: The lease assets may be plant, machinery, equipments, land, automobile, factory, building etc. Term of Lease: The term of lease is the period for which the agreement of lease remains for operations. Lease Rental: The consideration that the lessee pays to the leaser for lease transaction is the rental.

14. Type of Leasing (A) Lease based on the term of lease 1. Finance Lease 2. Operating Lease (B) Lease based on the method of lease 1. Sale and lease back 2. Direct lease (C) Lease based in the parties involved 1. Single investor lease 2. Leveraged lease (D) Lease based in the area 1. Domestic lease 2. International lease

15. Lease based on the term of lease Financing lease: Financing lease is also called as full payout lease. It is one of the long-term leases and cannot be cancellable before the expiry of the agreement. It means a lease for terms that approach the economic life of the asset, the total payments over the term of the lease are greater than the leasers initial cost of the leased asset. For example: Hiring a factory, or building for a long period. It includes all expenditures related to maintenance.

16. Lease based on the term of lease Operating lease: Operating lease is also called as service lease. Operating lease is one of the short-term and cancellable leases. It means a lease for a time shorter than the economic life of the assets, generally the payments over the term of the lease are less than the leaser’s initial cost of the leased asset. For example: Hiring a car for a particular travel. It includes all expenses such as driver salary, maintenance, fuels, repairs etc.

17. Lease based on the method of lease Sale and lease back: Sale and lease back is a lease under which the leasee sells an asset for cash to a prospective leaser and then leases back the same asset, making fixed periodic payments for its use. It may be in the firm of operating leasing or financial leasing. It is one of the convenient methods of leasing which facilitates the financial liquidity of the company.

18. Lease based on the method of lease Direct lease: When the lease belongs to the owner of the assets and users of the assets with direct relationship it is called as direct lease. Direct lease may be Dipartite lease (two parties in the lease) or Tripartite lease. (Three parties in the lease)

19. Lease based in the parties involved Single investor lease: When the lease belongs to only two parties namely leaser and it is called as single investor lease. It consists of only one investor (owner). Normally all types of leasing such as operating, financially, sale and lease back and direct lease are coming under this categories.

20. Lease based in the parties involved Leveraged lease: This type of lease is used to acquire the high level capital cost of assets and equipments. Under this lease, there are three parties involved; the leaser, the lender and the lessee. Under the leverage lease, the leaser acts as equity participant supplying a fraction of the total cost of the assets while the lender supplies the major part.

21. Lease based in the area Domestic lease: In the lease transaction, if both the parties belong to the domicile of the same country it is called as domestic leasing. International lease: If the lease transaction and the leasing parties belong to the domicile of different countries, it is called as international leasing.

22. Advantages of Leasing to the Lessor : Higher Profits: Tax Benefits: Quick Returns: Increased Sales

23. Disadvantages for the Lessor : High Risk of Obsolescence: Competitive Market: Price-Level Changes: Management of Cash flows: Increased Cost due to Loss of User Benefits: Long-term Investment:

24. Advantages of Leasing to the Lessee: Avoidance of Initial Cash Outlay: Minimum Delay Easy Source of Finance: Shifting the Risk of Obsolescence: Enhanced Liquidity Conserving Borrowing Capacity: Tax Planning and Differential Tax Advantage: Higher Return on Capital Employed Convenience and Flexibility: Lesser Administrative and Maintenance Costs:

25. Disadvantages of Leasing for the Lessee: Higher Cost: Loss of Moratorium Period: Risk of Being Deprived of the Use of Asset: No Alteration OR Change in Asset: Loss of Ownership Incentives: Penalties on Termination of Lease Loss of Salvage Value of the Asset:

26. Meaning of Hire Purchase: Hire purchase is a method of financing of the fixed asset to be purchased on future date. Under this method of financing, the purchase price is paid in instalments. Ownership of the asset is transferred after the payment of the last installment.

27. Features of Hire Purchase Agreement Under hire purchase system, the buyer takes possession of goods immediately and agrees to pay the total hire purchase price in instalments. Each installment is treated as hire charges. The ownership of the goods passes from the seller to the buyer on the payment of the last installment. In case the buyer makes any default in the payment of any installment the seller has right to repossess the goods from the buyer and forfeit the amount already received treating it as hire charges. The hirer has the right to terminate the agreement any time before the property passes. That is, he has the option to return the goods in which case he need not pay instalments falling due thereafter. However , he cannot recover the sums already paid as such sums legally represent hire charges on the goods in question

28. Advantages & Disadvantages of Hire Purchase: Advantages of Hire Purchase: i . Financing of an asset through hire purchase is very easy. ii . Hire purchaser becomes the owner of the asset in future. iii . Hire purchaser gets the benefit of depreciation on asset hired by him/her. iv . Hire purchasers also enjoy the tax benefit on the interest payable by them . Disadvantages of Hire Purchase: Ownership of asset is transferred only after the payment of the last installment. The magnitude of funds involved in hire purchase are very small and only small types of assets like office equipment’s, automobiles, etc., are purchased through it . The cost of financing through hire purchase is very high.

29. Unit III: Valuation of Business Business valuation refers to the process and set of procedures used to determine the economic value of an owner’s interest in a business.

30. Valuation Approaches: Adjusted Book Value Method:- Under this method current value of all assets including goodwill are totalled. Out of this total Current value of all current liabilities and provision are deducted. The balance is the amount of business value

31. Valuation Approaches: Value Of Share & Debt Method:- Under this method current value of all shares and debt of the company is considered as value of business. The current value may be available from the stock exchange in case the securities are listed and traded.

32. Valuation Approaches: C omparison method:- Under this method the value of similar business which have been sold recently. for these business we calculate the following ratio : Market value EBIDT   Market value Book Value   Market value Sale

33. Dividend Decisions Meaning of Dividend Dividend refers to the business concerns net profits distributed among the shareholders. It may also be termed as the part of the profit of a business concern, which is distributed among its shareholders. According to the Institute of Chartered Accountant of India, dividend is defined as “a distribution to shareholders out of profits or reserves available for this purpose”.

34. TYPES OF DIVIDEND/FORM OF DIVIDEND A . Cash Dividend B. Stock Dividend C. Bond Dividend D. Property Dividend

35. TYPES OF DIVIDEND/FORM OF DIVIDEND Cash Dividend If the dividend is paid in the form of cash to the shareholders, it is called cash dividend . It is paid periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are common and popular types followed by majority of the business concerns.

36. TYPES OF DIVIDEND/FORM OF DIVIDEND Stock Dividend Stock dividend is paid in the form of the company stock due to raising of more finance . Under this type, cash is retained by the business concern. Stock dividend may be bonus issue. This issue is given only to the existing shareholders of the business concern.

37. TYPES OF DIVIDEND/FORM OF DIVIDEND Bond Dividend Bond dividend is also known as script dividend . If the company does not have sufficient funds to pay cash dividend, the company promises to pay the shareholder at a future specific date with the help of issue of bond or notes.

38. TYPES OF DIVIDEND/FORM OF DIVIDEND Property Dividend Property dividends are paid in the form of some assets other than cash . It will distributed under the exceptional circumstance. This type of dividend is not Given in India.

39. Dividend Decision Dividend decision consists of two important concepts which are based on the relationship between dividend decision and value of the firm.

40. Dividend Decision and Value of Firms There are conflicting views regarding the impact of dividend decision on the valuation of the firm . According to one school of thought, dividend decision does not affect the share-holders' wealth and hence the valuation of the firm. On the other hand, according to the other school of thought, dividend decision materially affects the shareholders' wealth and also the valuation of the firm.

41. Dividend Decision and Value of Firms We will discuss below the views of the two schools of thought under two groups: The Irrelevance Concept of Dividend OR T he Theory of Irrelevance, and The Relevance Concept of Dividend OR The Theory of Relevance.

42. The Irrelevance Concept of Dividend or the Theory of Irrelevance Residual Approach: According to this theory, dividend decision has no effect on the wealth of the shareholders or the prices of the shares, and hence it is irrelevant so far as the valuation of the firm is concerned . This theory regards dividend decision merely as a part of financing decision because the earnings available may be retained in the business for re-investment . But, if the funds are not required in the business they may be distributed as dividends. This theory assumes that investors do not differentiate between dividends and retentions by the firm.

43. The Irrelevance Concept of Dividend or the Theory of Irrelevance Residual Approach: Their basic desire is to earn higher return on their investment In case the firm has profitable investment opportunities giving a higher rate of return than the cost of retained earnings, the investors would be content with the firm retaining the earnings to finance the same. However , if the firm is not in a position to find profitable investment opportunities, the investors would prefer to receive the earnings in the form of dividends . Thus, a firm should retain the earnings if it has profitable investment opportunities otherwise it should pay them as dividends.

44. Modigliani and Miller Approach (MM Model): Modigliani and Miller have expressed in the most comprehensive manner in support of the theory of irrelevance . They maintain that dividend policy has no effect on the market price of the shares and the value of the firm is determined by the earning capacity of the firm or its investment policy.

45. Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm's investment policy, its dividend policy may have no influence on the market price of the shares." Modigliani and Miller Approach (MM Model):

46. Assumptions of MM Hypothesis There are perfect capital markets. Investors behave rationally. Information about the company is available to all without any cost. There are no floatation and transaction costs. No investor is large enough to affect the market price of shares. There are no taxes or there are no differences in the tax rates applicable to dividends and capital gains. The firm has a rigid investment policy. Modigliani and Miller Approach (MM Model):

47. P0 = D 1 + P 1 (1 + Ke ) Where , P0 = Market price per share at the beginning of the period, or prevailing market price of a share. D1= Dividend to be received at the end of the period. P1 = Market price per share at the end of the period. Ke = Cost of equity capital or rate of capitalization. Modigliani and Miller Approach (MM Model):

48.   P1 can be calculated with the help of the following formula. P1 = Po (1+Ke) – D1 The number of new shares to be issued can be determined by the following formula: M × P1 = I – (X – nD1) Where, M = Number of new share to be issued. P1 = Price at which new issue is to be made. I = Amount of investment required. X = Total net profit of the firm during the period. nD1= Total dividend paid during the period. Modigliani and Miller Approach (MM Model):

49. Criticism of MM approach MM approach assumes that tax does not exist. It is not applicable in the practical life of the firm. MM approach assumes that, there is no risk and uncertain of the investment. It is also not applicable in present day business life. MM approach does not consider floatation cost and transaction cost. It leads to affect the value of the firm. MM approach considers only single decrement rate, it does not exist in real practice. MM approach assumes that, investor behaves rationally. But we cannot give assurance that all the investors will behave rationally.

50. Relevance Of Dividend According to this concept, dividend policy is considered to affect the value of the firm. Dividend relevance implies that shareholders prefer current dividend and there is no direct relationship between dividend policy and value of the firm. Relevance of dividend concept is supported by two eminent persons like Walter and Gordon.

51. Walter’s Model Prof . James E. Walter argues that the dividend policy almost always affects the value of the firm. Walter model is based in the relationship between the following important factors: Rate of return I Cost of capital (k) According to the Walter’s model , if r > k, the firm is able to earn more than what the shareholders could by reinvesting, if the earnings are paid to them. The implication of r > k is that the shareholders can earn a higher return by investing elsewhere. If the firm has r = k, it is a matter of indifferent whether earnings are retained or distributed.

52. Assumptions of Walter’s Model The firm uses only internal finance. The firm does not use debt or equity finance. The firm has constant return and cost of capital. The firm has 100 recent payout. The firm has constant EPS and dividend. The firm has a very long life.

53. Walter’s Model Where , P = Market price of an equity share D = Dividend per share r = Internal rate of return E = Earnings per share Ke = Cost of equity capital

54. Walter’s Model Walter model assumes that there is no extracted finance used by the firm. It is not practically applicable. There is no possibility of constant return. Return may increase or decrease, depending upon the business situation. Hence, it is applicable. According to Walter model, it is based on constant cost of capital. But it is not applicable in the real life of the business

55. Gordon’s Model Myron Gorden suggest one of the popular model which assume that dividend policy of a firm affects its value, and it is based on the following important assumptions: The firm is an all equity firm. The firm has no external finance. Cost of capital and return are constant. The firm has perpetual life. There are no taxes. Constant relation ratio (g= br ). Cost of capital is greater than growth rate ( Ke > br ).

56. Gordon’s model can be proved with the help of the following formula : P = E ( 1-b) Ke – br Where, P = Price of a share E = Earnings per share 1 – b = D/p ratio (i.e., percentage of earnings distributed as dividends) Ke = Capitalization rate br = Growth rate = rate of return on investment of an all equity firm. Gordon’s Model

57. Determinants of Dividend Policy Determinants of Dividend Policy Legal Restrictions: Magnitude and Trend of Earnings: Desire and Type of Shareholders: Nature of Industry: Age of the Company: Future Financial Requirements:

58. Determinants of Dividend Policy Economic Policy: Taxation Policy: Inflation: Control Objectives : Requirements of Institutional Investors Stability of Dividends: Liquid Resources:

59. Types of Dividend Policy Types of Dividend Policy Regular Dividend Policy Stable Dividend Constant dividend per share Constant payout ratio Irregular Dividend Policy: No Dividend Policy:

60. Unit IV: Mergers & Acquisitions Merger : A merger is said to occur when two or more companies combine into one company. One or more companies may merge with an existing company or they may merge to form a new company. Absorption : A combination of two or more companies into an existing company. Acquisition : Acquisition may be defined as an act of acquiring effective control over assets or management of a company by another company without any combination of businesses. Takeover : Unwilling acquisition is called takeover.

61. Unit IV: Mergers & Acquisitions Synergy : Synergy refers to benefits other than those related to economies of scale. Lever aged Buy-outs (LBO) : An acquisition of a company in which the acquisition is substantially financed through debt. Spin-off : When a company creates a new firm from the existing entity. Self-off : Selling a part of business to a third party is called sell-off.

62. Types of Mergers Mergers may be classified into the following three types- ( i ) horizontal, ( ii) vertical and ( iii) conglomerate.

63. Types of Mergers Horizontal Merger Horizontal merger takes place when two or more corporate firms dealing in similar lines of activities combine together . For example, merger of two publishers or two luggage manufacturing companies. Elimination or reduction in competition, putting an end to price cutting, economies of scale in production, research and development, marketing and management are the often cited motives underlying such mergers.

64. Types of Mergers Vertical Merger Vertical merger is a combination of two or more firms involved in different stages of production or distribution . For example, joining of a spinning company and weaving company. Vertical merger may be forward or backward merger . When a company combines with the supplier of material, it is called backward merger and when it combines with the customer, it is known as forward merger. The main advantages of such mergers are lower buying cost of materials, lower distribution costs, assured supplies and market, increasing or creating barriers to entry for competitors etc.

65. Conglomerate merger Conglomerate merger is a combination in which a firm in one industry combines with a firm from an unrelated industry. A typical example is merging of different businesses like manufacturing of cement products, fertilisers products, electronic products, insurance investment and advertising agencies. Diversification of risk constitutes the rationale for such mergers Types of Mergers

66. Advantages Of Merger And Acquisition Economies of Scale: Synergy Strategic benefits: Tax benefits Utilisation of surplus funds: Diversification