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PROJECT PLANNING AND EVALUATION

Capital Investment (Meaning & Definition)

The act of placing capital into a project or business with the intent of making a profit on the

initial placing of capital. An investment may involve the extension of a loan or line of credit,

which entitles one to repayment withinterest,or it may involvebuying an ownership stake in a

business, with the hope that the business will become profitable. Investing may also involve

buying a particular asset with the intent to resell it later for a higher price. Many types of

investing exist, and each is subject to greater or lesserregulation in the jurisdiction in which it

takes place. Legally,investing requires the existence and protection of individualproperty rights.

Investing wisely requires a combination of astuteness, knowledge of themarket,and timing.

The term Capital Investmenthas two usages in business. Firstly, Capital Investment refers to

money used by a business to purchasefixed assets,such as land, machinery, or buildings.

Secondly , Capital Investment refers to money invested in a business with the understanding that

the money will be used to purchase fixed assets, rather than used to cover the business' day-to-

day operating expenses.

http://financial-dictionary.thefreedictionary.com/Capitalhttp://financial-dictionary.thefreedictionary.com/Profithttp://financial-dictionary.thefreedictionary.com/Loanhttp://financial-dictionary.thefreedictionary.com/Line+of+Credithttp://financial-dictionary.thefreedictionary.com/Interesthttp://financial-dictionary.thefreedictionary.com/Buyinghttp://financial-dictionary.thefreedictionary.com/Assethttp://financial-dictionary.thefreedictionary.com/Pricehttp://financial-dictionary.thefreedictionary.com/Regulationhttp://financial-dictionary.thefreedictionary.com/Investinghttp://financial-dictionary.thefreedictionary.com/Property+Rightshttp://financial-dictionary.thefreedictionary.com/Markethttp://sbinfocanada.about.com/od/accounting/g/assets.htmhttp://sbinfocanada.about.com/od/accounting/g/assets.htmhttp://financial-dictionary.thefreedictionary.com/Markethttp://financial-dictionary.thefreedictionary.com/Property+Rightshttp://financial-dictionary.thefreedictionary.com/Investinghttp://financial-dictionary.thefreedictionary.com/Regulationhttp://financial-dictionary.thefreedictionary.com/Pricehttp://financial-dictionary.thefreedictionary.com/Assethttp://financial-dictionary.thefreedictionary.com/Buyinghttp://financial-dictionary.thefreedictionary.com/Interesthttp://financial-dictionary.thefreedictionary.com/Line+of+Credithttp://financial-dictionary.thefreedictionary.com/Loanhttp://financial-dictionary.thefreedictionary.com/Profithttp://financial-dictionary.thefreedictionary.com/Capital

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Types of Investment :

Following are the types of Capital Investment

1. Physical

2. Monetary assets

3. Intangible

4. Strategic Investment

5. Tactical Investment

6. Mandatory Investment

7. Replacement

8. Expansion

9. Diversification

10. R & D Investment

11. Miscellaneous

Analyzing different types of capital investment projects and investing in the most profitable

projects is what gives life and growth to a company. Unless a company conducts the necessary

research and development to develop new products, to improve existing products or services, and

to discover ways to operate more efficiently, that company and the economy in which it operates

will stagnate.

Companies of any size, and entrepreneurs starting a new business, do and should have a

Research and Development Department. That department, along with usually a committee

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composed of finance, marketing, technology, and other executives are charged with coming up

with ideas to improve the company and the products and services offered by the company.

Research and development is not free to a company. It is a cost/benefit operation. Well-managed

firms go to great lengths to develop good capital budgeting proposals that provide value to the

firm and the economy at large.

There are numerous types of capital budgeting projects as discussed below:

1. New Projects: New products or new markets

A new capital investment project is important for the growth and expansion of a company. It is

also important for the economy at large as it means research and development. This type of

project is one that is either for expansion into a new product line or into a new product market,

often called thetarget market.

A new product or a new target market could, conceivably, change the nature of the business. It

should be approved by higher-ups in the business organization. A new project, either a new

product or a new target market, requires a detailed financial analysis and the approval of possibly

even the firm's Board of Director's.

An example of a new product would be a new medical device that is conceived, researched and

developed by a company specializing in medical devices. Perhaps this medical device would tap

into a target market that the company had not yet been able to reach.

2. Expansion of existing products or markets

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The expansion of existing products or target markets means an expansion of the business. If a

company undertakes this kind of capital budgeting product, they are effectively acknowledging a

surge in growth of demand. A detailed financial analysis is required, but not as detailed as that

required for the expansion of the company into new products or new target markets.

3. Replacement project necessary to continue operations as usual

An example of a replacement project necessary to continue operations as usual would be, in a

manufacturing plant, replacing a worn out piece of equipment with a new piece of the same

equipment designed to do the same job. This is a simple capital budgeting project to evaluate. It

would be possible to use one of thesesimpler capital budgeting methods to evaluate this project

and abide by the decision of the capital budgeting method.

The cash flows from a replacement project necessary to continue operations as usual are fairly

easy to estimate, at least compared to other types of projects, because the business owner is

replacing the same type of equipment and is, therefore, somewhat familiar with it.

4. Replacement project necessary to reduce business costs

During theGreat Recession,many companies have been looking at this type of capital project.

Sometimes, businesses need to replace some projects with others in order to reduce costs. An

example would be replacing a piece of obsolete equipment with a more modern piece of

equipment that is easier to have serviced. This type of capital budgeting project would require a

detailed financial analysis with cash flows estimated from each piece of equipment in order to

determine which generates the most in cash flows and, thus, saves money.

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Difficulties in capital investment

The capital investment decisions suffer from a many constraints generally. The sum of capital

which an organization collects is restricted and thus it gets the restraint on the firms choice

down to an extent, over several project investments. When the firms debt is raised, the firms

debt-equity ratio too is increased and thus it gets hard for a business to be able to increase more

debts.

Making strategic capital investment decisions which are consistent could also be problematic

because a lot of people prefer usingcapital investment appraisal techniques which increases the

chances of having their favorites projects accepted. In a lot of cases, capital investment decisions

are reached subjectively and financial techniques are put in to use to rationalize, once the capital

investment decision has been made.

Most of the investment projects which are strategic have problems which are ill-structured,

calling for an approach which might never have been ever put to use before, thus, complexity,

novelty, irreversibility and ambiguity characterize these capital investment decision projects. Its

important that we recognize thus and put the strategies in place to deal with such issues and

problems because if you make one wrong capital investment decision, then it can impact a

businesss value negatively thereby making creditors and investors not really willing or keen to

fund the business any time in future.

The capital investment decision of project ranking plays a crucial role in capital investment

decisions. Depending upon the kind of project a firm has at a particular point of time, the

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companies prioritize the various projects. Project ranking is dependent on the fact as to how

much would a particular project return as well as which project has the ability to provide the

business, a maximum value. There are a lot of measures which

give an estimate of the firms return over several investment projects. To be able to determine a

specific projects value, the three most common used methods are - payback method, net present

value method, and the IRR methods. These are the different kind of methods which are put to use

while taking capital investment decisions.

Phases of Capital Budgeting

Capital budgeting is a very complex process which can be divided into five phases:

Planning-The planning phase of a firms capital budgeting process is concerned with

verbalization of its wide investment strategy and the creation and preliminary screening of

project proposals. The investment strategies of the firm describe the wide areas or types of

investments the firm plants to undertake. These give the framework which shapes, guides, and

define the identification of individual project opportunities.

Once a project proposal is recognized, it needs to be examined. To start with, a preliminary

project analysis is done. An introduction to the full blown possibility study, this exercise is

meant to judge (i) whether the project is prima-facie worthwhile to assess a possibility study and

(ii)what aspect of the project are grave to its visibility and thus warrant an in depth

investigation.

Analysis-If the preliminary screening proposes that the project is prima facie meaningful, a

detailed analysis of the marketing, technical, financial, economic, and ecological aspects is

undertaken. The questions and issues aroused in a detailed analysis are described in the

following section. The center of this phase of capital budgeting is on gathering, preparing and

resizing relevant information about various project proposals which are being considered for

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inclusion in the capital budget. Based on the information developed in this analysis, the flow of

costs and benefits with the project can be defined.

Selection-Selection follows, and usually overlaps, analysis. It addresses that -Whether the project

worthwhile? A broad range of appraisal criteria have been suggested to evaluate the worth while

ness of a project. They are usually divided into two broad categories, viz, non- discounting

standard and discounting standard. The main non-discounting standard is the payback time and

the accounting rate of return and the benefit cost ratio. To apply the various appraisals standard

cut-off principles have to be specified. These are fundamentally a function of the blend of

financing and the intensity of project risk. While the former can be defined with comparative

simplicity, the latter strictly tests the capability of the project evaluator. Certainly, in spite of a

wide range of tools and techniques for risk analysis (sensitivity analysis, Monte simulation,decision tree analysis, portfolio theory, capital asset pricing model, and the like), risk analysis

remains the most inflexible part of the project valuation exercise.

Implementation-The implementation phase for business project that involves setting up of

industrial facilities that consists of several stages such as

1. Projectand engineering designs

2. Negotiations and contracting3.Construction

4.Training, and

5.Plant commissioning

Translating an investment suggestion into a material is a complex, time- consuming, and risk

burdened task. Delays in implementation that are common, can lead to considerable cost

overruns. For speedy implementation at a rational cost, the below are helpful.

1. Adequate Formulation of Projects.

A major reason for the delay is not enough for formulation of projects. In other words, if

necessary homework in terms of preliminary studies and complete and detailed formulation of

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the project is not done, many surprises and shocks are likely to spring on the way. Thus the need

for sufficient formulation of the project cannot be greater.

2. Use of the Principle of Responsibility Accounting. Conveying specific responsibilities to

project managers for implementation of the project within the defined time-frame and cost limits

is supportive in quick execution and cost control.

3. Use of Network Techniques. For project planning and control two basic techniques are

available

4. PERT (Programmed Evaluation Review Technique) and CPM (Critical Path Method).

With the help of these methods, monitoring becomes easier.

Review-Once the project is made to order the review phase has to be set in motion. Performance

review should be done from time to time to evaluate actual performance with probable

performance. A feedback device can be useful in several ways.

(i) It throws light on how realistic were the suppositions underlying the project;

(ii) It provides a documented record of experience that is extremely valuable in future decision

making;

(iii) It proposes corrective action to be taken in the light of actual presentation;

(iv) It helps in finding judgmental biases;

(v) It encourages a desired warning among project sponsors.

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Decision Making LevelsinCapital Budgeting

For planning and control process, three levels of decision making have been identified:

1. Operating capital budgeting2. Administrative capital budgeting3. Strategic capital budgeting

Capital budgeting decisions could be categorized into these three decision levels.

1. Operating capital budgeting- This may include routine minor expenditures, such asexpenditure on office equipment. The lower or the middle level management can easily

handle the operating capital budgeting decisions.

2. Administrative capital budgeting- This involves medium-size investments such asexpenditure on expansion of existing line of business. Administrative capital budgeting

decisions are semi-structured in nature, and they may also involve some options, such as

option to delay. Generally, the senior management is assigned the responsibility of

handling these decisions.

3. Strategic capital budgeting - This involves large investments such as acquisition of anew business or expansion in a new line of business. Strategic investments are unique

and unstructured and involve simple or complex options, and they cast a significant

influence on the direction and value of the business. Top management, therefore,

generally handles such investments.

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Facets of Project Analysis

Analysis of sponsoring firms and project companies illustrates how financing structures affect

managerial investment decisions and subsequent cash flows. The project analysis mainly covers-

market analysis, technical analysis, financial analysis and economic and ecological analysis.

These are detailed below:

1. Market Analysis - Market analysis is concerned primarily with two questions ofaggregate demand andmarket share for the business in future. To answer the

above qu es tions, appr opriateforecasting methods and following information is required:

Present Supply position and forecast Production possibilities and constraints Other competing projects in the state Consumption trends in the past and the present consumption level Import and export Structure of competition Costs structure Elasticity of demand Consumer behavior, intentions, motivations Distribution channels and marketing policies in use Administrative, technical and legal constraints

2. Technical Analysis -Technical and engineering analysis seeks to determine whether theprerequisite for thesuccessful commiss ioning of th e pro ject have been

considered and reasonably goodchoices have been made with respect to location,

size, process etc. The criteria being

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Status of preliminary tests and studies for the project Availability of fuel, water, and other in outs Scale of operation and technology- is it suitable? Provision and requirement if affluent treatment Project schedules- is it realistic?

3. Financial Analysis - Financial analysis seeks to ascertain whether the proposedpro ject will be fi nancia llyviable and give satisfactory returns to the investor. It also

shows that the project is ableto meet the burden s ervi cing debt . The main aspect s

that have been looked into whileconducting financial appraisal are:

Investment outlay and capital cost of project; Means of financing including interest rates and repayment schedules Cost of capital Projected profitability Cash flows of the project Projected financial position Level of risk in the project4. Economic and Ecological Analysis - Economic analysis, also referred to as social

cost benefit analysis, is co ncerned with judging a proje ct from the larger

soci al poi nt of view. Environment is ano the r i ssue ,which needs special attention,

particularly for large projects such as power projects. Themajor issues are:

D i r e c t e c o n o m i c b e n e f i t s a n d c o s t s o f t h e p r o j e c t m e a s u r e di n t e r m s o f efficiency.

Impact of the project on the level of savings and investment in the society

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Contribution of the project towards the fulfillment of certain merit likese lf sufficiency, employment and social order

Environmental impact

Objectives of Capital Budgeting

1. Establish cost guidelines and benchmarks to assist analysts in budget development.2. Clarify our understanding of funding constraints and conditions to make it easier to correctly

align project types with funding sources.

3. By taking a more comprehensive approach to the budget development and implementationcycle, eliminate low-value tasks and help all participants focus on the most important issues.

4. Improve tools for the budget processes to reduce the burden of administrative tasks andincrease time available for analysis and decision-making.

5. Ensure better connections between the operating and capital budgets.6. Improve the allotment and monitoring processes to reduce time spent on non-value added

tasks.

7. Improve the guidance available for everyone involved in the capital budget process.8. Make better use of information about facility needs and conditions for budget development

and monitoring.9. Streamline the budget bill process.Limitations of Capital Budgeting

1. It has long term implementations which can't be used in short term and it is used asoperations 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.

2. Inadequate investment makes it difficult for the company to increase it budget and thecapital.

3. Capital budgeting involves large number of funds so the decision has to be takencarefully.

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4. Decisions in capital budgeting are not modifiable as it is hard to locate the market forcapital goods.

5. The estimation can be in respect of cash outflow and the revenues/saving and costsattached which are with projects.

Capital Structure

Meaning:- Capital structure presents the mix between different sources of finance basically long

term sources of finance, eg. Equity, preference, debentures, bonds, retained earnings etc.

The term capitalization is used for the total long term sources of finance. E. capital structure of

the company consists of Rs. 100000.00 in equity, Rs. 100000.00 in preference shares, and Rs.

50000.00 in retained earnings.

Capital Structure and Financial Structure:-

The term capital structure is different from financial structure. Financial structure refers to the

ways the firms assets are financed. In other words it includes both long term as well as short term

sources of funds. But capital structure is permanent financing of company represented primarily

by long term debt and shareholders funds excluding short term credits.

Pattern of capital structure:-

Basically there are 4 patterns of capital structure:-

1. With equity shares only2. With both equity and preference shares only3. With equity and debentures4. With equity shares, preference shares and debentures.

The choice of an appropriate capital structure depends upon the number of factors such as natureof company, business, earning of the company, condition of money market, attitude of investor

etc.

Debt is the liability on business hence interest has to be paid irrespective of companies profit

while equity consist of shareholders or owners funds on which payment of dividends depends

upon the availability of profits.

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A high proportion of debt content in capital structure increases the risk and may lead to financing

insolvency. However raising funds through debt is considered as cheaper source of finance rather

raising the funds through equity and preference shares. Reason for the same is interest on

debentures is considered as an expense and deductable for tax purpose.

Optimum Capital Structure:-

A firm try to maintain the optimum capital structure with a view to maintain financial stability,

the optimum capital structure is maintained when the market value per equity share is maximum,

in the value of the firm in stock exchange.

Optimum structure is defined as that mix of debt and equity which will maximize the market

value of the company.

Considerations:-

Following are the considerations will greatly helps the finance manager in achieving his goals ofoptimum structure.

1. He should take advantage of favorable financial leverage. In the other words if Return oninvestment is higher than the fixed cost of funds, he may prefer raising funds having

fixed cost to increase the return on equity.

2. He should take advantage of leverage offered by the corporate taxes.3. He should avoid a perceived high risk capital structure because if the equity shareholders

perceive an excessive amount on debt then the price of the equity will go down and

depress the market price of the equity shares.

Capital Structure theories:-

Basically there are four theories of capital structure:-

1. Net income approach2. Net operating income approach3. Modigilani-Millor approach4. Traditional Approach

Capital structure theories deal with the fact whether capital structure decisions are relevant to

the valuation of firm or not.

Assumptions:-

1. The firm employees only 2 types of capital

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(a)Debentures(b)Equity2. There are no corporate taxes, this assumption has been removed later.3. The firm pays 100% of its earning as dividends.4. Firms total assets does not change, that is investment decisions are assumed to be

constant.

5. Firms total financing remains constant, the firm can change its capital structure either byredeeming the debentures by issue of shares or by raising more debentures.

6. EBIT remains constant7. Business risk remains constant8. Firm has perpetual life.

NI Approach:-

Suggested by Durand David, According to him, capital structure decision is relevant to the

valuation of the firm. In the other word change in capital structure causes a change in overall cost

of capital as well as value of the firm.

According to this approach higher debt content in the capital structure will result in decline in the

overall cost of capital or WACC. This will cause increase in the market value of the firm and

consequently increase in the value of equity shareholders.

Assuptions:-

1. No taxes2. Cost of Debt is less than the cost of equity rate3. Use of debt does not change the risk perception of the investor.

Value of the firm on the basis of NI approach can be ascertained as follows:-

V=S+B

V= Value of the firm

S= Market value of Equity shares

B= Market value of the Debt

So the market value of the equity is =>

S= NI/Ke

Ke= equity capitalization rate

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Net operating Income Approach:-

This approach is also suggested by Durand David, just opposite of NI approach. According to

this approach the market value of the firm is not at all affected by the capital structure changes.

Market value of the firm is ascertained by capitalizing net operating income at overall cost of

capital which is considered as constant. The market value of equity is ascertained by deducting

the market value of debt from the market value of the firm.

Assumptions:-

1. Overall cost of capital remains constant.2. Market capitalizes the value of the firm as a whole and therefore, the split between debt

and equity is not relevant.

3. No corporate taxes4. Use of debt increases the risk of equity shareholders.

Value of the firm:=>

V=EBIT/Ko

S=V-B

Validity of NOI Appraoch can be verified by the calculations of the overall cost of capital

Ko=Kd(B/V)+Ke(S/V)

Ko= overall cost of capital

Kd= cost of debentures/Debenture capitalization rate

B= Total Debt

S= Total Equity shares

V= Value of the firm

Ke= Equity capitalization rate

According to the NOI approach, the market price per share remains unaffected in account of

change in debt equity mix.

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MM Approach

It is similar to NOI approach, according to this approach the value of the firm is independent of

its capital structure. But NOI approach and MM approach is different from each other because

NOI is purely definitional or conceptual based, it does not provide any operational justification

for irrelevance of capital structure.

But MM approach provides behavioral/ Operational justification. MM approach maintains that

WACC does not change with the change in the debt equity mix or capital structure of the firm. It

also gives operational justification of the same.

Basic propositions:-

1. The overall cost of capital and the value of the firm are independent of the capitalstructure, hence Ko and V remains constant.

2. Ke= Equity capitalization rate + Premium for the financial risk.3. The cut off rate for the investment is completely independent of the way in which an

investment is completely independent of the way in which an investement is financed.

Assumption:-

1. Perfect capital market2. All firms are classified into homogeneous risk class. All firms with the same class willhave the same degree of business risk.

3. All investors have same expectations of firms NOI.4. Dividend payout ration is 100%, in the other word there is no retained earnings.5. No Corporate taxes.

MM approach provides behavioral justification which is the process of arbitration:-

Arbitration process:- it refers to the act of buying an asset/ Security in one market having lower

price and selling it to another market having higher price. The consequence of such action is that

the market price of securities of the two firms will become similar in all respects.

The use of debt by investor for arbitrage is called home made or personal leverage.

This can be understand with the help of example.

Illustration:-Two firms A & B, are identical in all respect except that the firm A has 10% of Rs.

50000 debentures. Both firms have same earnings before intt and taxes amounted to Rs.

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In order to make similar amount of risk, Mr X borrows Rs. 5000 with intt rate of 10% to equalize

the impact of levered firm, so intt paid will be Rs.500.00

III Mr. X position with Firm B with overall investment in shares

(a)Total investment (3125+5000)= 8125(b)Total income (10000/80000)*8125 = 1016

Intt paid on loan= (-) 500

Income = Rs. 516.00

Hence Mr. X is now in better position, and this situation will continue till the market will be in

equilibrium.

MM Hypothesis with Corporate Taxes

If the corporate taxes are introduced, the value of the firm will increase and cost of capital will

decline. This is tax deduction on intt payment because of which effective cost of borrowing is less

than the contractual rate of intt.

Vl= Vu + Bt

Vl= Value levered firm

Vu=Value of unlevered firm

B= Amount of debt debt

t = tax rate

The optimum capital structure is not one which has maximum amount of debt. But one which has

desired amount of debt.

Vu= S

Vu is market value of unlevered firm will be equal to the market value of its share.

S= Market Value of equity

Vu=(1-t)EBT/Ke

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Traditional approach:-

It is midway between NI and NOI approach, according to NI approach, the cost of capital and

total value of the firm is dependent on capital structure, and according to NOI approach cost of

capital and value of the firm is independent on capital structure. It particularly contains the

features of both the approaches as given below:-

1) Traditional approach is similar to NI approach to the extent it accepts the capital structure or

leverage of the firm affects the cost of capital and its valuation. However it does not subscribe to

NI approach that the value of the firm will necessarily increase with the degree of leverage.

2) It subscribe to NOI approach that beyond a certain degree of leverage, the overall cost of

capital increase resulting in decrease in total value of the firm, however it differs from NOI

approach in the sense that the cost of capital will not remain constant for all degree of leverage.

The essence of the traditional approach lies in the fact that a firm through judicious use of debt

equity mix can increase its total value and reduction in cost of capital. Debt is considered as

cheaper source of finance as compared to shares because of tax advantage. However beyond a

point raising of funds though debt may become financial risk and would result in higher equity

capitalization rate. Up to a point, the content of debt in the capital structure will favorable affect

the value of firm but beyond a point, the use of debt adversely affect the value of the firm.

Factors determining capital structure:-

In case of unlevered firm there is no debt so EBIT means EBT, no intt on debt content.

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1. Trading on equity:- if the rate of return(ROI) on total capital employed is more than therate of intt on debentures or rate of dividend on preference shares, it is said that companyis trading on equity.If the company is trading on equity then the funds can be raised by using the mix of

debentures, preference shares and equity so that the company may be in position to pay

higher rate of return on equity funds.

Limitations:-

(a)only possible when company have trading on equity(b)Trading on equity is beneficial only when company have stability in their earnings.(c)Every rupee extra borrowing increases the risk and hence the rate of intt expected by

the lenders goes on increasing. Thus, borrowing become costlier source of financewhich ultimately result in increasing the cost and reducing the amount of profit.

2. Retaining Control:-As we know that preference shareholders and debenture holdershave not much say in management of the company, if promoters that is equityshareholders need extra source of funds and they do not want to lose their grip over theaffairs of the company they will prefer preference shares or debentures over the equity.

3. Nature of enterprise:- Business enterprise which have stability in their earnings orenjoy monopoly regarding their product may go for preference/debentures since theywill have adequate profits to meet the cost of fixed dividend/ intt. Eg. Public utilityconcerns.

4. Legal requirements:- promoters of the company have also to keep in view the legalrequirements while deciding capital structure.

5. Purpose of Financing:- if the funds are required for some directly productive purposelike for purchase of new machinery company can afford to raise the funds by issue ofdebentures on the other hands, if the funds are required for non productive purposethen the company should raise the funds by issue of equity shares.

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6. Period of finance:- in case, funds are required for 8-10 years , company should go fordebentures because in case the funds are issued by shares, their repayment after 8-10years will be subject to certain legal restrictions/compliance.

7. Market sentiments:- there are the periods in which market where people want haveabsolute safety. It will be appropriate to raise funds through debenture. On the otherhand when people may be intt in earning high speculative income, it will beappropriate to raise the funds by issue of equity shares.

8. Size of company:- Company with small size have to rely considerably upon theowners fund for financing .

9. Govt. Policies:- Change in lending policy of financial institution may completelychange the financial pattern of the company. Policies made by SEBI, can afford thecapital structure decisions. Besides this, the monetary and fiscal policies of thegovernment also affect the capital structure decisions.

Capital structure practice in India:-

Several research and theories have been conducted regarding the choice of capital structure.

These studies revealed the following:-

Capital structure and cost of capital:-Traditional view, that the cost of capital is affected by

the debt and equity mix, still hold good. The study conducted by Sama and Roa and Pandey

confirmed this viewpoint. Chakrabortys study also revealed the same facts. According to this

study the average cost of capital for all consumer goods industry was highest while lowest for

intermediary goods industry. This was primarily because of low debt content in total capital

structure in case of former category of industry as compared to the latter.

Choice between Debt and equity:-the earlier studies conducted by Bhatt and Pandey revealed

that corporate managers generally prefer borrowings to owned funds because of advantage of

lower cost and no dilution of existing management control over the company, but recent study

conducted by Babu and Jain, it has been found that the firms in India are now showing almost an

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equal perforce for debt and equity in designing their capital structure. In the study conducted by

RBI on the basis of sample of about 1950 non govt companies covering the period from 1984-88

to 1997-98, it was disclosed that the relevant share of internal sources tended to decline, while

the external sources tended to move up in the total capital structure of the company.

Among the external sources, corporates reliance or debt financing has been much more thanequity financing. Thus the study conducted by RBI confirms the result of the study consutted by

Babu and Jain.

Share valuation:- According to the study conducted by Prasanna Chandra, a significant

relationship existed between the share price and the variables like return, risk, growth, leverage

etc. Thus the leverage or the debt equity mix in the capital structure is also one of the important

factor affecting the value of a share of the firm.

Determination of Optimum capital structure:-

It is already stated that at optimum capital structure, the value of equity share is maximum while

the average cost of capital is minimum. The value of equity share mainly depends upon earning

per share, so as long as ROI is more than the cost of borrowing, each rupee of extra borrowing

pushes up the earning per share in turn pushes up the market value of the share. However each

extra rupee borrowing increases the risk, therefore in spite of increasing EPS, Market Value of

equity may fall because investors taking it as more risky investment.

Increase in the risk may increase the value of the companys equity shares, because of investors

speculations in future profits. It will be impossible to precisely measure the fall in the market

value of equity on account of high profit risk cause due to high debt content. Market factors are

psychological, complex and do not follow accepted theoretical principals.

Thus it is not possible to find out the exact debt equity mix where the capital structure is

optimum. However the range of capital structure can be determined. It simply means, if the

company maintains capital structure with in this range, the value of the equity will not decline

due to more risk. In order to maintain maximum tax advantage on intt payable the company may

maintain debt equity ratio near the range keeping in view other factors like profitability,

solvency, control etc.

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Hence capital structure may arrived may not be optimum but it is preferable to use term

Appropriate or sound capital structure.

Diversification

Diversification strategies are used to expand firms' operations by adding markets, products,services, or stages of production to the existing business. The purpose of diversification is toallow the company to enter lines of business that are different from current operations. When thenew venture is strategically related to the existing lines of business, it is called concentricdiversification. Conglomerate diversification occurs when there is no common thread of strategic

fit or relationship between the new and old lines of business; the new and old businesses areunrelated.

DIVERSIFICATION IN THE CONTEXT OF GROWTH STRATEGIES

Diversification is a form of growth strategy. Growth strategies involve a significant increase inperformance objectives (usually sales or market share) beyond past levels of performance. Manyorganizations pursue one or more types of growth strategies. One of the primary reasons is theview held by many investors and executives that "bigger is better." Growth in sales is often usedas a measure of performance. Even if profits remain stable or decline, an increase in salessatisfies many people. The assumption is often made that if sales increase, profits will eventually

follow.

Rewards for managers are usually greater when a firm is pursuing a growth strategy. Managersare often paid a commission based on sales. The higher the sales level, the larger thecompensation received. Recognition and power also accrue to managers of growing companies.They are more frequently invited to speak to professional groups and are more often interviewedand written about by the press than are managers of companies with greater rates of return butslower rates of growth. Thus, growth companies also become better known and may be betterable, to attract quality managers.

Growth may also improve the effectiveness of the organization. Larger companies have a

number of advantages over smaller firms operating in more limited markets.

1. Large size or large market share can lead to economies of scale. Marketing or productionsynergies may result from more efficient use of sales calls, reduced travel time, reducedchangeover time, and longer production runs.

2. Learning and experience curve effects may produce lower costs as the firm gainsexperience in producing and distributing its product or service. Experience and large sizemay also lead to improved layout, gains in labor efficiency, redesign of products or

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development are eliminated would improve overall efficiency. Quantity discounts throughcombined ordering would be another possible way to achieve operating synergy. Yet anotherway to improve efficiency is to diversify into an area that can use by-products from existingoperations. For example, breweries have been able to convert grain, a by-product of thefermentation process, into feed for livestock.

Management synergy can be achieved when management experience and expertise is applied todifferent situations. Perhaps a manager's experience in working with unions in one companycould be applied to labor management problems in another company. Caution must be exercised,however, in assuming that management experience is universally transferable. Situations thatappear similar may require significantly different management strategies. Personality clashes andother situational differences may make management synergy difficult to achieve. Althoughmanagerial skills and experience can be transferred, individual managers may not be able tomake the transfer effectively.

CONGLOMERATE DIVERSIFICATION

Conglomerate diversification occurs when a firm diversifies into areas that are unrelated to itscurrent line of business. Synergy may result through the application of management expertise orfinancial resources, but the primary purpose of conglomerate diversification is improvedprofitability of the acquiring firm. Little, if any, concern is given to achieving marketing orproduction synergy with conglomerate diversification.

One of the most common reasons for pursuing a conglomerate growth strategy is thatopportunities in a firm's current line of business are limited. Finding an attractive investmentopportunity requires the firm to consider alternatives in other types of business. Philip Morris'sacquisition of Miller Brewing was a conglomerate move. Products, markets, and production

technologies of the brewery were quite different from those required to produce cigarettes.

Firms may also pursue a conglomerate diversification strategy as a means of increasing the firm'sgrowth rate. As discussed earlier, growth in sales may make the company more attractive toinvestors. Growth may also increase the power and prestige of the firm's executives.Conglomerate growth may be effective if the new area has growth opportunities greater thanthose available in the existing line of business.

Probably the biggest disadvantage of a conglomerate diversification strategy is the increase inadministrative problems associated with operating unrelated businesses. Managers from differentdivisions may have different backgrounds and may be unable to work together effectively.Competition between strategic business units for resources may entail shifting resources awayfrom one division to another. Such a move may create rivalry and administrative problemsbetween the units.

Caution must also be exercised in entering businesses with seemingly promising opportunities,especially if the management team lacks experience or skill in the new line of business. Withoutsome knowledge of the new industry, a firm may be unable to accurately evaluate the industry'spotential. Even if the new business is initially successful, problems will eventually occur.

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Executives from the conglomerate will have to become involved in the operations of the newenterprise at some point. Without adequate experience or skills (Management Synergy) the newbusiness may become a poor performer.

Without some form of strategic fit, the combined performance of the individual units will

probably not exceed the performance of the units operating independently. In fact, combinedperformance may deteriorate because of controls placed on the individual units by the parentconglomerate. Decision-making may become slower due to longer review periods andcomplicated reporting systems.

DIVERSIFICATION: GROW OR BUY?

Diversification efforts may be either internal or external. Internal diversification occurs when afirm enters a different, but usually related, line of business by developing the new line ofbusiness itself. Internal diversification frequently involves expanding a firm's product or marketbase. External diversification may achieve the same result; however, the company enters a new

area of business by purchasing another company or business unit. Mergers and acquisitions arecommon forms of external diversification.

INTERNAL DIVERSIFICATION.

One form of internal diversification is to market existing products in new markets. A firm mayelect to broaden its geographic base to include new customers, either within its home country orin international markets. A business could also pursue an internal diversification strategy byfinding new users for its current product. For example, Arm & Hammer marketed its baking sodaas a refrigerator deodorizer. Finally, firms may attempt to change markets by increasing ordecreasing the price of products to make them appeal to consumers of different income levels.

Another form of internal diversification is to market new products in existing markets. Generallythis strategy involves using existing channels of distribution to market new products. Retailersoften change product lines to include new items that appear to have good market potential.Johnson & Johnson added a line of baby toys to its existing line of items for infants. Packaged-food firms have added salt-free or low-calorie options to existing product lines.

It is also possible to have conglomerate growth through internal diversification. This strategywould entail marketing new and unrelated products to new markets. This strategy is the leastused among the internal diversification strategies, as it is the most risky. It requires the companyto enter a new market where it is not established. The firm is also developing and introducing anew product. Research and development costs, as well as advertising costs, will likely be higherthan if existing products were marketed. In effect, the investment and the probability of failureare much greater when both the product and market are new.

EXTERNAL DIVERSIFICATION.

External diversification occurs when a firm looks outside of its current operations and buysaccess to new products or markets. Mergers are one common form of external diversification.

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Since servicing is an important part of many products, having an excellent service departmentmay provide an integrated firm a competitive advantage over firms that are strictlymanufacturers.

Some firms employ vertical integration strategies to eliminate the "profits of the middleman."

Firms are sometimes able to efficiently execute the tasks being performed by the middleman(wholesalers, retailers) and receive additional profits. However, middlemen receive their incomeby being competent at providing a service. Unless a firm is equally efficient in providing thatservice, the firm will have a smaller profit margin than the middleman. If a firm is too inefficient,customers may refuse to work with the firm, resulting in lost sales.

Vertical integration strategies have one major disadvantage. A vertically integrated firm places"all of its eggs in one basket." If demand for the product falls, essential supplies are notavailable, or a substitute product displaces the product in the marketplace, the earnings of theentire organization may suffer.

HORIZONTAL DIVERSIFICATION.

Horizontal integration occurs when a firm enters a new business (either related or unrelated) atthe same stage of production as its current operations. For example, Avon's move to marketjewelry through its door-to-door sales force involved marketing new products through existingchannels of distribution. An alternative form of horizontal integration that Avon has alsoundertaken is selling its products by mail order (e.g., clothing, plastic products) and throughretail stores (e.g., Tiffany's). In both cases, Avon is still at the retail stage of the productionprocess.

DIVERSIFICATION STRATEGY AND MANAGEMENT TEAMS

As documented in a study by Marlin, Lamont, and Geiger, ensuring a firm's diversificationstrategy is well matched to the strengths of its top management team members factored into thesuccess of that strategy. For example, the success of a merger may depend not only on howintegrated the joining firms become, but also on how well suited top executives are to managethat effort. The study also suggests that different diversification strategies (concentric vs.conglomerate) require different skills on the part of a company's top managers, and that thefactors should be taken into consideration before firms are joined.

There are many reasons for pursuing a diversification strategy, but most pertain to management'sdesire for the organization to grow. Companies must decide whether they want to diversify bygoing into related or unrelated businesses. They must then decide whether they want to expandby developing the new business or by buying an ongoing business. Finally, management mustdecide at what stage in the production process they wish to diversify.

2. DIVERSIFICATION DEBATE

To diversify or not to diversify? For corporations in pursuit of a sound acquisitions strategy, this

is indeed the eternal question. Traditional wisdom holds that diversification offers protection

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against the vagaries of the business cycle. But throughout the mergers-and-acquisitions boom of

the 1990s, the business cycle seemed to have disappeared and a relentless focus on core

competencies was all the rage. Diversify if you must, the markets urged, but only if you can

demonstrate synergies between businesses as you do so.

Few companies mastered this feat as well as The Walt Disney Co., whose move into television

broadcasting made it the very model of a synergistic conglomerate. Of course, such companies

used to be called vertically integrated, and everyone who has forgotten the risks inherent in such

structures could learn a lesson from Disney's recent troubles in the capital markets. These days,

diversification is back in favor. But as with "synergies," the advantages of diversifying aren't

always what they seem, especially in the wake of September 11.

To be sure, Disney managed to raise $1 billion in two- and three-year notes the first day the

markets reopened after the attacks. But roughly $200 million of the debt was initially left in the

hands of Goldman Sachs, which underwrote all but 3 percent of the deal. Not surprisingly, some

three weeks later, Disney enlisted the help of nine underwriters besides Goldman to raise another

$830 million in yen-denominated medium-term notes, and in mid-October used six banks for

$275 million in 30-year bonds aimed at individuals.

The more underwriters an issuer needs, of course, the more it pays in fees. And Disney's capital

requirements remain considerable: It must finance the acquisition of Fox Family Worldwide, a

cable TV operation, for $5.2 billion in cash and assumed debt. Yet even before the terrorist

attacks, Disney's two most important business segments, theme parks and television advertising,

were suffering. And while the prospects of both have since shown some improvement, Disney's

difficulties have nonetheless led to its first credit downgrades since 1996, when it borrowed

heavily to finance the acquisition of Capital Cities/ABC.

"Most investors thought Disney was well diversified," notes Glenn Eckert, a senior analyst for

Moody's Investors Service. But he says the attacks, along with the economic downturn, have

revealed how closely correlated the travel and entertainment businesses can be. Yet anyone who

took Disney's own discussions of its strategy seriously shouldn't have been surprised, as success

was predicated on each of its business segments, in effect, feeding the others. CFO Thomas

Staggs recently told Bloomberg News Service that the company was comfortable with its

balance sheet and liquidity

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Portfolio Planning Models

Portfolio planning tools have been developed to guide the process of strategic planning and

resource allocation .

Three such tools are :-

BCG Matrix The General Electric Stoplight matrix & The Mckinsey matrix

BCG MATRIX

Developed by Boston Consulting Group , the BCG matrix classifies the various businesses in a

firm portfolio on the basis of relative market share and relative market growth rate .

The BCG matrix consists of four cells with market share on horizontal axis and market growthrate on the vertical axis .

The BCG matrix classifies businesses in four categories as described below :

Stars : Business which enjoy a high market share and high growth rate are referred to asstars. Though they earn high profits , they require additional commitment of funds

because of the need to make further investment for expanding their production and sales

.As growth declines and additional investment need diminish stars become cash cows .

Question Marks : Business with high growth potential but low present market share arecalled question marks . Additional resources are required to improve their market share

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1. To Finance fixed assets : Business requires fixed assets like machines, Building, furnitureetc. Finance required to buy these assets is for a long period, because such assets can be used fora long period and are not for resale.

2. To finance the permanent part of working capital:Business is a continuing activity. It must have a certain amount of working capital which would

be needed again and again. This part of working capital is of a fixed or permanent nature. Thisrequirement is also met from long term funds.

3. To finance growth and expansion of business:Expansion of business requires investment of a huge amount of capital permanently or for a longperiod.

Factors determining long-term financial requirements :

The amount required to meet the long term capital needs of a company depend upon manyfactors. These are :

(a) Nature of Business:

The nature and character of a business determines the amount of fixed capital. A manufacturingcompany requires land, building, machines etc. So it has to invest a large amount of capital for along period. But a trading concern dealing in, say, washing machines will require a smalleramount of long term fund because it doesnot have to buy building or machines.

(b) Nature of goods produced:

If a business is engaged in manufacturing small and simple articles it will require a smalleramount of fixed capital as compared to one manufacturing heavy machines or heavy consumeritems like cars, refrigerators etc. which will require more fixed capital.

(c) Technology used:In heavy industries like steel the fixed capital investment is larger than in the case of a businessproducing plastic jars using simple technology or producing goods using labour intensivetechnique.

The main sources of long term finance are as follows:

1. Shares:These are issued to the general public. These may be of two types:(i) Equity and (ii) Preference. The holders of shares are the owners of the business.

2. Debentures:These are also issued to the general public. The holders of debentures are the creditors of thecompany.

3. Public Deposits :

General public also like to deposit their savings with a popular and well established companywhich can pay interest periodically and pay-back the deposit when due.

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finance for supporting a concept or idea of an entrepreneur. The capital is provided forproduct development, R&D and initial marketing.

Expansion financing- This is the second stage financing for working capital andexpansion of a business. It involves development financing so as to facilitate the publicissue.

Acquisition/ buyout financing- This later stage involves:-i. Acquisition financing in order to acquire another firm for further growth

ii. Management buyout financing so as to enable the operating groups/ investors foracquiring an existing product line or business and

iii. Turnaround financing in order to revitalise and revive the sick enterprises.In India, the venture capital funds (VCFs) can be categorised into the following groups:-

Those promoted by the Central Government controlled development finance institutions,for example:-

ICICI Venture Funds Ltd. IFCI Venture Capital Funds Limited (IVCF) SIDBI Venture Capital Limited (SVCL)

Those promoted by State Government controlled development finance institutions, forexample:-

Gujarat Venture Finance Limited (GVFL) Kerala Venture Capital Fund Pvt Ltd. Punjab Infotech Venture Fund Hyderabad Information Technology Venture Enterprises Limited (HITVEL)

Those promoted by public banks, for example:- Canbank Venture Capital Fund SBI Capital Markets Limited

Those promoted by private sector companies, for example:- IL&FS Trust Company Limited Infinity Venture India Fund

Those established as an overseas venture capital fund, for example:-

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Walden International Investment Group SEAF India Investment & Growth Fund BTS India Private Equity Fund Limited

All these venture capital funds are governed by theSecurities and Exchange Board of India

(SEBI) . SEBI is the nodal agency for registration and regulation of both domestic and overseasventure capital funds. Accordingly, it has made the following regulations, namely,Securities andExchange Board of India (Venture Capital Funds) Regulations 1996 andSecurities andExchange Board of India (Foreign Venture Capital Investors) Regulations 2000.Theseregulations provide broad guidelines and procedures for establishment of venture capital fundsboth within India and outside it; their management structure and set up; as well as size andinvestment criteria's of the funds.

Profit-and-Loss Projection

Projection of your sales and expenses is the first step toward creating a cash flow budget that

your business can rely on. This profit and loss (P&L) projection is not intended to be a detailedfinancial statement. It is intended to act as a guide to help you forecast your company's sales andexpenses. The categories on the projection work sheet are arbitrary and should be changed toreflect your company's operations. After you've completed this projection, you may wish tocreate a more detailed P&L projection that reflects your business's sales and expenses on amonthly or quarterly basis.

How to use this projection:

Here are four steps to creating a P&L projection using this tool:

1.

Forecast sales:During the course of the next year, what are the lowest sales figures youcould expect? What are the highest? Break down your sales assumptions by product (orservice) lines, starting with the worst-case scenario. The product/service lines areplaceholders where you can insert products or services that reflect your business'soperations. The goal here is to get a handle on the worst possible situation. Then projectsales under the best possible conditions, with all of your sales efforts succeeding andcustomers flocking to your door.Once you've forecasted sales, record a forecast for the cost of goods sold. Use thecategories you've assigned to the sales forecast here, as well.

2. Forecast expenses:Identify all of the expenses that you'll incur to generate revenueunder both the low and high sales projections you've made. Unless your company is astart-up, you should review past operating statement and business records to derive thisinformation.

Costs that, whatever your sales level, are present and remain fairly constant should beentered as fixed expenses. They may include such expenses as rent/mortgage payments,

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certain taxes, leased equipment payments, and basic telephone and utilities expenses.Expenses that increase and decrease with production are considered variable expenses.They may include cost of goods sold, cost of sales, advertising, labor, and variableutilities.

Fixed expenses will most likely remain the same for best- and worst-case situations.When projecting variable expenses, many expenses will remain a constant percentage ofsales, but some will not. Payroll and payroll taxes may fluctuate as new hires are broughton to keep up with demand. Or advertising expenses may increase if you try to take overmore market share. If you're confused whether an expense is fixed or variable, tryconsidering it a fixed expense; that will force you to create a conservative forecast.

3. Compare and review "best" and "worst":Now that you've recorded both scenarios,create a "most likely" scenario by comparing the two. With this method, you will producea more realistic forecast upon which you can make decisions.

4. Look at your profit level:Now total your scenarios to discover your profit beforedepreciation. You will have three potential profit figures: one low, one high, and one that

is most likely.

Next, calculate the depreciation of your fixed assets. (Depreciation involves theamortization of the cost of fixed assets over time. Check with your accountant for moredetails.)

Now discover your net profit before income taxes. Subtract "depreciation" from "profitbefore depreciation and income taxes" to arrive at your net profit before income taxes.