Financial Analysis is the process of identifying the financial

strengths and weaknesses of the firm by properly

establishing relationships between the items of the balance
sheet and the profit and loss account.

Financial Analysis is about how to analyse the financial
performance of a firm and how to manage corporate funds
and liquidity.

Financial Analysis focuses on the financial decision-making
and the role of financial manager as the efficient user of
financial resources.
USERS OF FINANCIAL ANALYSIS
Financial analysis can be undertaken by management of the
firm, or by parties outside the firm, viz, owners, creditors,
investors and others. The nature of analysis will differ
depending on the purpose of the analyst:

TRADE CREDITORS

SUPPLIERS OF LONG TERM-DEBT

INVESTORS

MANAGEMENT

Accounting is concerned with the recording,
classifying, summarising, analysis and
interpretation of the business transaction.

According to the American Institute of Certified
Public Accountants Accounting is a art of
recording, classifying and summarising in a
significant manner and in terms of money,
transactions and events, which are in part
atleast, of a financial character and interpreting
the result thereof.


FINANCIAL
ACCOUNTING
MANAGEMENT
ACCOUNTING
PROFIT &
LOSS
ACCOUNT
BALANCE
SHEET
CASH
FLOW
STATEMEN
T
COST
ACCOUNTIN
G
DECISION
MAKING
COSTING & PLANNING
AND CONTROL
BUDGETING &
STANDARD
COSTING
SHORT
TERM
LONG
TERM
SOME CONCEPTS
CONTD.
Authorized capital: The authorized capital of a company (sometimes,
referred to as the authorizes share capital or the nominal capital,
particularly in the United States) is the maximum amount of share capital
that the company is authorized by its constitutional documents to issue
to shareholders. Part of the authorized capital can (and frequently does)
remain unissued. (say Rs. 100 cr.).
Issued capital: The part of authorized capital which has been issued to
shareholders is referred to as the issued capital of the company. (say
Rs. 80 cr.).
Subscribed capital: The subscribed capital is that part of the issued
capital that is actually subscribed by the public. (say Rs. 60 cr.).
Paid-up-capital: The amount of shareholders capital that has been paid
in fully by shareholders.
or,
Paid-up-capital is essentially the portion of authorized stock that the
company has issued and received payment for.
CONTD.
EQUITIES: The claim against, or interest in, an organisation assets.

OWNERS EQUITY: The excess of assets over the liabilities.

STOCK HOLDERS EQUITY: The owners equity of a corporation.

PAID-IN-CAPITAL: The ownership claim arising from funds paid-in by the owners.
or,
PAID-IN-CAPITAL (or, CONTRIBUTED CAPITAL) refers to the capital contributed to a
corporation by investors through purchase of stock from the corporation (PRIMARY
MARKET) (not through purchase of stock in the OPEN MARKET from other
stockholders i.e. SECONDARY MARKET).

RETAINED INCOME (RETAINED EARNINGS): The ownership claims arising from the
reinvestment of previous profits.

ACCOUNT PAYABLE: Amounts owed to vendors for purchase on open account.

ACCOUNT RECEIVABLE: Amounts due from customers for sale on open accounts.

AUDIT: An examination or in-depth inspection of financial statements and company's
records that is made in accordance with GENERALLY ACCEPTED ACCOUNTING
PRINCIPLES(GAAP).

CONTD
REVENUE: Increase in ownership claims arising from the delivery of goods and
services.

EXPENSES: Decrease in ownership claims arising from delivering goods or services
or using up assets.

PROFITS (EARNINGS, INCOME): The excess of revenue over expenses.

CASH BASIS: A process of accounting where revenue and expenses recognition
would occur when cash is received and disbursed.

UNEXPIRED COST: Any asset that ordinarily becomes an expenses in future
periods, e.g. inventory and pre-paid rent.

UNEARNED REVENUE (DEFFERED REVENUE): Collections from customers
received and recorded before they are earned.

DIVIDINDS: Distributions of assets to stockholders that reduce retained income.
FINANCIAL STATEMENTS
1. BALANCE SHEET: A snapshot of the financial status of an
organization at an instant of time. It records the assets, liabilities and
capital of a business at a certain point in time. Assets less liabilities will
equal capital. Capital is thus the owners interest in the business.

2. INCOME STATEMENT (PROFIT & LOSS ACCOUNT): A statement
that summarizes a companys revenues and expenses. It measures
the performance of an organization by matching its accomplishments
and its efforts. Hence, a profit and loss account, as its simplest,
records the income and expenses of a business over time.

3. CASH FLOW STATEMENT: A cash flow statement shows the cash
inflows and outflows of the business.



SUMMARY BALANCE SHEET AT 31 MARCH 20XX

20X1 20X2
Rs. Rs.

FIXED ASSETS
TANGIBLE & INTANGIBLE ASSETS 4243.4 4387.5
Investments 55.0 61.2
4298.4 4448.7
Current assets
Stocks 474.4 514.7
Debtors 2555.2 2355.7
Cash & Investments 687.5 485.5
3717.1 3355.9
Current liabilities
Creditors: amounts falling due within one year 2162.8 2029.8
NET CURRENT ASSETS 1554.3 1326.1
TOTAL ASSETS LESS CURRENT LIABILITIES 5852.7
5774.8
Creditors: amount falling due after more than one year 804.3 772.6
Provisions for liabilities and charges 126.6 105.0
NET ASSETS 4921.8 4897.2
SHAREHOLDERS FUNDS (all equity) 4905.3 4883.9
Interests/Profit (all equity) 16.5 13.3
TOTAL CAPITAL EMPLOYED 4921.8
4897.2


SUMMARY PROFIT & LOSS A/C FOR THE YEAR ENDED 31 MARCH 20XX

20X1
20X2
Rs.
Rs.
Sales 8224
8243
Add: Other income 34
104
8258
8347
Less: Expenses 7712
7192
Profit before Taxation 546 1155
TAXATION (176)
(339)

Profit after Taxation 370 816
Other 2 -
DIVIDENDS (413)
(409)

RETAINED (LOSS)/PROFIT (41)
407
Note: The profit and loss account has been simplified and reconstructed. The original
summary profit and loss account can be found different.

SUMMARY CASH FLOW INFORMATION FOR THE YEAR ENDED 31 MARCH 20XX
20X1
20X2
Rs.
Rs.
OPERATING ACTIVITIES
Received from customers 7989.9
7884.1
Payments to suppliers (5357.1)
(5464.2)
Payments to and on behalf of employees (1138.3)
(1153.9)
Other payments (803.8)
(793.1)
Exceptional operating cash flows (49.2)
(0.6)

CASH INFLOW FROM OPERATING ACTIVITIES 641.5
472.3
Returns on investments and servicing of finance 15.2
29.0
Taxation (145.7)
(345.9)
Capital expenditure and financial investments (167.0)
(628.1)
Acquisitions and others (21.1)
1.0
Equity dividends paid (413.5)
(412.6)

CASH OUTFLOW BEFORE FUNDING (90.6)
(884.3)
FUNDS FLOW STATEMENT
The statement of changes in financial position, prepared to determine only the
sources and uses of working capital between dates of two balance sheets, is
known as the funds flow statement .

Funds flow statement is referred to as the statement of changes in financial
positions. Thus, the statement is intended to summarize:

Changes in assets and liabilities resulting from financial and investment
transactions during the period, as well as those changes which resulted due to
change in owners equity; and

The way in which the firm used its financial resources during the period (for
example to acquire fixed assets, to pay debts, to pay dividends to shareholders and
so on).
BALANCE SHEET CHANGES SOURCES AND USES OF FUNDS
(Rs.
000)
March 31, 20X1 March 31, 20X2
Change
ASSETS
Cash 54 135 (+)
81
Debtors 6750 8235 (+)
1485
Stock 10125 22680 (+)
12555
Total Current
Assets 16929 31050 (+)
14121
Fixed assets 2970 6075 (+)
3105
Other assets 945 1890 (+)
945
Total Assets 20844 39015 (+)
18171

LIABILITIES & CAPITAL
Bank borrowings 3510 8664 (+)
5154
Creditors 2835 6615 (+)
3780
Provision for taxes 270 972 (+)
702
Accrued expenses 810 2700 (+)
1890
Total Current
Liabilities 7425 18951 (+)
11526
Long-term debt 1944 1404 (-)
540
Total
Liabilities 9369 20355 (+)
10986
Paid-up share capital 8370 8370 ----
----
Reserves & surplus 3105 10290 (+)
7185
Total Funds 20844 39015 (+)
18171
(Rs.
000)
Amount
%
SOURCES
INCREASE IN CURRENT LIABILITIES:
Bank borrowings 5154
27.5
Creditors 3780
20.2
provision for taxes 702
3.8
Accrued expenses 1890
10.1
Total 11526
61.6

Increase in share holders equity:
Reserves (retained income) 7185
38.4

TOTAL SOURCES 18711
100.0

USES
INCREASE IN CURRENT ASSETS:
Cash 81
0.4
Debtors 1485
7.9
Stock (inventory) 12555
67.1
Total 14121
75.4

Increase in fixed assets 3105
16.6
Increase in other assets 945
5.1
Decrease in long-term debt 540
2.9

TOTAL USES 18711
100.0
WORKING CAPITAL
Working Capital is defined as the difference between current assets and current
liabilities.
Working capital determines the liquidity position of the firm.
As a historically analysis, the statement of changes in working capital reveals to management
the way in which working capital was obtained and used.

Sources of working capital (Funds)
1) Funds from operations (adjusted net income).

2) Sale of non-current assets:
i) sale of long-term investments (shares, bonds/debentures)
ii) sale of tangible fixed assets like land, building, plants, or equipments.
iii) sale if intangible fixed assets like goodwill, patents, or copyrights.

3) Long term financing:
i) long-term borrowings (institutional loans, debentures, bonds etc.).
ii) issuance of equity and preference shares.

4) Short-term financing such as bank borrowings.
STATEMENT OF CHANGES IN WORKING CAPITAL FOR THE YEAR ENDED DECEMBER 31, 20X1
Sources and uses of working
capital



SOURCES RS.
Funds from operations
1,20,000
Sale of machine
30,000
Issuance of debentures
1,00,000
Issuance of equity shares
1,00,000
Funds Provided
3,50,000

USES
Purchase of long-term
Investments
80,000
Payment of long-term
Loans
90,000
Payment of cash dividends 60,000
Increase in working capital
1,20,000
Funds Applied
3,50,000

Schedule of changes in working capital
31 Dec. 31 Dec. Increase
Decrease
20X1 20X2
Rs. Rs. Rs.
Rs.
Current Assets
Cash 80,000 1,25,000 45,000 ------
-----
Debtors 50,000 45,000 -------------
5,000
Inventory 1,15,000 1,65,000 50,000 ------
-----
TOTAL 2,45,000 3,35,000 95,000
5,000

Current Liabilities
Bills payable 20,000 8,000 12,000 -------
-----
Creditors 45,000 47,000 ------------
2,000
Other current
Liabilities 25,000 5,000 20,000 ------
------
TOTAL 90,000 60,000 32,000
2,000

Working Capital 1,55,000 2,75,000 1,27,000
7,000
Increase in working
capital ------- -------- --------
1,20,000

TOTAL 1,27,000
1,27,000
USES OF FUNDS AND CASH FLOW ANALYSIS
1. LIQUIDITY: What is the position of the firm?

2. CHANGES IN FINANCIAL POSITION: What are the causes of changes in the firms working
capital or cash position?

3. ACQUISITION OF FIXED ASSETS: What fixed assets are acquired by the firm?

4. DIVIDEND PAYMENT: Did the firm pay dividends to its shareholders or not? If not, was it due to
shortage of funds?

5. INTERNAL FUNDS: How much of the firms working capital needs were met by the funds
generated from current operations?

6. EXTERNAL FUNDS: Did the firm use external sources of finance to meet its needs of fund?

7. DEBT-EQUITY: If the external financing was used, what ratio of debt and equity was maintained?

8. SALES OF NON-CURRENT ASSETS: Did the firm sell any of its non-current assets? If so, what
were the proceeds from such sales?

9. DEBT PAYMENT: Could the firm pay its long-term debt as per the schedules?

10. INVESTMENTS AND FINANCING: What were the significant investment and financing activities
of the firm which did not involve working capital?
RATIO ANALYSIS
A Ratio is defined as the indicated relationship of two mathematical
expressions and as the relationship between two or more things.

RATIO ANALYSIS IS A POWERFUL TOOL OF FINANCIAL ANALYSIS

The relationship between two accounting figures, expressed
mathematically, is known as a FINANCIAL RATIO (or simply as RATIO).

In financial analysis, a ratio is used as a benchmark for evaluating the
financial position and performance of a firm, because the absolute
accounting figures reported in the financial statements do not provide a
meaningful understanding of the performance and financial position of a
firm.
TYPES OF RATIOS
LIQUIDITY RATIOS: measure the firms ability to meet current
obligations.


LEVERAGE RATIOS: show the proportions of debt and equity in
financing the firms assets.


ACTIVITY RATIOS: reflect the firms efficiency in utilising its assets.


PROFITABILITY RATIOS: measure overall performance and
effectiveness of the firm.

LIQUIDITY RATIOS
1.CURRENT RATIO : The current ratio is a measure of the firms short-term
solvency. It indicates the availability of current assets in rupees for every
one rupee of current liability.
CURRENT RATIO = CURRENT ASSETS
CURRENT LIABILITIES
2. QUICK RATIO: This ratio establishes a relationship between quick, or liquid,
assets and current liabilities.
QUICK RATIO = CURRENT ASSETS INVENTORIES
CURRENT LIABILITIES
3. CASH RATIO: This ratio indicates the relationship between the availability of
cash including trade investment or marketable securities to the current
liabilities.
CASH RATIO = CASH + MARKETABLE SECURITIES
CURRENT LIABILITIES
4. NET WORKING CAPITAL RATIO: The difference between current assets and
current liabilities excluding short-term borrowings is called net working
capital (NWC) or net current assets (NCA). It is used as a measure of firms
liquidity.
NWC RATIO = NET WORKING CAPITAL
NET ASSETS

LEVERAGE RATIOS
1. TOTAL DEBT RATIO: It compute debt ratio by dividing total debt (TD) by
capital employed (CE) or total net assets (NA) to analyse the long term
solvency of a firm.
DEBT RATIO = TOTAL DEBT = TOTAL DEBT
TOTAL DEBT + NET WORTH CAPITAL
EMPLOYED

2. DEBT-EQUITY RATIO: Shows relationship describing the lenders
contribution for each rupee of the owners contribution and computed by
dividing total debt by net worth.
DEBT-EQUITY RATIO = TOTAL DEBT
NET WORTH

3. COVERAGE RATIO: The interest coverage ratio shows the number of
times the interest charges are covered by funds that are ordinarily
available for their payment. It is computed by dividing earnings before
interest and taxes(EBIT) by interest charges.
INTEREST COVERAGE = E B I T
INTEREST
ACTIVITY RATIO
1. INVENTORY TURNOVER: This ratio indicates the efficiency of the firm in
selling its products. It is calculated by dividing the cost of goods sold by
the average inventory.
INVENTORY TURNOVER = COST OF GOODS SOLD
AVERAGE INVENTORY

DAYS OF INVENTORY HOLDINGS = AVERAGE INVENTORY X 360
COST OF GOODS SOLD
2. DEBTOR RATIO: Debtor turnover indicates the number of times debtor
turnover each year.
Debtor turnover = SALES
DEBTORS
3. ASSETS TURNOVER: The relationship between sales and assets is
called assets turnover.
ASSETS TURNOVER = SALES
ASSETS
PROFITABILITY RATIOS
GROSS PROFIT MARGIN = SALES COST OF GOODS SOLD
SALES

NET PROFIT MARGIN = PROFIT AFTER TAX
SALES

OPERATING EXPENSES RATIO = OPERATING EXPENSES
SALES

RETURN ON INVESTMENT(ROI):
(I) ROI = ROTA = EBIT (1-T) = EBIT (1-T)
(Return on total assets) TOTAL ASSETS TA
(II) ROI = RONA = EBIT (1-T) = EBIT (1-T)
( Return on net assets) NET ASSETS NA

DIVIDEND PER SHARE = EARNINGS PAID TO SHARE HOLDERS
NUMBER OF ORDINARY SHARES OUTSTANDINGS

DIVIDEND PAYOUT RATIO = DIVIDENDS PER SHARE
EARNINGS PER SHARE



COMPOUNDING
The interest that is paid on the principal as well as on any interest earned but
not withdrawn during earlier periods is called compound interest.

The process of finding the future value of payment (or receipt) or series of
payments (or receipts) when applying the concept of compound interest is
known as compounding.

Time Preference for Money
An individuals preference for possession of a given amount of cash now,
rather than the same amount at some future time is called time
preference for money.

Three reasons may be advanced to account for the individual's time
preference for money:
1) Uncertainty
2) Preference for consumption
3) Investment opportunities.
HOW IS COMPOUND VALUE OF A LUMP SUM CALCULATED?
1) Suppose Rs.100 deposited in a bank at 10% rate of interest for 1 year. How
much future sum would you receive after one year?
you would receive:
FUTURE SUM = 100 + .10 X 100
= 100 (1.10) = 110.
Therefore, F1 = P (1 + i )

2) AFTER 2 YEARS:
FUTURE SUM = (100 + .10 x 100) + .10(100 + .10 x 100)
= 100 (1.10) (1.10)
= 121.
Therefore, F2 = P (1 + i )2

3) AFTER n YEARS:
Fn = P (1 + i ) n


HOW IS COMPOUND VALUE OF AN ANNUITY CALCULATED?
An annuity is a fixed payment (or receipt) each year for a
specified number of years. For example, the equal
installment loans from the housing finance companies or
employers, etc.
Thus, the compound value of an annuity of Re 1 for 4 years at 6% rate of
interest computed and expressed as follows:
F4 = A (1+i)3 + A(1+i)2 + A(1+i) + A
= A [ (1+i)3 + (1+i)2 + (1+i) + 1 ]
Where A is the annuity, we can extend the equation for n periods and rewrite
it as follows:
Fn = A (1 + i)n 1
i
SINKING FUND: The fund which is created out of fixed payments each year
to accumulate to a future sum after a specified period is called sinking
fund. The factor used to calculate the annuity for a given future sum is
called the sinking fund factor. i.e.
A = F i
(1+i)n - 1


PRESENT VALUE
The present value of a future cash inflow and outflow is the amount of
current cash that is of equivalent desirability, to the decision maker, to a
specified amount of cash to be received or paid at a future date.

The process of determining present value of a future payment (or receipts)
or a series of future payments (or receipts) is called discounting.

The compound interest rate used for discounting cash flows is called the
discount rate.
F1 = P (1 + i )
where, F1= Future value, P= Present value, i= Rate of interest.
therefore,
P = F1
(1 + i )
PRESENT VALUE: HOW MUCH WOULD THE INVESTOR GIVE UP NOW TO GET AN
AMOUNT OF RUPEE 1 AT THE END OF ONE, TWO, OR THREE YEARS ?
If the amount grows to F1 = Re 1 after a year at 10%, the amount to be
deposited or sacrificed in the beginning:
F1 = P( 1 + i )
therefore, P = F1
(1 + i )
The present value of Re.1 inflow at the end of two years:
F2 = P (1 + i )2
therefore, P = F2
(1 + i)2
The present value of Re.1 to be received after three years:
F3 = P(1 + i)3
therefore, P = F3
(1 + i)3
The present value can be worked out for any number of years and for any
interest rate:
P = Fn
(1 + i)n or P = Fn [ (1+i) n ]
The term in brackets is the present value factor (PVF), and it is always less than
1.0 for positive i, indicating that a future amount has a smaller present value.

WHAT IS PRESENT VALUE OF AN ANNUITY?
The computation of the present value of an annuity can be written in the
following general form:

P = A + A + A + . + A
(1+i) (1+i)2 (1+i)3 (1+i)n

= A 1 + 1 + 1 + ... + 1
(1+i) (1+i)2 (1+i)3 (1+i)n
Where, A is a constant payment (or receipt) each year. Therefore, above
equation can be solved and expressed as
= A 1- 1
(1-i)n
i
= A (1+i)n -1
i (1+i)n
CAPITAL RECOVERY
The reciprocal of the present value annuity factor is called the capital
recovery factor. It is useful in determining income to be earned to recover
an investment at a given rate of interest.

For example: suppose that you plan to invest Rs. 10,000 today for a period
of four years. If your interest rate is 10 percent, how much income per
year should you receive to recover your investment?



A = P i (1+i)n
(1+i)n - 1
WHAT IS AN ANNUITY DUE?
The concept of compound value and present value of an annuity are based
on the assumption that series of payments are made at the end of the
year.

In practice, payments could be made at the beginning of the year. When you
buy a fridge on installment sale, the dealer requires you to make the first
payment immediately (viz. in the beginning of the first period) and
subsequent installments in the beginning of each period.

Therefore,
A series of fixed payments starting at the beginning of each
period for a specified number of periods is called an annuity due.

Fn = A (1+i)n 1 (1+i)
i


MULTIPLE COMPOUNDING
Multiple compounding indicates that the cash flow can occur
more than once a year rather than once in a year. For
example, banks may pay interest on saving accounting
quarterly. On bonds or debentures and public deposit,
companies may pay interest semi-annually.

The interest rate is usually specified on an annual basis in a
loan agreement or security (such as bonds), and is known as
the nominal interest rate. If the compounding is done more
than once a year, the actual rate of interest paid (or received)
is called the effective interest rate (EIR); effective interest rate
would be higher than the nominal interest rate.


THE FORMULA FOR CALCULATING EIR IN THE FOLLOWING GENERAL FORM
EIR = 1 + i n x m - 1
m
Where i = annual nominal rate if interest, n = number of years and m =
number of compounding per year.
The effective rate of interest if the compounding is done:
A. For the half-yearly compounding , EIR will be:
EIR = 1 + i 2 - 1
2

B. For quarterly compounding, EIR will be:
EIR = 1 + i 4 -1
4

C. For weekly compounding, EIR will be:
EIR = 1 + i 52 -1
52
NET PRESENT VALUE
Net Present Value of a financial decision is the difference between the
present value of cash inflows and the present value of cash out flows.

The Net Present Value (NPV) Method is the classical economic model of
evaluating the investment proposals. It is one of the discounted cash flow
(DCF) techniques explicitly recognising the time value of money.


NPV = A1 + A2 + .. + An - Co
(1+i) (1+i)2 (1+i)n

n
NPV = At - Co
t=1 (1+k)t
Where At is cash inflow in period t, Co cash outflow, k opportunity cost of capital and t the time
period.
THE FOLLOWING STEPS ARE INVOLVED IN THE CALCULATION OF NPV:
Cash flows of the investment projected should be forecasted based on
realistic assumptions.

Appropriate discount rate should be identified to discount the forecasted
cash flow. The appropriate discount rate is the firms opportunity cost of
capital which is equal to the required rate of return expected by investors
on investments of equivalent risk.

Present value of cash flows should be calculated using opportunity cost
of capital as the discount rate.

Net present value should be found out by subtracting present value of
cash out flows from present value of cash inflows.
The project should be accepted if NPV is positive (i.e. NPV >0)

ACCEPTANCE RULE : NPV METHOD
It should be clear that the acceptance rule using the NPV method is to
accept the investment project if its net present value is positive (NPV>0)
and to reject it if the net present value is negative (NPV<0).

The market value of the firms share would increase if projects with positive
net present values are accepted. This will be so because the positive net
present value will result only if the project would generate cash inflows at
a rate higher than the opportunity cost of capital.

A project may be accepted if NPV=0. A zero NPV implies that project
generates cash flows at a rate just equal to the opportunity cost of capital.

Thus the NPV acceptance rules are:
Accept NPV > 0
Reject NPV < 0
May accept NPV = 0
INTERNAL RATE OF RETURN (IRR) METHOD
The internal rate of return can be defined as that rate
which equates the present value of cash inflows with
the present value of cash out flows of an investment.
In other words, it is the rate at which the net present
value of the investment is zero.

It is called internal rate because it depends solely on the outlay and
proceeds associated with the investment and not on any rate determined
outside the investment.

Hence, the internal rate of return (IRR) method is another discounted cash
flow technique which takes account of the magnitude and timing of cash
flows.
CONTD..
The IRR can be determined by solving the following equation for r :
Co = C1 + C2 + C3 + .. + Cn
(1+r) (1+r)2 (1+r)3 (1+r)n

n
C0 = Ct
t=1 (1+r)t
or,
n
Ct - C0 = 0
t=1 (1+r)t
It can be noticed that the IRR equation is the same as the one used for the NPV method with the difference
that in the NPV method the required rate of return, k, is assumed to be known and the net present
value is found, while in the IRR method the value of r has to be determined at which the net present
value is zero.


ACCEPTANCE RULE : IRR METHOD
The accept-or-reject rule, using the IRR method, is to accept
the project if its internal rate of return is higher than the
opportunity cost of capital (r > k). Note that k is also known
as the required rate of return, or the cutoff, or hurdle rate.
The project shall be rejected if its internal rate of return is
lower than the opportunity cost of capital (r < k). The
decision maker may remain indifferent if the internal rate of
return is equal to the opportunity coat of capital.

Thus the IRR acceptance rules are:
Accept r > k
Reject r < k
May accept r = k
PAYBACK (PB) METHOD
The payback (PB) is one of the most popular and widely recognized
traditional methods of evaluating investment proposals.
It is defined as the number of years required to recover the
original cash outlay invested in a project.
If the project generates constant annual cash inflows, the payback period
can be computed by dividing cash outlay by the annual cash inflow i.e.

PAYBACK = INITIAL INVESTMENT = C0
ANNUAL CASH INFLOW C

In case of unequal cash inflows, the payback period can be found out by
adding up the cash inflows until the total is equal to the initial cash outlay.
ACCEPTANCE RULE: PAYBACK METHOD
Many firms use the payback period as an accept or
reject criterion as well as a method of ranking
projects. If the payback period calculated for a
project is less than the maximum payback period set
by management, it would be accepted; if not, it
would be rejected.

As a ranking method, it gives highest ranking to the
project which has shortest payback period and
lowest ranking to the project with the highest
payback period. Thus, if the firm has to choose
among two mutually exclusive projects, project with
shorter payback period will be selected.
DISCOUNTING PAYBACK PERIOD
The number of periods taken in recovering the
investment outlay on the present value basis is
called the discounting payback period.

One of the serious objections of the payback method is that it
does not discount the cash flows for calculating the payback
period. However, the discounted payback period still fails to
consider the cash flows occurring after the payback period.
COST OF CAPITAL
CONCEPT OF COST OF CAPITAL:
The discount rate is the projects
opportunity cost of capital (or simply the cost of capital) for discounting
its cash flow.

The projects cost of capital is the minimum acceptable rate of return on
funds committed to the project.

The firms cost of capital will be the overall, or average, required rate of
return on the aggregate of the investment projects.

Therefore,
The cost of capital is the minimum required rate of return on
the investment project that keeps the present wealth of the share
holders unchanged.

DETERMINING COMPONENT COST OF CAPITAL
The component cost of a specific source of capital is equal to the investors
required rate of return.

But the investors required rate of return should be adjusted for taxes in
practice for calculating the cost of specific source of capital to the firm. In
the investment analysis, net cash flows are computed on after-tax basis,
therefore, the component costs, used to determine the discount rate,
should also be expressed on an after-tax basis.

Thus, the methods of computing the component costs of three major sources
of capital are:
Debt,
Preference shares,
Equity shares.

contd.
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
The composite, or overall cost of capital is the weighted average of the costs
of various sources of funds, weights being the proportion of each source
of funds in the capital structure.
Hence, once the component costs have been calculated, they are multiplied
by the weights of the various sources of capital to obtain a weighted
average cost of capital (WACC).

The following steps are used to calculate the weighted average cost of
capital:
To calculate the cost of the specific sources of funds (i.e. cost of debt,
cost of equity, cost of preference capital etc.).
To multiply the cost of each source by its proportion in the capital
structure.
To add the weighted component costs to get the firms weighted average
cost of capital.
THE MECHANICS OF COMPUTING THE WEIGHTED AVERAGE COST
OF CAPITAL IS SHOWN BELOW:
The following is the capital structure of the firm:
Source of finance Amount (Rs.)
Proportion (%)
Equity (paid-in) share capital 450000 45
Retained earnings (Reserves) 150000 15
Preference share capital 100000 10
Debt 300000 30
1000000 100
The firms expected after-tax component costs of the various sources of
finance are as follows:
Source Cost (%)
Equity capital 18.0
Retained earnings 18.0
Preference capital 11.0
Debt 8.0

contd.
CONTD.
The weighted average cost of capital of the firm, based on the existing
capital structure is computed as follows:
COMPUTATION OF WEIGHTED AVERAGE COST OF CAPITAL
Source Amount Proportion After-tax Cost Weighted Cost
(1) (2) (3) (4) (5)=(3)X(4)
Equity capital 450000 .45 .18 .081
Retained earnings 150000 .15 .18 .027
Preference capital 100000 .10 .11 .011
Debt 300000 .30 .08 .024
1000000 1.00 .143
Weighted Average Cost of Capital ko=
14.3%
The weighted average cost of capital of the firm can alternatively be calculated as
follows:
COMPUTATION OF WEIGHTED AVERAGE COST OF CAPITAL
Source Amount After-tax Cost (Rate) After-tax Cost
(1) (2) (3) (4) =(2)X(3)
Equity capital 450000 .18 81000
Retained earnings 150000 .18 27000
Preference capital 100000 .11 11000
Debt 300000 .08 24000
1000000 143000
Weighted Average Cost of Capital, ko = Rs. 143000 X 100 = 14.3%
Rs. 100000


CAPITAL ASSET PRICING MODEL (CAPM)
Capital Asset Pricing Model (CAPM), an important tool used to analyze the
relationship between risk and rate of return.
STEPS IN THE CAPM APPROACH
STEP 1: Estimate the risk-free rate, rRF.
STEP 2: Estimate the current expected market risk premium, RPM, which is the
expected market return minus the risk-free rate.
STEP 3: Estimate the stocks beta coefficient, bi, and use it as an index of the
stocks risk. The i signifies the ith companys beta.
(The relevant risk of an individual stock, which is called its beta
coefficient, is defined under the CAPM as the amount of risk that the
stock contribute to the market portfolio).
STEP 4: Substitute the preceding values into the CAPM equation to estimate
the
required rate of return on the stock:
rs = rRF + (RPM)bi
Where as, rs is the cost of common equity raised internally by reinvesting earnings. Thus, if a
company cannot earn atleast rs on reinvested earnings, then it should pass those earnings
on to its stockholders and let them invest the money themselves in assets that do provide
rs.
AN ILLUSTRATION OF THE CAPM APPROACH
To illustrate the CAPM approach for firm ABC, assume that rRF=8%, RPM=6%,
and bi=1.1, indicating that the firm ABC is some what riskier than average.
Therefore, ABCs cost of equity is 14.6%:

rs = 8% + (6%) (1.1)
= 8% + 6.6%
= 14.6%

It should be noted that although the CAPM approach appears to yield an
accurate, precise estimate of rs, it is hard to know the correct estimates of
the inputs required to make it operational because:
1. It is hard to estimate precisely the beta that investors expect the company
to have in the future, and
2. It is difficult to estimate the market risk premium.

Despite these difficulties, surveys indicate that CAPM is the preferred choice
for the vast majority of companies.
MODIGLIANI & MILLER (MM): MODERN CAPITAL
STRUCTURE THEORY (1958)
Modigliani and Miller: No Taxes
Assumptions:
1. There are no brokerage cost.
2. There are no taxes.
3. There are no bankruptcy cost.
4. Investors can borrow at the same rate as
corporations.
5. All- investors have the same information as
management about the firms future investment
opportunities.
6. EBIT is not affected by the use of debt.

IF MM ASSUMPTIONS HOLD TRUE:
MM proved that a firms value is unaffected by its capital structure, hence
the following situation must exist:
VL = VU = SL + D
Here VL is the value of a levered firm, which is equal to VU, the value of an
identical but unlevered firm. SL is the value of the levered firms stock,
and D is the value of its debt.

Recall that the WACC is a combination of the cost of debt and the relatively
higher cost of equity (rs)- if MM assumptions are correct, it does not
matter how a firm finances its operation, so capital structure decisions
would irrelevant
i.e. As leverage increases, more weight is given to low-cost debt, but
equity gets riskier, driving up rs. Under MMs assumptions, rs increases
by exactly enough to keep the WACC constant.

WHAT IF SOME OF THE MM ASSUMPTIONS ARE
RELAXED:
1. Modigliani and Miller: The Effect of Corporate Tax
2. Modigliani and Miller: Trade Off Theory (relaxed the assumption of no
bankruptcy cost).
3. Modigliani and Miller: Signaling Theory.