Financial Management for Analysts

    •  Capital expenditure decisions occupy a very important place in corporate finance for the following reasons: Once the decision is taken, it has far-reaching consequences which extend over a considerably long period, which influences the risk complexion of the firm. These decisions involve huge amounts of money. These decisions are irreversible once taken. These are among the most difficult to make when the company is faced with various potentially viable investment opportunities.
    • While capital expenditure decisions are extremely important, managers find it extremely difficult to analyse the pros and cons and arrive at a decision because: Measuring costs and benefits of an investment proposal whether it be a mini-steel plant or a library is difficult because all costs and benefits cannot be expressed in tangible terms. The benefits of capital expenditure are expected to occur for a number of years in the future which is highly uncertain. Because the costs and benefits occur at different points of time, for a proper analysis of the viability of the investment proposal, all these to be brought to a common time-frame. Hence, time value of money becomes very relevant here.
    • The investment decision consists of (i) identification of potential investment opportunities (ii) preliminary screening (iii) Feasibility study (iv) Implementation and (iv) Performance Review.

     

    • The appraisal of a project includes the following types of appraisal:

     -    Market Appraisal

    -    Technical Appraisal

    -    Financial Appraisal

    -    Economic Appraisal.

     

                                                                                                Evaluation Criteria

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                                                                             ______________________________________________

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                                                           Non-Discounting Criteria                                                                  Discounting Criteria

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                                               ____________________________                                                             ____________________________________________________

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                                Paybackperiod                            Accounting Rate of Return                                     Net Present                  Benefit Cost              Internal                      Annual

                                                                                        (ARR)                                                                    Value (NPV)                 Ratio (BCR)          Rate of Return(IRR)           Capital Charge

    •  The financial appraisal of a project can be viewed as a two-step  procedure.

    Step 1:  Define the stream of cash flows (both inflows and outflows) associated with the project.
               Step 2:  Appraise the cash flow stream to determine whether the project is financially viable or not. The two important assumptions that underlie the discussions are: (a) The cash flows occur only once a year, (b) The risk characterizing the project is similar to the risk complexion of the ongoing projects of the firm.

    •  The payback period measures the length of time required to recover the initial outlay in the project.
    • In  order to use the payback period as a decision rule for accepting or rejecting the projects, the firm  has to decide upon an appropriate cut-off period. Projects with pay back periods less than or equal to the cut-off period will be accepted and others will be rejected.
    • The accounting rate of return or the book rate of return is typically defined as follows:
    • Accounting Rate of Return (ARR) = Average Profit After Tax/Average book value of the investment.
    • To use it as an appraisal criterion, the ARR of a project is compared with the ARR of the firm as a whole or against some external yard-stick like the average rate of return for the industry as a whole.
    • The net present value is equal to the present value of future cash flows and any immediate cash outflow. In the case of a project, the immediate cash flow will be investment (cash outflow) and the net present value will be therefore equal to the present value of future cash inflows minus the initial investment.
    • A project will be accepted if its NPV is positive and rejected if its NPV is negative.
    • The NPV is a conceptually sound criterion of investment appraisal because it takes into account the time value of money and considers the cash flow stream in its entirety. Since net present value represents the contribution to the wealth of the shareholders, maximizing NPV is congruent with the objective of investment  decision making viz., maximization of shareholders wealth.
    • The decision-rules based on the BCR (or alternatively the NBCR) criterion will be as follows:

    If ---
                 BCR > 1 (NBCR > 0) Accept the project.
                 BCR < 1 (NBCR < 0) Reject the project.

    • The internal rate of return is that rate of interest at which the net present value of a project is equal to zero, or in other words, it is the rate which equates the present value of the cash inflows to the present value of  the cash outflows. While under NPV method the rate of discounting is known (the firm's cost of capital) under IRR this rate which makes NPV zero has to be found out.
    • Annual Capital Charge: This appraisal criterion is used for evaluating mutually exclusive projects or alternatives which provide similar service but have differing patterns of  costs and often unequal life spans.