Evaluation of Financial Feasibility

Prof. Sarbesh MishraFinance Area, NICMARHyderabad – 500 084.

About Myself

Name : SARBESH MISHRA

Qualifications 1. B.Com (Hons)2. Post-graduate in Commerce3. M.Phil in Commerce4. Ph.D. (Commerce)

Experience : Joined University of Delhi, as a Lecturer in Commerce in 2001 and continued till 2005 and then joined Army Institute of Management, NOIDA as a Senior Faculty, Finance prior to current appointment at NICMAR.

Related to Time (Thoughts)My interest is in the future because I am going to spend the rest of my life there.

Charles Franklin Kettering, Former Head-Research, General Motors

The man should never be ashamed to own that he has been in the wrong, which is but saying in other words, that he is wiser today than yesterday.

Jonathan Swift, Famous Satiric Writer, Ireland

Remember that time is money.Benjamin Franklin, Noted Economist, USA

Contd….

You can’t get caught up in things that you can’t control…….we can’t control our selling price. We can control our cost of manufacturing. We can control our efficiencies. We can control our waste.

Steven Appleton, CEO of Micro Technology

If you don’t know where you’re going, it doesn’t matter how you get there.

Prof. Sarbesh Mishra, NICMAR, Hyderabad

Meaning - Capital Budgeting

It is the process of identifying, evaluating, and selecting the projects that require commitments of large sums of funds and generate benefits stretching well into future.

Features of Investment Decision

The exchange of current funds for future benefits

The funds are invested in the long-term assets.

The future benefits will occur to the firm over a series of years.

Importance of Investment Decision

Influence the firm’s growth in long-termThey affect the risk of the firmThey involve commitment of large volume of fundsThey are irreversible, or reversible at substantial lossThey are among most difficult decisions to make.

Types of Capital Investment

Assets to meet regulatory, safety, health, & environmental requirement.

Assets to enhance operating efficiency and/or increase revenue.

Assets to enhance competitive effectiveness.

Investment Evaluation Criteria

Estimation of Cash flows.

Estimation of required rate of return (Opportunity cost of capital)

Application of decision rule for making the choice

Cash FlowsCash inflows or outflows occur at three stages of capital investment project

1. Project Initiation (For beginning operations, Working Capital needs, Replacement of asset)

2. Project Operation (Operating Expenditure, Addl. Working capital need, inflow of cash generated by the investment)

3. Final Project Disposal (Cash inflows or outflows related to investment’s disposal, Cash inflows from the release of working capital no longer committed to the investment)

Opportunity CostOpportunity cost is the cost incurred (sacrifice) by choosing one option over the next best alternative (which may be equally desired). Thus, opportunity cost is the cost of pursuing one choice instead of another.

The opportunity cost of capital is the expected return forgone by bypassing of other potential investment activities for a given capital. It is a rate of return that investors could earn in financial markets otherwise referred as second best alternative

Investment appraisal Techniques

Traditional TechniquesPayback Period MethodAccounting Rate of return Method

Discounted Cash flow Technique1. Net Present Value method (NPV)2. Internal Rate of Return Method (IRR)3. Profitability Index Method (PI)

Traditional TechniquesPayback Period Method

Payback is the number of years required to recover the original cash outlay invested in a project.

Payback = Initial Investment

Annual Average Cash Flows

Project would be accepted if its payback period is less than the maximum or standard payback period set by management.

Accounting Rate of Return (ARR)

This measures the profitability of an investment.

ARR = Average IncomeAverage Investment

Projects with higher ARR over the minimum rate established by the management will be accepted.

DCF TechniquesIt explicitly recognizes the time value of money.

Cash flows arising at different time periods differ in their value and are comparable when their present values are found out.

The compound interest rate is used for discounting cash flows is also called as the discount rate.

Net Present Value Method (NPV)

Cash flows of the invested projects should be forecasted based on realistic assumptions.Appropriate discount rate should identified to discount the forecasted cash flows.Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.Net Present Value is found out by subtracting present value of cash inflows.

NPV Formula

n

Ʃt=1

Ct

(1+k)t

- C0 NPV =

C1, C2 ….. Represent cash inflow in year 1,2 …., k is the opportunity cost of capital C0 is the initial cost of investment n is the expected life of the investment * k is assumed to be known and is constant

Acceptance Rule

1. Accept the project when NPV is positive

2. Reject the project when NPV is negative

3. May accept the project when NPV is zero.

Higher the NPV, the better it is.

IRR and PIThe internal rate of return is the rate that equates the investment outlay with the present value of cash inflow received after one year. The project shall be accepted if IRR is higher than the opportunity cost of capital.

Profitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment.

Risk Analysis in Capital Budgeting

Uncertainty arises from the lack of previous experience and knowledge. Attached factors are:

1. Date of Completion2. Level of capital outlay required3. Level of selling price4. Level of sales volume5. Level of revenue6. Level of Operating Costs7. Taxation Rules

Probability and Expected Values

The probability of a particular outcome of an event is simply the proportion of times this outcome would occur if the events were repeated a great number of times.Expected Values – It results from the multiplication of each possible outcome of an event by the probability of that outcome occurring.

Total Risk = Systematic Risk + Unsystematic Risk

Systematic Risk1. Part of risk which can’t

be diversified otherwise known as Market Risk.

2. Change in the interest rate policy, increase in inflation, RBI promulgate restrictive credit policy, Govt. increases or reduces capital gains tax, etc.

Unsystematic Risk1. Diversifiable and arises

from unique uncertainties.

2. Companies workers declares strike, R&D expert leaves the company, formidable competitor enters to the market, Company loses big contract in a bid, Unavailability of adequate raw materials, Govt. increases customs duty on materials used by the company, etc.

Business Risk and Financial Risk

Business risk talks about how it invests its funds i.e. type of projects which it undertakes while financial risk is determined by how it finances these investments.

Business risk gets influenced by – Company’s competitive position, industries in which it operates, the company’s market share, rate of growth of market and stage of maturity.

Financial risk gets influenced by – Interest cover, Operating leverage (Contribution upon operating profit) , and cash flow adequacy.

Risk Adjusted Discounted RateThe capital asset pricing model (CAPM) has provided an approach to determine project required rate of return with risk consideration.A measure of risk developed in the portfolio theory is beta (β).

RADR = Rf + Ri (K0 – Rf)Rf = Risk free rateK0 = Cost of CapitalRi = Risk index of the project

THANK YOU