Content Index ‘Chapter L Financial Markets 5 ‘Chapter IT Time Value of Money 18 Chapter II Capital Budgeting Techniques 41 Chapter IV Risk Analysis in Capital Budgeting 62 Chapter V Cost of Capital 80 Chapter VI Dividend Decision Making 95 Chapter VIL Value Based Managément 98 Chapter VIII Corporate Governance Social Responsibility us Annexures 131 Compounding and Discounting Tables Table A The Compound Value of One Rupee Table B ‘The Compeund Value of an Annuity of One Rupee Table C The Present Value of One Rupee ‘Table D ‘The Present Value of an Annuity of One Rupee indian School of Petroleum Page ¢ Ths men i the repay property of Inn Shon of Pt ont ots prc wn ie ‘Gandy Canc ie daresee ae ee The Financial System Introduction’ he Financial sysiem comprises a’ variety of intermediaries, markets and instruments that are ‘elated in the manner shown below. The financial system provides the principal means by which Serines ae transformed into investments. Given its role in lie silence resources, the efficient functioning of the financial system ic critical toa merdern economy. Funds EianaL Insitutions Deposits/ Shares “ommnercial Banks Insurance Companies Mutual Funds Non Banking Finance Companies ers of Demanders of Funds Individuals Individuals Businesses Governments Businesses Governments Securities Money Market Capital Market Securities Soca The Financial System While an understanding of a financial system is useful to all informed citizens, it is particularly 1 Scipate in decisions which can be taken better if they financial intermediaries, how do financial markets work, stat signals aze provided by the financial prices and retums, where can surplus funde be parked, what regulatory framework Structure applies to the financial system, so on and so forth, Indian School of Petroleum Page genet the epitope of Tlie of Panda ead tetas pated wd te ‘Caen Came gen se ene, 5WET eee eee - ARE This chapter provides a conceptual framework for understanding how the financial system werks, so that you can make better financial decisions. It is divided inta six sections as follows: L_ Functions of the Financial System. w Financial Assets UL Financial Markets Iv, Financial Market Returns Vv. Financial Intermediaries Vi Regulatory Infrastructure patter (echoes Entel ela ‘The financial system performs the following interrelated functions that are essential to a modern economy, (provides a payment system for the exchange of goods and services. Gi) enables the pooling of funds for undertaking large scale enterprises, Gil) provides a mechanism for spatial and temporal transfer of resources. Gv) provides a way for managing uncertainty and controlling risk. (¥) generates information that helps in coordinating decentralized decision making. (vi) helps in dealing with the incentive problem when one party has an informational advantage. meee Depository financial intermediaries such as banks are the pivot of the payment system, Credit card companies play a supplementary role. To realize the importance of this function, simply look at the hardship and inconvenience caused when the payment system breaks down. meer Modem business enterprises require large investments that are often beyond the means if an individual or even of hundreds of individuals, Mechanisms like financial markets and financial intermediaries, which are an integral part of the financial system, facilitate the pooling of household savings for financing business. From another perspective, the financial system enables households to participate in large indivisible enterprises. pemmcsceree) ‘The financial system facilitates the transfer of economic resources across time and space: As Robert Merton says, “A well developed, smooth-functioning financial system facilitates the efficient life-cycle allocation of household consumption and the efficient allocation of physical capital ta its most productive use in the business sector”. "A well developed, smooth-functioning, capital market also makes it possible the efficient separation of ownership from management of the enterprise, This in turn, makes feasible efficient specialization in productionaccording to the principle of comparative advantage” indian Schoot of Petroleum Page 6 Ti cuneate peer property of Icon Soe af Peat ents priced waar ie Conf Clan! ie te eu‘A well developed financial system offers a variety of instruments that enable economic agents to ‘pool, price and exchange risk, It provides opportunities for risk-pooling and risk sharing for the ‘household and business firms. ‘The three basic methods for managing risk ave hedging, diversification, and insurance. Hedging entails moving from a risky asset to a risk-less asset. A forward contract, for example is a hedging device. Diversification involves pooling and sub-dividing risks. While it dees not eliminate total risk, it redistributes rick to enable the insured to retain the economic benefits of ownership while Laying off the possible losses. Of course, to do this a fee or insurance premium has to be paid. Price Information for Decentralized Decision Making ‘Apart from the manifest function of facilitating individuals and businesses to trade financial ‘assets, financial markets serve an important latent function as well. They provide information that helps in coordinating decentralized decision making. Robert Merton puts it thus: “Interest rates and security prices are used by households or their agents in making their consuniption-saving decisions and in choosing the portfolio allocations of their wealth. The same prices provide important signals te managers of enterprises in their selection of investment projects and financing” DY meer seo When one party to a transaction las information that the other does not have, informational asymmetry exists, This leads to problems of moral hazard and adverse selection, which are broadly referred to as agency problems. The nature of these problems may be illustrated with reference to insurance. A person who has taken a fire insurance policy is likely to somewhat negligent. This is a moral hazard faced by the insurance company, A person who is more likely to experience fire losses will be inclined to take fire insurance. This is the adverse selection problem faced by the insurance company. Financial intermediaries like banks and venturé capital organizations can solve the problem of information asymmetry by handling sensitive information discreetly and developing a reputation for profitable activity. Broadly speaking, an asset whether tangible or intangible is any possession that has value in exchange. A tangible asset is one whose value depends on its physical properties, Examples of tangible assets are land, buildings, machines, and vehicles. An intangibleasset represents a claim to some future benefits, Financial assets, for example are intangible assets as they represent claims to future cash flows, The terms financial asset, instrument, or security are used interchangeably ‘The entity that offers future cash flows is called the issuer of the financial asset and the owner of the financial asset is called the investor. Debt versus Equity Clai 5 ‘A financial asset may entitle its owner to a fixed amount or a varying residual amount. In the former case, the financial asset is called a debt security like a bond or debenture. In the latter case, the financial asset is referred to a5 an equity security. indian School of Petroleum Page 7 Thi acca te papery propery of Inn So ofPtrlien ant oie rte drs Confit Cs ie in Became,ie Re Some securities straddle in both categories. Preference shares for example, represent an equity claim that entitles the owner to get a fixed rupee amount. This payment. however can be made only when an issuer earns a profit. Ill. Financial Markets A financial market is a market for creation and exchange of financial assets, If you buy or sell Financial assets, you will participate in financial markets in some way ar the other. (Teissenen eed A financial market plays pivotal role in allocating resources in an economy by performing three important functions: a 1, Financial markets facilitate price discovery, The continual interaction among numerous buyers and sellers who participate in financial markets helps in establishing the prices of financial assets, Well-organized financial markets seem to be remarkably efficient in price discovery. That is why financial economists say: "If you want to know the value of a financial asset simply look atits price in the financial market." 2, Financial markets provide liquidity to financial assets. Investars can readily sell their financial assets through the mechanism of financial markets. In the absence of financi markets which provide such liquidity, the motivation of investors to hold financial assets will be considerably diminished. Thanks to negotiability and transferability of securities through the financial markets, itis possible for companies (and other entities) to raise long-term funds from investors with short-term and medium-term horizons. While one investor is substituted by another when a security is transacted, the company is assured of long term availability of funds. 3. Financial markets considerably reduce the cost of transacting. The two major costs associated, with transacting are search costs and information costs. Search costs comprise explicit costs such as the expenses incurred on advertising when one wants to buy or sell an asset and implicit costs such as the effort and time one has to put in te locale a customer, Information costs refers to costs incurred in evaluating the investment merits of financial assets. ‘There are different ways of classifying financial markets, One way is ta classify financial markets by the type of financial claim. The debt market is the financial market for fixed claims (debt instruments) and the equity market is the financial market for residual claims (equity instruments). A second way is to classify financial markets by the maturity of claims. The market for short-term financial claims is referred to as the money market and the market for long-term financial claims is called the capital market, Traditionally the cut off betwven short-term and long-term has been one year-though this dividing line is arbitrary, it is widely accepted, Since short-term financial elaims are almost invariably debt claims, the money market is the market for shortterm debt instruments, The capital market is the market for long-term debt instruments and equity instruments, A third way to classify financial markets is based on whether the claims represent new issues or outstanding issues. The market where issuers sell new claims is refezred toas the primary market and the market where investors trade outstanding securities is called the secondary market. A fourth way to classify financial markets is by the timing of delivery. A cash or spot market is one where the delivery occurs immediately and a forward or futures Tedian School of Petroteum Page 6 “Ts cunt: fh propria ppety of Trion Sabor of Pura aed itr vat pried nner ty Confeatiaiy Clem’ en in te darens BF market is one where the delivery occurs at a predetermined time in future. A fifth way ta-classify financial markets is by the nature of ils organizational structure. An exchange-traded market is characterized by a centralized organization with standardized procedures. An over-the-counter market is a decentralized market with customized procedures. The Exhibit below presents a summary of the classification of financial markets, Summarv of Classification of Financial Markets SS Debt Market ‘Nature of Claim Equity Market Maturity of Chim ————~_—Monay Market Capital Market Seasoning of Claim Primary Market Secondary Market Timing of Delivery —_ Gashor Spot Market Forward or Futures Market” (Organizational Structure Exchange-traded Market Ean Over the counter Market PU APC TE rmeree cen Every day we are bombarded with news and reports on financial market returns like interest rates and equity returns over various media like newspapers, television, radio, and on-line computer service. Pisses ‘An interest rate is a rate of return promised by the borrower to the lender. Different interest rates apply to different kinds of borrowing and lending. For example, the mortgage rate applies to a home loan whereas the term lending rate applies to a term loan for an industrial project. ‘The interest rate on any type of loan (or fixed income security) depends en several factors, the most important being ‘he unit of account, the maturity, and the default risk. The unit of account is the medium such as rupees, dollars, pounds, yen, or gold in which payments are dominated. ‘The maturity of a loan is the periad over which it is paid back, Default risk is the possibility that the borrower may not honor his commitment to pay interest and principal as promised, Generally, the interest rate is low when the unit of account depreciates very little due to inflation, the maturity period is short, and the default risk is negligible. On the other hand, the interest rate ishigh when the unit of account depreciates due to inflation, the maturity peried is long. and the default risk is high Tndlan School of Petroteum Page 9 “hit dest the rpricay pay of aan Sebcl af Preier od os proteael ane the Coietioiy Clana Ihe dsm.Pea Inferest rales represent promised returns on debt instruments. However, many assets do not promise a given return. For example, if you invest in equity shares or real estate or a piece of art or for that matter any risky asset you don’t eam an assured return, How should one measure the rate of retum on a risky asset like equity stock? The retum from. such an asset comes from two sources: each dividend and capital gain (or loss). To illustrate, suppose you buy a share of a company’s equity stack at a price of Rs100, After one year you get a dividend af Rs.5.and the shace price rises fo Rs.115. Your one-year return, ris: Cash dividend + Beginning price Ending price - Beginning price Beginning price = 5 + _115-100 100 100, = 5% 15% The first components called the dividend income component (or dividend yield) and the second component is called the capital change compenent (or capital yield) i Renae enerses To make meaningful economic comparisons over time, the prices of goods and services must be corrected for the effects of inflation. A distinction has to be made between nominal price, or prices in terms of some currency, and real prices, or prices in terms of purchasing powder. This point may be illustrated with an example. Suppose the price of butter increases from Rs 100 per kg in year 0 to Rs 110 per kg in year 1, During this period the Consumer Price Index increases from 500 to 540, that is by 8 per cent. So wve say that even though the nominal price of butter increased by 10 per cent, its eal price rose by only 1.85 per cent(1.10/1.08). Just as a distinction is made between nominal and real prices, so too a distinction is made between nominal and real interest rates, ‘The nominal interest rate on a bond is the rate of return in neminal terms whereas the real rate is the nominal rate corrected for the inflation factor. For example, if you earn a nominal rate of 15 per cent in year when the inflation rate is 10 per cent, your real rate works out to ((1.15//1:10)-1). ‘The general relationship between these rates is as follows: 1+Realrate = 1+Nominal rate 1+ Inflation rate Put differently, Real rate = Nominal rate ~ Infl: 1+ Inflation rate Tidian School of Petroleum Page 10 ‘Tiss dawnt preety af Tei Sel of Pee an is erin praeed wader the ‘Coie Clos’ in Bedeee A DRMnenen seer a cena What factors determine the rates of return ina market economy? The principal factorsare: 1 Expected productivity af capital 2 Degree of uncertainty characterizing the productivity of capital 3. Time preferences of people 4 Degree of risk aversion Rare eee Capital resources, comprising tangible capital and intangible capital, help in producing goods and services, Tangible capital consists of physical assels like factories, mines, dams, railway Relworks, power stations, roads, and inventories. Intangible capital consists of non-physical assets like patents, copyrights, technical know-how, and brand image. ‘The productivity of capital is expressed as a percentage per year, referred to as the return on capital. The expected return on capital varies across time and place. Inter alfa, it depends on the state of technology, availability of other factors of procluction, and the strength of demand for goods and services produced by capital, ‘The returns camed by investors ultimately depend on how productive the capital is. Henee, the Aigher the expected productivity of capital, the higher the level of interest rates in the economy, and vite versa EP Eee a esse eee ore kee TT The retum on capital is subject to uncertainty stemming from a host of factors like technologieal changes, shifts in consumer preferences, erratic weather, policy changes, social unrest, anc! $0 on. Meee ees Ce eee eT Other things being equal, the higher the degree of uncertainty about the productivity of capital, the higher the risk premium required by equity investors, and vice versa, Eases People prefer current consumption to future consumption. Why? A principal reason is that they know that they are alive now and can enjoy current consumption whereas they are insecure about future. Other things being equal, the greater the preference of the: society for current consumption, the higher the interest rate in the economy and vice versa, pee ey ‘The return on capital in any economy, as we have learnt, is uncertain, The financial system provides a mechanism for partitioning the uncertain return. on capital into diflezent streams subject to different risks. Very broadly, it splits the uncertain return on capital into two components: a risk-ime return eared on debt securities and a risky return carned on equity securities, The following refationship holds: Risk-free return on debt securities < Excepted retum on capital < Expected return an equity sec Indian Schoot of Petroleum Page 11 ‘Thi deem i fl reer papery of ain Schoo f Parlers ond itr uniensprtred wader the Canfetiatly Clas! isn in he daceoe ihe Put differently, risk-averse people who want a risk-free return have t compensale risk-tolerant people for bearing risk in the form of risk premium. Other things being equal, the higher the degree of risk-aversion of the population, the higher will be the risk premium, and correspondingly the lower will be the risk-free rate, Financial intermediaries are firms that provide services and products that custamers may not be able to get more efficiently by themselves in financial markets. A good example of a financial intermediary is a mutual fund which pools the financial resources of many people and invests in 8 basket of securities. [t enjays economies of scale in conducting research, in maintaining records, and in executing transactions. Hence, it offers its customers a more efficient way of investing than what they can generally do on their own. The important products and services of financial intermediaries include current accounts, savings accounts, loans, mortgages, mutual fund schemes, insurance contracts, credit. Tating, and soon. Zhe structure of financial intermediaries in India is depicted in exhibit given below. ose ee | [ee a =o" | Es | Gs a = 7] = a Enatitutbors India — = =e ean Crs ae a as = rr Banks cee Heating Grher . ea = a Funds Structure of Financial Intermediaries Before we learn about various financial intermediaries in India, let us understand the rationate for financial intermediaries, Rationale for Financial Intermed) What is the rationale for financial intermediaries? Put differently, what are the benefits to individual investors when they invest inditectly through financial intermediaries rather than directly in operating companies? It seems that there are several advantages: indian School of Petroleum Page 12 is damon ce propeicay preps af Trin Seal of Pialan onde cones protected war he Coadetcty Claus gies in the denenmt Peete The pool of funds mobilized by financial intermediaries is invested in a broadly diversified portfolio of financial assels (stocks, money market instruments, bonds, and loans). Individual investors can scarcely achieve such diversification on their own. Remember that a diversified portfolio reduces risk, mere errs The average size of a transaction of a financial institution is much higher than that of an individual investor. The transaction cost in percentage terms tends to decrease as the transaction size increases, Hence, financial intermediaries, compared to individual investors, incur lower transaction costs. eee Buying and holding securities (or for that matter granting loans and supervising them) calls for information gathering and processing and regular monitoring. These functions entail cost Financial intermediaries, thanks to their bigger size and professional resources, enjoy economies of scale in performing these functions and hence they have a comparative advantage over individual investors, (eels Companies seeking funds or the continuing support of existing investors are required to disclose information that they like to keep confidential for competitive reasons. They would feel more comfortable in dealing with few financial intermediaries rather than numerous individual investors. Information shared with financial intermediaries may be kept confidential whereas information disclosed to numerous individual investors falls in the domain of public knowledge Eran With greater professional expertise at their command, financial intermediaties can pick wp and interpret signals and cues provided by companies which are likely to gravitate to them. In this manner, financial institutions perform a signaling funetion for the investing community. Commercial Bank: Commercial banks comprising public sector banks, foreign banks, and private sector banks represent the most important financial intermediary in the Indian financial system. ‘The largest commercial Bank in India, the State Bank of India (SBI), was set up in 1955 when the Imperial bank was nationalized and merged with some banks of the princely states. In 1969, in one fell swoop, the fourteen largest privately-owned commercial banks were nationalized Subsequently, several other privately-owned commercial banks were nationalized. As a result of these actions, public sector commercial banks, dominate the commercial banking scene in the country. ‘The changes in banking structure and control have resulted in (wider geographical spread and deeper penetration of rural areas, Gi)__higher mobilization of deposits, Gi) reallocation of bank credit to priority activities, and (iv)__ lower operational autonomy for bank management. indian School of Petroleum Page 13 This cues ss peopricar preperty of Ini School af Peruse ands nents prsral uncer the Confit lens’ gen ve he doesentwy Foreign banks like Citibank have been in India for a long time and have been expanding their operations. The newest entrants on the commercial banking scene have been the private sector banks like HDFC Bank and ICICI Bank which were set up in mid 1990s in the wake of banking liberalization, This segment has shown remarkable growth and vitality since the beginning, LSC toes gee rots ey Since independence a number of developmental financial institutions have been set up to primarily cater to the long term financing needs of the industrial sector. An elaborate structure of financial institutions consisting of all-India term-lending institutions (IDBI. FCI, and ICIC), State Financial Corporations, and State Industrial and Developing Corporations has come into being. Due to the importance given to the small scale sector, the government established the Small Industries Development Bank of India (SIDBI) in July 1989. Tis a subsidiary of IDBI and functions as the chief refinancing agency for the small scale sector. Traditionally, these institutions focused on project finance, Now they provide project finance as well as working, capital finance. Earlier, they had a strong developmental orientation. Now, they have a ‘commercial orientation. ‘Till recently there were two insurance companies in India: the Life Insurance Corporation (LIC) of India and the General Insurance Corporation (GIC) of India (which is essentially a holding company that has four fully-owned subsidiary companies in its fold). The Life Insurance Corporation of India, which provieles life insuranee, has massive resources at its command due to two reasons: (f) insurance policies usually incorporate a substantial element of savings, and ({i) insurance premiums are payable in advance, The subsidiaries of the General Insurance Corporation of India, which are engaged in the business of property insurance, too, have considerable resources with them because of the advance collection of insurance premiums, With the liberalization af the insurance sector many private sector players like ICICI- Prudential, Tata AIG, Birla Sunlife, and Metlife have set up insurance business in India, Co TSUN eum ues O tris cys ‘There are a variety of other public sector financial institutions. A brief description of the more important ones follows: Post Office Savings Bank (POSB) Run by the Postand Telegraph Department on behalf of the Ministry of Finance, Government of India, the POSB is operated through the vast network of past affices. The POSB cellects funds through various schemes like savings bank accounts, recurring and cumulative time deposit schemes, Public Provident Fund, and Kisan Vikas Patras, National Bank for Agriculture and Rural Development (NABARD) The apex agricultural financing institution. NABARD channelizes assistance through an elaborate network of regional, state level, and field level institutions like the Regional Rural Banks (RRB), the State Co-operative Banks, and so on. Indian School of Petroleum Page 14 Th ith fori ope bin Sof Po ne prt nar te Caley Cl i(pi EERE creo een eR) ‘The apex agency for housing finance, NHB secs to promote an institutional framework for the supply of finance in the housing sector, Rr! ‘A mutual fund is a collective investment arrangement. In India three entities are central to a mutual fund: the sponsor, the trust, and the asset management company. The spansor promotes the mutual fund, The mutual fund is organized as a trust (with a board of trustees). It is, ina way, an umbrella organization which floats variqus schemes in which the investment public can participate. The asset management company, organized a3 a separate joint stock company, manages the funds mobilized under Various schemes, Mutual funds have recorded a very impressive growth in India in the last several years. While there was only one mutual furtd in India, viz, the Unit Trust of India, tll 1986, presently there are a number of mutual funds in both the public sector as well as the private sector, EMEEN an sene eee From the mid-eighties many non-banking financial companies have come into being in the public sector as well as the private sector- numerically, of course, most of them are in the private sectar. Some of the well-known non-banking finance companies are SBI Capital Markets, Kotak ‘Mahindra Finance, Sundaram Finance, and Infrastructure Leasing and Finance Corporation. Non-banking financial companies engage in a variely of fund based as well as non-fund based activities. The principal fund-based activities are leasing, hire-purchase, and bill discounting; the main nonfund based activities are issue management, corporate advisory services, loan syndication, and forex advisory services, Other Organizations Merchant banks, venture capital firms, and information services are some of the other financial intermediaries, IEEE? Merchant banks are firms which help business, governments, and other entities raise finances by issuing securities. They also facilitate mergers, acquisitions, and divestitures. The leading merchant banks in India are SBI Capital Markets, DSP Merrill Lynch, JM Morgan, and ICICI Securities ‘Venture capital firms provide finance to high risk high return ventures. Young firms with timited managerial expertise often require adviee in running the business in addition to finance. Venture capital firms provide managerial support as well as capital. Many financial service firms provide information as a supplementary service, but there are firms that specialize in giving information. The most well known are credit rating agencies like CRISIL, CARE, and ICRA and capital market information services like CMIE, Probity Research, and Capital Market Indian School of Petroleum Page 15 “This cuamct i he propecia peoperty of edi Schoo f Plea adie enim posed and th Crfiritiy Cw en in he doinea ae Se @ VI. Regulatory Infrastructure ‘As the maker and enforcer of laws in a society, the government has the respansibility of = = : regulating the financial system, The two major regulatory arms of the Government of India are the Reserve Bank of India and the Securities Exchange Board of India. eerie ey ‘As the central banking authority of India, the Reserve Bank of India performs the following traditional functions of the central bank: ‘Tt provides currency and operates the clearing, system for the banks. It formulates and implements monetary and credit policies. ‘Tt functions as the banker's bank. Itsupervises the operations of credit institutions. Ik regulates foreign exchange transactions, It moderates the fluctuations in the exchange value of the rupee. In addition to the traditional functions of the central banking authority, the Reserve Bank of India performs several functions aimed at developing the Indian financial system: 1 Itseeks to integrate the unorganized financial sector with the organized financial sector. Itencourages the extension of the commercial banking system in the rural areas. E ouRene Seine 2 3. Itinfluences the allocation of credit. 4 Itpromotes the development of new institutions. ‘The Securities Exchange Board of India has been entrusted with the responsibility of dealing with various matters relating to the capital market SEBI's principal tasks are to: Regulate the business in stock exchanges and any ather securities markets, Register and regulate the capital market intermediates (brokers, merchant bankers, portfolio managers, and so on) Register and regulate the working of mutual funds, Promoteand regulate the working of mutual funds. Probibit fraudulent and unfair trade practices in securities markets, Promote investors’ education and training of intermediaries of securities markets Regulate substantial acquisition of shares and takeovers of companies. Perform such other functions as may be prescribed, eusome Indian School of Petroleum Ths den riety propery ef nen See of emer on it emt prorat mt Cfinsikiy Coe lied@ Summary 1. The financial system- consisting of a variety of institutions, markots, andl instruments related in @ systematic manner-provides the principal means by which savings are transformed into investments, 2 It provides a payment mechanism, enables the pooling of funds, facilitates the management of uncertainty, generates information for decentralized decision making. and helps in dealing with informational asymmetry. 3 Financial assets represont claims against the future income and wealth of others Financial liabilities, the counterparts of financial assets, represent promises to pay some Portion of prospective income and wealth to others. 4 The important financial assets and Liabilities in our economy are money, demand deposit, short-term debt, intermediate term debt,long term debt, and equity stock. 5 A financial market is a market for creation and exchange of financial assets, Financial markets facilitate price discovery, provide liquidity, and reduce the cost of transacting. 6 There are different ways of classifying financial markets. The important bases for classification are: type of financial claims, maturity of claims, new issues versus outstanding issues, timing of delivery, and nature of organizational structure, 7 The interest rate on any type of loan (or fixed income security) depends on several factors, the most important being the unit of account, the maturity, and the default risk. 8 Justas a distinction is made between nominal and real prices, so too a distinction is made between nominal and real interest rates. The nominal interest rate on a bond is the rate of retum in nominal terms whereas the real rate is the nominal rate adjusted for tho inflation factor. 9 The principal determinants of rates of return in a market economy are: expected productivity of capital; degree of uncertainty characterizing the productivity of capital: time preferences af people; and degree of risk aversion, 10 Financial intermediaries seein to offer several advantages: diversification, lower transaction cast, ceonamies of scale, confidentiality, and signaling benefits 11 The major financial intermediates in India are commercial banks, developmental financial institutions, insurance companies, mutual funds, non-banking financial companies, and merchant banks. 12 As a maker and enforcer of laws in a society, the government has the responsibility for regulating: the financial system. The two major repulatory arms of the Government of India are the Reserve Bank of India (RBI) and the Securities Exchange Board in India (SEB) sndian School of Petroleum Page 17 ‘Ths da he proprio property of nian Sct of Pett acs eee prc une Cosy Cn gerain he dears,End of Year 2 3 ch Deposit atthe Ret Ret paul ee end of yeor Re. 1.060 Rs. 1.128 Rs. 1.191 Future sum Rs, 4.375 Graphic Representation of compound value of an annuity of Re.1 ‘This is the compound value of an annuity of Re 1 for four years at 6 per cent rate of interest. The graphic presentation of the compound value of an annuity of Re 1 is shown in the Figure below. Itcan be seen that for a given interest rate, the compound value increases over period. The computations shown in the figure above can be expressed as follows: Fi=A(L+iPFA(14i 4 A(1EDEA Fut AL(14i)34 (14 iP + (14) 41] ae) Where A is the annuity. We can extend Equation (4) for n petiods and rewrite it as follows: rey Where A is the constant periodic flow of cash Sannuity) and the term within brackets is the compound value factor for an annuity of Re.1, which we shall refer as CV AR, Suppose Rs, 100 are deposited at the end of each of the next three years at 10 per centinterest rate. The compound value employing Equation (6) is; Fo = Rs200 | (1-10)? -1 10 = Rs100x3.31 = Rs33l It would be quite difficult to solve Equation (5) if is very large. Our calculations can be facilitated by pre calculated compound values of an annuity of Re 1, Table B at the end of the book gives compound value factors for an annuity of Re 1 for variaus combinations of time petiod (tt) and rates of interest (i). This table is constructed under the assumption that the funds are deposited at the end of a period. The compound value factor of an annuity (CVAF) should be ascertained from the table to find out the Future value of the annuity. indian School of Petroleurn Page 23 This eset i We freuritan per of India Seba! of Pea ard semen pater andr the Ceti Clean te the darnTr Tot us suppose that a firm deposits Rs 5,000 at the end of each year for four years at 6 per cent ate of interest, Hw much would this annuity accumulate at the end of the fourth year? From Table B, we find that fourth row and 6 por cont column give us a CVAF of 4375. Ife multiply 4575 by Rs 9,000, we obtain a compound value of Rs 21,875, We ean also write Equation (5) a follows: EV=(CVAR, i) Where CVAF.ris the eompound value factor of an annuity for n periodsat i rate of interest. Applying the formula and using Table B, we get FV =RsS00Q(CVAF, 15) 6) = Rs 5,000x1.3755" Rs 21, 875. Present Value| We have shown so far haw compounding technique can be used for adjusting the time value of one. It increases investor's analytical power to compare eash flows that ae separated by more than one period, given his or ber interest rate per period. Whereas with the compotn: technique it is possible to translate any amount of present cazh into an amount ef cash of equivalent value to be received at the end of any number of future periods; itis convenient and a common practice to wark in the reverse direction-working from future cash flows to their Prosent values, The preset value of a future cash inflow or outflow is the amount of present cash. that is of equivalent desirability. to the decision - maker, to a specified amount of cash to be ‘eceivedl ar paid at a futuze date. The process of determining present value of a future payment (or receipts} or a series of future payments (or receipts) is called diseexnting. The compound Interest rate used for discounting cash flows is also called the discewit sade. ACS Me Ua weer We have shown earlier thal an investor with an interest rate of i per year would remain indiiforent between Re 1 now and Re 1 (1 + i) one year from now, ar Re I (1+ i}? afer two years, or Rel (1+ srafter n years, We can now raise axelated question How nwich would the investor sive up now to get an amount of Re Tat the end of ane, two or three years? Assuming 10 per cent interest rate, we know thatan amount sacrificed in the beginning of year will grow to Fl= P (1.10) after a year. Ifthe amount grows to Fl = Re | after a year at 10 per cent, we can easily Find out the amount to be deposited or sacrificed in the beginning as follows: Fi -PQ+ i) indian Scheel of Petroleum Page 26 Ths uoonont ite prepriten property of lad Schr! of Perot anism preted war te Confetti Cra ge in he cnet“Thuis implies that if the interest rate is 10 per cent, the present value of Re I to be received after ‘ane year is equivalent to Re 0.909, In other words, ata 10 per cent rate, Re 1 to be received after a Year is 110 per cent of Re 0.909 sacrificed now. Stated differently, Re 0.909 deposited now will grow toRe | after one year. The present value of Re 1 inflow at the end of two years can also be worked out easily. An amount p deposited now would graw to F: = P (1 + ifpafter two years. Therefore, if Fy expected to be received after two yearsis Re 1, the following amount should be deposited now: Fa P(THp = Re0.75 ‘| 1331 Fe 0.826 is the present value of Re 1 at 10 per cent interest rate to be received after two years. The investor would be indifferent between Re T after 2 years and Re 0.826 now. At 10 per cent interest rate Re 0.826 now will grow to Re 1 after two years. Similarly, the present value of Re 1 to be received after three years will be: = Fal(1+i) *] o+-48) ‘The present value calculations ean be worked out for any number of years and for any f interest fale, The following general formula can be employed to calculate the presont value of a lump ‘Sum to be received after some future periods: PV=F, (PVF, The term in brackets is the prosent value factor (PVF), and itis always less than 1.0 for positive indicating that a future amount has.a smaller present value, When we want to solve for present value of some amount, we need not make the complicated calculations, We can refer to Table C at the end of the book which gives the pre-calculated resent value of Re 1 received (or paid) after n periods at rte of interest, To find out the present value of a future amount, we have simply to find out the present value factor (PVE) from the table and multiply by the amount. Ta Suppose that an investor wants to find out the present value of Rs 50,000 to be received after 15 years. His interest rate is 9 per cent. First we will find out the present value factor from Table C. When we read row 15 and 9 per cent column, we get 0.275 as the present value factor, Multiplying 0.275 by Rs 50,000, we obtain Rs 13,750 as the present value, Indian School of Petraleurn Page 25 Tas hommes 1b prt prapary Pion Soa of Peay ants wat proce wat “Cantisity Chena! guen (Be dievmentoO. We can rewrite Equation (8) as: PV=Fy (PVFa) Wiiete PVE is the present value factor forn poriads at | rate of interest: Applying the formula and using Table C, we got: PVRs 50,000 (PVF ise) = Rs50,000.X 275+ Rs, 13,750 See ee Ab investor may have an opportunity to ceive a constant periodie amount (an annuity) for certain number of years. The present value of an annuity cannot be found oul by using Fauation (@). We will have to find out the present value of the amount every year and wll have pease gate all the present values to get the total presont value of the annuity, for example, an investor, who has determined his interest rate ag 10 per cent, may-have an Spportunity to receive an annuity of Re 1 for Four years. ‘The present value of Re received after one yearis, P=1/(1.10) = Re 0.909, after two years, P= 1/(1.10)2= Re 0.826, alter three years, P = 1/(1.10)3 =Re 0.751, and alter four years, P= 1/(1.10}4.« Re0683, ‘Thus the total present value ofannuity of Re 1 is Rs 3.169; 1 1 L 1 EP [a “aig? Gao tag 909+0,826+0.75140,683=Re 3,169 {Rel would have been received as a ump sum at the end of the fourth year, the present value rould be only Re 0.683, Notice that the present value factors of Re | after one, iro, three ancl {our years andl so on can be ascertained from Table C, and when they are aggregated we obtain the present value of the annuity of Re, The present value of an anituity of feel for four years at 10 Per cent interest rate és shown in Figure 2 It can be noticed that the present value declines over period fora given discount rate, ‘The computation of the present ofan annuity can be writen in the following general form: ay (en +5* Ingkan School of Petroleum Page 26 Te amen 1h price progr oflonSchel o Prabam aed ttt rad un ee Coshimity Clee a he dren= = = = = = > > > = = = = = 2 = = 2 = 5 > > > : > 2 > > > > > = : : = et ine Where A isa constant payment (or receipt) each year. Equation (10) can be solved and expressed as follows: 1 P {= at ‘+g | 8) End of Year T T z 34 Rel Red Rel Receiptat the end of year Re, 0.909 Re, 0.826" Re. 0751 Re, 0.483, Rs. 375, Present value Graphic Representation of Present Value of an Annuity of Re.1at 10%. The term within brackets of Equation (11) is the present value factor of an annuity of Re 1, which we will call PVAE, and itis a sum of single-payment present value factors, To illustrate, let us suppose that a person receives an annuity of Rs 5,000 for four years. IFthe rate of interest is 10 per cent, the present value of Rs5,000 annuity is: ate t.t0y" P= Rs 5,000 = Rs 5,000 x 3.170 = Rs 15,850 It can be realized that the present value calculations of an annuity for a long period would be extremely cumbersome, Our calculations are, however, simplified when we use the pre-calculated present values of an annuity of Re 1 as given in Table D at the end of the book, Table D is constructed using Equation (10). To compute the present value of an aniuity, we should simply find out the appropriate factor from Table D and multiply it by the annuity value. In our example, the value 3.170 solved using Equation (II) could be indian Schoo! of Petrateure Foge 27 This dames ste protic papery of alan cool of Pera and its eaten prced vader be ‘Cacfentatty Clone! gen in Be creatascertained directly from Table D. Reading fourth row and 10 per cent column, the value is3.170. Equation (11) can also be written as follo PVA (PAI (12) whore PVAF ,, | i present value factor of an annuity of Re 1 for periods at j rate of interest. Applying the formula and using Table D, we get: PV= Rs5,000{PVAF. 10) = Rs 5,000 x 3.170 = Rs 15,850 ETE re esticsey The reciprocal of the present value annuity factor is called the capital recovery factor (CRE). It is useful in determining income to be camed to recover an investment at a given rate of interest. Suppose that you plan to invest Rs 10,000 today for a period of four years. If your interest rate is 10 per cent, how much income per year should you receive to recover ‘your investment? Using Equation (12), the problem can be written as follows: PY=A(PVAF a) vn PVAF n, A=PV (CRFn,i) v3) Using Equation (13) we obtain A 3.170. It would be thus clear that the term 3155 is the capital recovery facter (CRFni), and it is reciprocal of the present value annuity factor, The annuity is found out by maltiplying the amount of investment by CRF, Capital recovery factor helps in the preparation of a loan-amortization schedule, ; ar Rs 10,000 [+a = Rs 10,000,315 =Rs3,155 t ion Let us take the following example. Suppose you have borrowed a 3-year Toan of Rs 10,000 at 9 per cent from your employer to buy a motorcycle. If your employer requires three equal end-of-year repayments, then the annual installment will be; Rs 10,000 = A (PVAFS, .09) Thdian School of Petroleum Page 28 “Thr dco ithe poopy prope of Ine School aati adits cits prt uncr te Cot Cur gen se cameae iw — Rs10,000 2.531 By paying Rs 3,951 each year for thme years, you shall completely pay off your loan with 9 percent interest, This ean be obgerved from the following loan amor tization schedule: R10, 000 = A (2.531) or = Rs3.951 ‘Table 1. Loan Amortization Schedule Tnd of year Payment Interest Principal repayment Guisianding balance 0 1 3951 900 35 6949 2 3951 623 3326 368 3 3951 326 3,625" o “Rounding off error. You pay Rs 3,951 at the end of each year. At the end of the first year, Rs 900 of this amount it interest (Rs'10,000 x09), and the remaining amount (Rs 3,051) is applied towards the repayment of principal. The balance of Ioan at the beginning of the second year is Rs 6,949 (Rs 10,000 - Rs-3,051). As for the first year, calculations for interest and principal repayment can be made for the second and third years. At the end of the third year, the loan is completely paid lf. Darrin eect eta When an annuity is expected to occur indefinitely, it is called a perpetuity. Perpetuities ‘are not very common in financial decision making. But one ean find £ few examples. For instance, in the case of irredeemable preference shares (1, preference shares without a maturity), the company is expected to pay preference dividend perpetually. By definition ina perpetuity time periad, n, is so large (mathematically napproaches infinity) that the ‘expression (1 +i)a if in Equation (11) tends to become zero, and the formula for a perpetuity simply becomes: of) To take an example, let us assume that an investor expects a perpetual sum of Rs 500 annually from his investment. What is ihe present value of this perpetuity if his interest rate is 10 per cent? Applying Equation (14), we get Rs5,00 10 Prema CCR nc eueges cto P = Rs5,000 iret In the investment decisions of a firm, ene would not frequently get a constant periodic gum (annuity). In most instances the firm rectives a stream of uneven cash inflows. Thus the present value factorsas given in Table D cannot be used. indian Sen00f of Petroleum Page 27 Th tiowaca i te pga pepe of Pi Shel of Pre adits one tcl er he ity Come genie He scantAy 4 Gen a (15) where # indicates the time period and extends from one period to n period. In operational terms, Equation (15) can be written as follow: PA’ = Ay (PVF, ) + Aa (PVEori} + Aa (PVE, +. + An (PVFe) iii AS an example, consider that an investor fas an opportunity of receiving Re 1,000, Rs 1,500, Rs 800, Rs 1,100 and Rs 400 respectively at the end of one through five years. Find out the present Value of this stream of uneven cash flows, if the investor's interest rate is 8 percent? The present value is calculaied.as follows: Present-value - Rs 1000 + Rs7,500+ Rs800+ RsiAOD + Reddo (+08) 0+.08)' “a+08) as 0R* = ar 08)* The complication of solving this equation can be sesolved by using Table C at the end of the book. We can find out the approprinte-present value factors (PVFs) from the table and multiply by the respective amount, The present value calculation is shown below: PV = Rs 1,000 (PVF) + RS 1,500 (PVE: os) + Rs 800 (PVE: ce) + Rs 1,100 (PVE: ox) + Rs 400 (PVE os) = Rs 1,000 0.926 + Rs 1,500 x 0.857 + Rs 800 X 0.794 4 Rs 1,100 x 0.735 + Rs 400 x 0.681 = Rs3,927.60 Een eens menen The concepts of compound value and present value of an annuity discussed earlier 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 periad. Similarly it is common in lease contracts to require payments to be made in the beginning af each period. A series of fixed payments starling at the beginning of each period for a specified number of periodsis called an annwity due. Indian School of Petroleum Page 20 Thu dass i eproizary propery of Tin Ss ef Paseo ott pre arth ‘Camfntiaby Cla genin Ihe canoes(er ke eee eee Jf you deposit Re 1 in a savings account at the beginning of each year for 4 years to earn 6 per cent interest, how much will be {he compound value at the end of 4 years? You may recall that when deposits of Re 1 are made at the end of the years, the compound value at the end of 4 years is Rs 4.375 (see Figure 1). The Re 1 deposited in the beginning ‘of each of year 1 through year 4 will cam interest respectively for 4 years, 3 years, 2 years and 1 year. F= Re 1 (1.06)! + Re 1 (1.06}"4 Re 1 (1.067 + Re 1 (1.08) =Rs 1.262+ Rs 1.191 + Rs 1124+ Rs 1.0 = Rs 4.637 “The formula for the compound value of an annuity dtie i Fos Al +i) + (LH) (1H). (7 Fiz A (CWAF ni) (+i) (18) ‘Applying Equation (18), the compound value of Re 1 deposited at the beginning of each year ford years Re 1(4.375) (1.06)= Rs 4.637 ‘The campound value annuity factors in Table B should be multiplied by (141) to obtain relevant factors for an annuity due. How Pie een ee en ee Let us consider a 4-year annuity of Re 1 each year, the interest rate being 10 per cent What is the present value of this annuity if cach’ payment is made at the beginning of the year? You may again recall that when payments of Re 1 are made at the end of the years, the prosont value is Rs 3.169 (see Figure 2}. Note that the first payment i made immediately (this is equivalent of end of period O or the beginning of period 1), therefore its present value is equal to its absolute value. Other payments have bean discounted at 10 per cent to compute their present values. Thus, ih present value of the series of payments is: Rel , Rel | Rel (io) @.10)F © (10 = Re 1 + Re0.909 + Re 0.826 + Re0.751=Rs 3.487 PV=Rel ‘The formula for the present value of an annuity due is: p=alie—t : ar (0 0+? ata Indica School of Petroleum Page 37 is dunes rors papery of Taian Scola Pea a tet pred andr be Coney loge in Ihe deret120-9" lay P=A( PVAF: 3)(1+i) (20) Applying Equation (20), the present value of Re 1 paid at the beginning of each year for 4 years is: Re 1 (3.170) (1.10) = Rs3.487 ‘The present value annuity (actors in Table D should be multiplied by (1+i) to obtain relevant factors for an annuity due, DEREe enn: ‘We have assumed in discussion so far that cash flows occurred once a year, In practice, ash flows can occur more than once a year. For example, banks may pay interest on savings account quarterly. On bonds or debentures and public deposits, companies may Pay interest semi-annually. Similarly, financial institutions may require borrowers to pay interest quarterly or half-yearly. The interest rate is usually specified on an annual basis in a loan agreement or security (euch as bonds), and is known as the nominal interest rate. If compounding is dene more than once a year, the actual rate of interest paid (ar received) is called the effective interest rate; effective interest rate would be higher than the nominal interest rate. Suppose you invest Rs 100 now in a bank, interest rate being 10 per cent a year, and that the bank will compound interest semi-annually (ie. twice @ year). How much amount will you get after a year? The bank will calculate interest on your deposit of Rs 100 for first six months at 10 per cent and add this interest to your principal. On this total amount accumulated at the end of first six months, you will again receive interest for next six ‘months at 10 per cent. Thus, the amount of interest for first six months will Interest = Rs 100 x 10% x1/2= Rs5 and the outstanding amount at the beginning of the second six-month period will be: Rs 100 + Rs 5 ~ Rs 105. Now you will eam interest on Rs 105, The interast on Rs 105 for ext six months will be: Interest = Rs 105 x 10% x1/2 = Rs 5.25 ‘Thus, you will accumulate Rs 100 + Rs 5 + Rs 5.25 = Rs 110.25 at the end of a year. If the interest were compounded annually, you would have received: Rs 100 + 10 per cent of Rs 100 = Rs 110, You received more under semi-annual compounding because you camed interest on intessst eamed during the first stx month, You will get still higher amount if the compounding is done quarterly or monthly, Whatefectine annual interest rate did you earn on your depositof Rs 1007 On an anawal basis, you earned Rs 10.25 on the deposit af Re 100; s0 the effective interest rate (EIR) is: pig = RSS+85.25 100 = 10.25% indian School of Petraleara Page 32 Thabo se roprtary reperty f Inon Shoe f Persea ad items ft wad die ‘Caniitiay Clsu' gw ix the henson,PUTT TFET ETFS EF EOE FO TTT ET TTT TTT ee ine ‘This implies that Rs 100 compound annually at 1025 per cent, or Rs 100 compounded semi annually at 10 per cent will accumulate to the same amount: EIR in the above example can also be found outas follows: rae rea essa ure|!* 3 Ds 102Sar10.25% Notice that annual interest rate, j, has been divided by 2 to find our semi-annual interest rate since we want to compound interest twice, and since there are two compounding periods in one ‘year the term (I+ ‘Ph ynas been squared, If the compounding is done quarterly, the annual interest rate, j, will be divided by four and there will be four compounding periods in one year, This logie can be extended further as shown in Iustration given below. ieee You can get an annual rate of interest of 13 per cent on a public deposit with a company. What is the effective rate of interest if the compounding is done (a) half-yearly, (b) quarterly and (c) weekly? For the half-yearly compounding, EIR will be: = 1M2 or 13.42% For the quarterly compounding, EIR will be: [4] =1 =.1565 or 13.65% For the weekly compounding, EIR, will be: |! +3 386 oF 13.86% zure[14 | z 2 32 ‘The formula for calculating EIR can be written in the follawing general form: El where { is the annual nominal rate of interest, n number of years and m the number of compounding per year. In annual compounding m = 1, in monthly compounding m = 12 and soon, The concept developed above can be used to accomplish the multi period compounding or discounting for any number of years. For example, if a company pays 15 per cent intetest compounded quarterly, on a 3-year public deposit of Rs 1000, then the total amount compounded after 5 years will be: indica School of Fetroleum Page 33 ‘Ths sea be papier prope of Tein Schaef Pawan adie wens pated ander thy ‘Coney lion gee in he scent E wf21)oO Fe Rs 1,000 i eal = Rs 1,000 (1.0875) = Rs 1000x1555 = Re 1,555 We can thus use the following formula for computing the compounded value of a sum in cage of the mulii period compounding: Where Fy is the future value, P is the sum today, i is the anual rate, n is the number of years and m is the number of compounding per year. The compound value of an annuity in case of the mult! period compounding is given as follows: (23) The logic developed above can be extended to compute the present value of a sum oran annuity in case of the multi period compounding: The discount rate will be i/m and the time horizan will be equal tonxm, w ante Let us find out the compound value of Rs 1,000 interest rate being 12 per cent annum if compounded annually, semi-annually, quarterly and monthly for 2 years, (@) Annual compounding Rs 1000 (1.12)° = Rs 1,000 X 1.254 = Re 1.258 (ii) Hal-yearly compounding 2 ~ Rs 1.00 (1.08)*= - Rs 1,000% 1.262 Re 1,262 Fe= Rs 1,000 m 2 NEST {t has been stated earlier that the firm's financial ebjective should be to maximize the shareholder's wealth. Wealth is defined as net present value (NPV), NPV of a financial decision is the difference between the present value of eash inflows and the present value of cash outflows. Suppose you have a sum of Rs 200,000. Yeu want to invest this money in land which can fetch you Rs 245000 after one year when you sell it, You should undertake this investment if the present value of the expected Rs 2,45,000 after a year is greater than the investment outlay of Re 2,00,000 today. You can put your money to alternate uses. For example, you can invest Rs 2,00,000 in units (Unit Trust of India sells ‘units’ and invests money in securities of companies on behalf of investors) and eam, say, 15 por cont dividend Indian Schoo! of Petroleum Page 34 ‘Tihs oreo se proprntary papery Indian Schaal Par ad etal deed wad dbr ‘Coxaitin: Clee" info te carsip 4 year, How much should you invest in units to obiain Rs 2,45,000 after a year? In ather words, if your opportunity cost of capital is 15 pee cent. what is the present value of Rs 2,45/000 if you invest in land? The present value is; PV = Rs 2,45,000 (PVE,, 1») = Rs 245,000 x 870 = Rs 2,13,150) ‘The land is worth Rs 213,150 today, but that does not mean that your wealth will incnease by Rs 213,150, You will have to commit Rs 200,000, and therefore, the net increase in your wealth or net present value is: Rs213,150 - Rs200,000-Rs 13,150. It is worth investing in land. The general formula for calculating NPV can be weitten as follows: 4, +0 dea? ape NPV=95 45 where Av is cash inflow in period 4 Cs cash outflow, k the opportunity cost of capital and | the time period. Note that the opportunity cost of capital is 15 per cent because it is the return foregone by investing in land rather than investing in securities (units). The opportunity cost of capitals used as. discount rate. Pre PATER oe eran You may be frequently reading advertisements in newspapers: deposit, say Rs 1,000 today and get twice the amount in 7 years; or pay us Rs 100 a year for 10 years and we will pay you Rs 100 a year thereafter in perpetuity and so on, In such situations, you would be interested to know what rate of interest is being offered by the advertiser. You can use the concept of present value to find out the interest rate of return of these offers, Let us take some examples. A bank offers you to deposit Rs 1,000 and promises to pay Rs 1,762 at the end of five years. What rate of interest are you earning? You ean set your problem as follows: Rs 1,000 is the present value of Rs 1,762 due to be received at the end of fifth year. Thus, P= Rs 1,000= Rs 1,1762 (PVFs i) Now you refer to Table C given at the end of the’ book. Since 567 is a PVF at / rate of interest for 5 years, look across the row for period 5 and interest rate column until you find this value. You will natice this factor in the 12 per cent column, You will, thus earn 12 pet cent on your Rs 1,000, (Check: Rs 1,000 (1.12}5 = Rs 1,000 (1.762) = Rs 1.762.) Lot us lake another example. Assime you borrow Rs 70,000 from the Housing Development Finance Corporation (HDFC) to buy a car in Ahmedabad, You are required to mortgage the flat and pay Rs 11,396.93 annually for a period of 15 years. What interest rate would you be paying? Notice Rs 70,000 is the present value ofa fifteen-year annuity of Rs 11,396.93. Thal is Indian School of Peirateum Page 35 ‘ihe dames is he propre peop of lacie Sebo of Pees au tx coset paced ale She ‘Cofieriiy Clon’ gin sn Mesias= ae P = Rs 70,000 = Rs 11,396.98 x PVAF 5, 70,000 RS11,39693 This time look aerss in Table D the row for period 15 and interest rate columns until you get the value 6142, You find this value in the 14 per cent column. Thus, HDEC is charging M per cent interest from you, PVAFi5i« = 6.142, Finding the rate of retum for an uneven series of cash flows is a bit difficult, By practice and using trial and error method you can find it, Let us suppose that your friend wants to borrow fram you Rs 1,600 today and would return you Rs 700, Rs 600 and Rs 500 in yeer 1 through year 3 as principal plus interest, What rate to interest would you be eaming? You can again recognize that Rs 1600 is the present value of Rs 700, Re 600 and Rs 500 received respectively after one, two and three years. You feel that your friend must have perhaps considered paying you an interest of 8 per cont, When you calculate the present value of the cash flows at 8 per cent, you get the fallowing amount Cash flow P¥ ofeash flow Year Rs, PVE at 8% Rs. 1 700 926 618.20 2 600 857 514.20 3 500 7d 397.00 : 1,559.40 Since this amount is Jess than Rs 1,600, it seems that your friend is allowing you 2 lower interest rate: so you try 6 per cent. You oblain the following results: Cash flow PW of Cash flow: Year Rs PYF at6% Rs 1 700 38 2 600 Bo a 500 840 Your friend seems to offer you approximately 6 per cent interest, In fact, the actual rate would be a little higher than @ per cent. At 7 per. cent, the present value of cash flows is Rs 1,586, You can interpolate as follows to calculate the actual rate: Difference Required PV Rs 1,600 Red PV até per cent 1614 Rs.28 PV.at7 per cent 1,586 Tadian School of Petroteun Page 36 “TWe dns teppei papi Ion haa f Peels andi cit proeiedwcere Camiiy Cane gene he cuntTe cod ‘Thus, the rate of interest is: = 6 + 9% 68) RE Rs28 = 6% 4 5E= 65% At 637 per cent rate of interest, present value of Rs 700, Rs 600 and Rs 500 occurring respectively in year one through three is equal to Rs 1,600: _ R700, Rx600. _Rs500 (1.065) (1.065)? (1.065)" = FOO x 0.939 + Rs 600 xO.883 + Rs 500 x 0.828 = Rs 1,600. Tran Schoal of Petroleum Page 37 Te eer te prprcty property fn Sn of Pre ais cote prad war Conf Clea gh is he diuenti ee ee i oO Individuals generally prefer possession of a given amount of cash now, rather than the same amount at same future time, This time preference for money may arise because of fo)” uncertainty of cash flows, (b) subjective preference for consumption, and (0) availability ofvastment opportunities, The lat reason fs the most senstble justification for the time value of money. A tisk premium may be demanded, over and above the compensation for time, to account for the uncertainty of cash flows. {hlerust rate or ime preference rate gives many its value, and facilitates the comparison of eash flows occurring at different time periods. A risk-premium rate is added to the vsk. free tae Preference rate to derive requized interest rate fram risky investments. ‘Two altematice proseclums an be used to find the value of eash flows: compounding and discounting, In ‘Shmpeunding, future values of cash flows at a given interest rate at the end ofa given period of ‘ime are found. The future value (F) of a lump'sum today (R) for n periods at /rate of interest is given by the following formula; Fr=P(ieip = P(CVEA) ‘The compound value factar (CVFa,) can be found out from Table A given at the end of the book ‘he future value of an annuity (that i, the same amount ofcash each year) for n periods at irate of inlerest is given by the following equation: Fe? [| =P(cvar,) 7 The ‘compound value of an annuity factor (CVAFu) can be found from Table B given at the end of the beck, Uh Giscounling, the present value of exsh flows at a given interest rate atthe beginning of a given period of time are computed, The present value concept is the most important concept in financial decision-making. ‘The present value (P) of a lump sum (F) occurring at the end of n period at rate of interest is given by the following equation: Por Teva) “The present value factor (PVFn,i) can be obtained from Table C given at the end of the book, ‘The present value of an annuity () occurring for n periods ati rate of interest can be founcl out as follows; 1 = Peal OS" eal evarna) i +i" “able D can be used to find out the present value of annuity factor (PVAFn). indian School of Petroleum Page 38 Te cats he pring rapa sf cn Slt f Peale ae ent rtd ane the Cafe Cla ge in ie duce.eee ES ‘The present value of an annuity formula can ‘be usad to determine annual cash flows to be eared to recovera given investment. The following equation can be used: 1 A=P|———| =P(CRI lem The capital recovery factor (CRFy) is a reciprocal of the present value annuity factor, PVAEn, i. The present value concept can be easily extended to compute present value of an uneven series of cash flows, cash flows growing at constant rate, ‘or perpetuity When interest compounds for more than onoe in a given period of time, itis ealled multi period compounding, [fis the nominal interest rate for a period, the effective interest rate (EIR) will be ‘more than the nominal rate jin multi period compounding since interest on interest within a year will also be earned, EIR is given as follows: sie=[t+ “| 4 where m is the number of compounding in a year and nis number of years. Indian School of Petroleum Poge 32 Ta aucun he pricy pepe fae Shel f Perey is ene rated wed anietity Clo’ ie a he deatwy The Table gives the summary of the compounding and discounting formuloe. Table Summary of Compounding and Discounting Formulae Purpose Given Calculate Formula 2 Compound value ofa lump sum POF Fe Pus)" (+i) 9 Compound value ofan annuity A F Fea=|S7 7 @ Present value ofa lump sum F Present value ofan annuity A 1D Capital recovery i 2 Present value of a perpetuity A 0 Compound value of anannuitydue A @ Present value of an annuity due A P aj deor=! al ian" lo ‘An important corollary of the present value is the rate of retum. It is the rate which equates the present value of cash flows to the initial i wwestment. Thus in operational terms, in the present value equation, all variables are known except i and i can be found out by trial and ecroz method as discussed in the chapter. indian School of Fetroteum Boge 40 “This dicac ic be ree pooper of asian Seber af Puram ud ts sontentsposcewade the ‘Coaeniliy lua’ gen the coos(Oteraces OE Capital Budgeting | Introduction | ‘The efficient afiocation of capital is the most important finance function in the modem times. It involves decisions to commit the firm's funds to the long-term assets. Such decisions are of considerable importance to the firm since they tend to determine its va and size by influencing its growth, profitability and risk. In this chapter, we shall discuss the nature of investment decisions and the criteria for investment analysis, We shall also provide a comparison of the various investments criteria to indicate the most consistent caiterion. What are Cay ns 2| The investment decisions of a firm are generally Known as the capital budgeting, or capital expenditure decisions. A capital budgeting decision may be defined as the firm's decision to invest its currant funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years. The long-term assels are those, which affect the firm's operations beyond the one-year periad. The firm's investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is alsa analyzed as an investment decision. Activities such as change in the methods of sales distribution, or undertaking an advertisement campaign or a research and development programme have long. term implications for the firm's expenditures and benefits, and therefore, they may also. be evaluated as investment decisions, It is important to note that investment in the fong- term assets invariably requires funds to be tied up in the current assets such as inventories and receivables. As such, investmentin fixed and current assets is one single activity. ‘The following are the features af investment decisions: + The exchange of current funds for future benefits. + ‘The funds are invested in long-term assets, * The future benefits will occur to the firm over a series af years It is pertinent to emphasize that expenditures and ‘benefits of an investment should be measured in cash. In the investment analysis, it i5 cash flow, which is important, not the accounting profit. It may also be pointed out that investment decisions affect the firm's value. The firm's value will increase if investments are profitable and add to the shareholders wealth. Thus investments should be evaluated on the basis of @ criterion which is compatible with the objective of the shareholders’ wealth maximization. An investinent will add to the sharcholders' wealth if it yields benefits in excess of the minimum benefits as per the apportunity cost af capital. In this chapter, we assume that the investment project's opportunity cost of capital is known, We also assume that the Indian School of Petroleum Page 4 Thi dere i dhe prmpiary papery of Tdi Seal ef Peri amd ite enous preted nar the Cafes, Clone givenZ \Be ‘expenditures and benelits of the investment are known with certainty, Both these assumptions are relaxed later, y are Investment Decisions Important Investment decisions require special attention because of the follawing reasons + They have long-term implications for the firm, and can influence its risk complexion. + They involve commitment of large amount of funds. + ‘They are irreversible decisions + ‘They are among the most difficult decisions to make. The effects of investment decisions extend into the future and have (0 be endured for a longer period than the consequences of the current operating expenditure, Firm's decision to invest in long-term assets has a decisive influence on the rate and direction of its growth. A wrong decision can prove disostrous for the continued survival of the firm; unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm. On the other hand, inadequate investment in assets would make it difficult for the firm to compete successfully and maintain its market share, iRisi] Long-term commitment of funds may also change the risk complexion of the finn: If adoption of an investment increases average gain, but causes frequent fluctuations in its camings, the fim will become moze risky. Thus investment decisions shape the basic character of a firm. Investment decisions generally involve large amount of funds which make it imperative for the firm to plan its investment programmes very carefully and make advance arrangement for procuring finances internally or externally. Fannin Most investment decisions are irreversible, It is difficult to find a market ‘of such capital items once they have been acquired, The firm will incur heavy losses if such assets are scrapped, Investment decisions are among the firm's» most difficult decisions. They are an assessment of future events which are difficult to predict. It is really a complex problem to corrvetly estimate future cach flows of an investment The cash flow uncerlainty is caused by economic, political, social and technological forces. Indian School of Petroleum Pose 42 Tier cate i te prspriiary prapery of dow Seba ef Pera aa it att rate nr de “Canfileatably Clue pew in the dcoertDrea There are: many ways to classify investments, Some of the classifications are: ‘Expansion of existing business - Expansion of new business = Replacement and modernization Een eed ‘A company adds—scapacity to sits,—existing product lines to expand existing operations, For example, a fertilizer company may increase its plant size to manufacture more urea. Expansion of new business requires investment in new products and a new kind of production. activity within the firm. If a manufacturing company invests in new plant and machinery for a product, which the firm has not manufactured before, this represents expansion of new business or diversification. Sometimes a company acquires existing firms to expand its business. In either case, the firm makes investment in the expectation of additional revenue, Investments in existing ‘ornew products may also be called as revenue-expansion investments, Rtperonten erent ‘The main objective of modemization and replacement is to improve operating efficiency anc reduce costs. ‘Cost savings will reflect in increased profits, but the firm's revenue may remain unchanged. Assets become outdated and obsolete with technological changes. The firm must decide to replace those assets with new assets that operate more economically. If a cement company changes from semi- automatic drying equipment to fully automatic drying equipment, it is an example of modemization and replacement. Replacement decisions help to introduce more efficient and economical assets and therefore, are also called cos(-reduection investments, However, replacement decisions which involve substantial modemization and technological improvements expand revenue as well as reduce costs. Ayyet another useful way to classify investments is as follows: + Mutually exclusive investments + Independent investments + Contingent investments, Mutually exclusive investments serve the same purpose and compete with each other. IF ane investment is undertaken, others will have to be excluded. A company may, for example, either ‘use a more labor-intensive, semi-automatic machine, ar employ a more capital-intensive, highly automatic machine for production. Choosing the semi-automatic machine precludes the acceptance of the highly automaticmachine. Independent investments serve different purposes and do not compete with “each other. For example, a heavy engineering company may be considering expansion of its plant capacity to manufacture additional excavators and addition of new production facilities to manufacture a new product—light commercial vehicles. Depending on their profitability and availability of funds, the company can undertake both investments, Indian Sehoot of Petroleum Page 43 “ies dione ish prapcan poapesof Indian Sebo of Pra a its ctats patted wader be Coy Clas gia ie ie seieee ee Cee Cee we Contingent investments are dependent projects; the choice of one investment necessitates that cone OF mote other investments should also be undertaken. For example, if a Sompany decides to build o factory in a remote, backward area, it may have to invest in Houses; raads, hospitals, schools etc. for employees to attract the work force. Thus building of factory also requires investment in facilities for employees, The otal expenditure wih be ueated as one single investment UUs Arr esterny ‘Three steps are involved in the evaluation of an investment: * Estimation of cash flows * Estimation of the required rate of return * Application of a decision rule for making the choice, {he First two steps, which are discussed in. subsequent chapters, are assumed ag given, Tus our discussion in this chapter is confined to the third step. Specifically, we focus on the merits and demerits of various decision rules, Investment decision rules may be refered to as eapital budgeting techniques, or investment criteria. A sound appraisal technique should be used to measure the economic worth of an investment project. The essential property of a sound technique is that it should maximize the shareholders’ wealth, The following other characteristic should also. be Possessed by a sound investment evaluation criterica: { _Ttshould consider ail eash flows to determine the true profitability of the project. * _ltshould provide foran objective and unambiguous way of separating: good projects from bad projects, + Itshould help zanking of projects according to their true profitability, * It should recognize the fact that bigger cash flows are preferable ta smaller ones andl early cash flows are preferable to later ones, * It should help to choose among mutually exclusive projects that project which maximizes the shareholders’ wealth, * __ Ttshould to a criterion which is applicable toany conceivable investment project independent of others, These conditions will be clarified as we discuss the featums of various investment crileria in the following pages, e PPEERCr eee o cee = A number of capital budgeting techniques are in use in practice. They may be grouped in the following two categories: "Discounted Cash Flow (DCF) Criteria + Net Present Value (NPV) ‘+ Internal Rate of Return (IRR) * Profitability Index (Pt) + Nor-discounted Cash Flow Criteria + Payback Period (PB) + Accounting Rate of Return (ARR) Indian School of Petroteum Poge 44 Fein i preity propery of Ldn Ss! of Peter and is ott pratt de be Canfieticty Chugh in Be dom,Chapter IT Time Value of Money Most financial decisions, such as the purchase of assets or procurement of funds, affect the firm's cash flows in different periods. For example, if a fixed asset is purchased, it will require an immediate cash outlay and will generate cash flows during many future periods, similarly, if the firm Lerrows funds from a bank or from any other source, it receives cash now and commits an sbligation to pay interest and repay principal in future periods. Besides borrowing, the organization may raise funds by issuing equity shares. The organization’s cash balance will increase at the time shares are issued, but, as it pays dividends in future, the outflow of cash will occur. Sound decision-making requires that the cash flows which an enterprise is expected to give up over period should be logically comparable. In fact, the absolute cash flows which differ ming and risk are not directly comparable. Cash flows become logically comparable when they are appropriately adjusted for their differences in timing and risk, ‘The recognition of the time value of money and risk is extremely vital in financial dectsion- making. If the timing and risk of cash flowrs is not considered, the firm may make decisions, which may allow it to miss its objective of maximizing the owners’ welfare. The welfare of ‘owners would be maximized when net wealth or net present value is created from making a financial decision. What is net present value? Itis a time value concept. ‘The purpose of this chapter is to explain the method for adjusting the time value in financial decisions. We shall concentrate particularly on the rationale for time preference far money and ‘he time-adjusting mechanics of compounding and discounting. IEE Jt an individual behave rationally, he would not value the opportunity to receive a specific amount of money now equally with the opportunity to have the same amount at some future date, Most individuals value the opportunity to receive money now higher than waiting for one ‘or more years to receive the same amount. The phenamenan is referred to as an individ wal’s time Preference for maney. Thus, an individual's preference for possession of a given amount of cash how, rather than the same amount at some future time, is called “time preference for money," * Uncertainty © Preference for consumption + Investment opportunities. We live under uncertainty. As an individual is not certain about future cash receipts, he prefers receiving cash now. Most people have subject preference for present consumption over future consumption of goods and services either because of the urgency of their present wants or because of the risk of not being in a pasition to enjay future consumption that may be caused by illness or death, or because of inflation. As money is the means by which individuals acquire Indian School of Petroleum Poge 16 ‘Ths ome be paps popu of Tene Sheol af Pare aie cemlnts prtucied wader the Comfdetiatiy Cane in in Phe dosenta ARs most goods and services, they may prefer to have money now. Further, most individuals prefer Present cash to future cash because of the available investment opportunities to which they can put present cash to earn additional cash, In case of the business firms as well as individuals, the justification for time preference for money lies simply in the availability of investment opportunities. in financial decision-making under certainty, the firm has to determine whether one alternative yields more cash or the other. In case of a firm which is owned by a large number of individuals, it neither needs nor it is possible to consider the consumption preferences of owners. The uncertainty about future cash flowsis also not a sufficient justification for time preference far money. We are not certain even about the usefulness of the present cash held; it may be last or stolen, In investment and other decisions of the firm what is needed is the search for methads of improving decision-maker’s knowledge about the future, In the firm’s investment decision, for example, certain statistical tools such as probability theory, or decision tree are used to handle the uncertainty associated ‘with cash flows. RRS ee cee eee on ‘The Ume preference for money is generally expressed by an interest rate. This rate will be positive even in the absence of any risk, It may be therefore called the risk-free rate. For instance, if time preference rate is 5 per cent, it implies that an investor can forego the opportunity of receiving Rs 100 if he is offered Rs 105 after one year (i. Rs 100 which he would have received now plus the interest which he could eam in a year by investing Rs 100 at 5 per cent). Thus, the individual is indifferent between Rs 100 and Rs 105 a year from now as he considers these two amounts equivalent in value. In reality, an investor will be exposed ta some degree of tisk. ‘Therefore, he would require a rate of return from the investment which compensates him for bath time and risk. His required rate of return will be: Required rate of return =Risk-free rate + Risk premium (1) ‘The risk-free rate compensates for time while risk premium compensates for risk. The required rate of return may also be called the opportunity cast of capital of comparable-tick, It js called so because the investor could invest his money in assets or securities of equivalent risk. Like individuals, firms, also have required rate of return and use them in evaluating the desirability of alternative financfal decision. The existence of interest rates provides money with its time value quite apart from the preferences and attitudes of any one person. How dees knowledge of the required rate of return or simply the interest rate help an individual ora firm in making investment decision? It permits the individual or the firm to convert different amount offered at different times to amount of equivalent value in the present, a common point of reference. To illustrate, let us assume an individual with an interest rale of 10 per cent. IF hes offered Rs. 11590 one year from now in exchange for Rs 100 which he should accept the offer. When his interest rate is 10 per cent, this implies that he is indifferent between any amount today and 110 per cent of the amount (Le. more than Rs 110 in the example) one year from now; but if the amount offered one year from now were less than 110 per cent of the immediate payment, he would retain the immediate payment. He would accept Rs 115.50 after a year since it is more than T10 per cent of Rs 100 which he és sequired to sacrifice today. Indian School of Petraleum Page 19 The deme ihe rarity Peery of nan cholo Pete aoa es ents proteta nndr the Coafidnlaiy Clese’ gen én be easeiB? We can ask another question: Between what amount today and Rs. 115.50 one year from now would our investor be indifferent? The answer is that amount of which Rs 115,50 is exactly 110 percent. DividingRs 115.50 by 110 per cent or 1.10, we get: Rs 115.50 =Rs 105. 110 ‘This amount is larger than what the investor has been asked to give up. He would, therefore, accept the offer. Compound Value} We have thus developed the logic for deciding between cash flows that are separated by one period, such as one year. But most investment decisions involve more than one period, To solve such complicated investment decisions, we simply need to extend the logic developed above, Let ‘us assume that an investor require 10 per cent interest rate to make him indifferent to cash flows ‘one year apart. ‘The question is : How should he arrive at comparative value of cash flows two, three or any number of years apart? ‘Once the investor has determined his interest rate, say, 10 per cent, he would like to receive at least Rs, 1.10 after one year or 110 per cent of the original investment of Rs 1 today. A two-year period is tow successive one-year periods. When the investar invested Rs 1 for one year, he must have received Rs 1.10 back at the end to that year in exchange for the original Rs 1. if the total amount so received (Rs 1.10 ) is reinvested, the investor would expect 110 per cent of that amount, or Rs 1.21 9 ic. Rs. 1x 1.10 1.10) at the end of the second year, Notice that for any time after the first year he will insist or receiving interest on the first year interest as well as interest on. the original amount (principal). 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 a payment (or receipt) of series of payments (ar receipts} when applying the concept of compound interest is known as compounding. How is Compound value of a Lump Sum Calculated: Suppose you gave your son Rs 100 on your eighteenth birthday. You deposited this amount ina bank at 10 per cent rate of interest for one year. How much future sum would you receive after ‘one year? You would receive Rs. 110 as, Future sum = 100 + 0.10% 100 = 100 (1.10) = Rs 110 ‘What would be the future sum if you deposited Rs 100 for two years? You would now receive interest on interest earned after on year: Future sum = (100 #0.10 x 100) + 0.10 (100 + 0.10 X 100) = 100(1.10) 1.10) =Rs 121 ‘You could similarly calculate future sum for any number of years. We can express this procedure, Indian School of Petroteum Page 20 ‘Tihs ascent the peeprivior property of Tie Seo fof Params ants ones fodced wai the Confetti Clona'gien in the deer.@ of calculating compound or future value in formal terms, Let I represent interest rate per period, n the number of periods before payoff, and F the future, or compound value, if the present amount is invested at Irate of interest for one year, then the future value F; (that is z, principal plusinterest } at the end of one year will be: RyeP +P Fi-p (141) The outstanding amount a the beginning of second year is: fi = P (1#1). ‘The compound sum at the end of secand year will be: Fr=Fl+Fli=Fl (1+) F,= PIQH) +P (+i Taking out P (1+I) as common factor, we have: Fe =P (1+) (1+) Fe =P G41? Similarly, B = f (1+1) = P (+1 and so on. The general form of equation for calculating the future value of a lump sum after n periods may, therefore, be written as follows: Fy P (1+1e scat 2) ‘The term (144 is the compound value factor (CVF) af a lump sum or Re 1, and italways has a ‘value greater than 1 for positive i, indicating the CVF increases as i and n increase. ‘Suppose that Rs 1,000 are placed in the savings account of a bank at'S per cent interest rate, [t will grow to Rs 1,050 at the end of one year since F, = Rs1 000 (1.05) = Rs 1,080, Atthe end af two years, we will have a total sum of F: = Rs 1,050 (1.05) (Or Rs 1,000 (1.08): = Rs 1,000 (1.1025) = Rs 1,102.50. Notice that outstanding sum of Rs 1,050 in the first year will earn an interest of Rs 52.50, thus making the outstanding amount equal to Rs 1,10250 at the end of second year. ‘The compound value at the end of third year will grow to: y= Re 1,102.50 (1.05) or Rs 1,000 (1 + .05)'= Rs 1000 (1.1576) = Rs 1,157.60 and soon. We can, see that the compound value factor (CVF) for a lump sum of one rupee at 5 per cent for ‘one year is 1.05, for tivo years 1.1025 and for three years 1.1576. The compound value can be computed for any lump sum amount at i rate of interest , for m years, employing Equation (2), However, calculations of compound value will become very difficult ff the amount is invested for a very long period, say, for 15 years. The compound value ‘of Re | for various pertods of time at different rates of interest can be pre calculated. Such pre calculated values are available in Table A given at the endl of the baok, With the use of this table, the compound value calculations become very easy. To compute the future value of a lump sum, we should simply multiply it by compound value factor (CVF) for given Land n from Table A. It should be noted that time periods in the table can be days, months, quarters, years, or any other indian School of Petroteum Page 21 ‘Ths acumen t be prprieiany prpery of Indie Sse of Pema ond. ensat prec ane the Canfienticy Clown ge in the dcrtime period. The compound CF value factor is always greater than 1.0 for positive interest rates, indicating that present value will always grow to a larger compound value If one deposited Rs 55,650 in a bank which was paying 2 12 per cent rate of interest on a ten-year time deposit, how much would the deposit grow at the end of ten years? We will first find out compound value factor at 12 per cent for 10-years. Referring to Table A and reading," tenth row for 10-year period and 12 per cent column, we get CVF of Re 1 as 3106. Multiplying 3.106 by Rs 55,650, we got Re 1,72,818.90 as the compound value, Equation (2) far computing future value of a lump sum ean also be written as follows FV=P(CVFai) ‘Where Fv is the future or compound value and CVF, the compound value factor where subscript n refers to period and I rate of interest. Thus, in Illustration 2, future value isi (3) PV=R55,650(CV Eat) i= Rs 55,650 x 3.106 = Rs 1, 72,818.90 How: of an Annuity Calculated: An annuity isa fixed payment (or receipt) each year for a specified number of years. If you rent a flat and promise to make a series of payments over an agreed period, you have created an. annuity. ‘The equal installment loans from. the house financing companies or employers are common examples of annuities. The compound value ofan annuity cannot be computed directly from Equation (2) Let us illustrate the computation of the compound value of an annuity. Suppose a constant sum of Re 1 is deposited ina savings account at the end of each year for four yearsat 6 per cent interest. This implies that Re 1 deposited at the end of the first year will grow for years, Re 1 at end of second year for 2 years, Re Lat the end of the third year for 1 year and Re 1 at the end of the fourth year will not yield any interest. Using the concept of the compound value of a lump sum, we can compute the value of annuity, ‘The compound value of Re 1 depasited in the first year will be: Re 1 (1 + .06)3 = Rs 1.191, that of Re I deposited in the second year will be: Re I (I +.08)2= Rs 1,124 and Re 1 deposited at the end of third year will grow to; Re 1 (1 + .06)1 = Rs 1.06 and Rs, 1 deposited at the end of fourth year will remain Rel. The aggregate compound value of Re 1 deposited at the end of each year for four years would be: Re 1.191 + Rs 1.124* Rs 1.060+ 1.00-Ret.375. Tadian School of Petroleum Poge 22 "hr dhament i eprepriny pryperge of Tdi Seba of Paseo its ont proce wads “Cofietoty Clam giv the daceoo. pe {twill be shown in the subsequent text that the net present value criterion is the most valid technique of evaluating an investment project. It is generally consistent with the objective ‘of maximizing the shareholders wealth, BS Cue ey asd ‘The net present value (NPV) method is the classic economic method of evaluating the investment proposals. It is one of the discounted cash flow (DCF) techniques explicitly recognizing the time value of, money, It correctly postulates that cash flow arising at different time perieds differ in value and are comparable only when their equivalents— present values—are found out. ‘The following steps are involved in the calculation of NPV: ‘+ Cash flows of the investment project should be forecasted based on realistic assumptions. + Appropriate discount rate should be identified o discount the forecasted cash flows. ‘The appropriate discount rate is the firm's opportunity cost of capital which ts equal to the required rate of return expected by investorson 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 outflows from present value of cash inflows. The project should be accepted if NPV is positive (ie. NPV>0) ae Let us consider an example. Oe i Assume that Project X costs Rs 2500 now and is expected to generate yearend cash inflows of Rs $00, Rs #00, Rs 700, Rs 600 anel Re 500 in years 1 through 5. The opportunity cost of the capital may be assumed to be 10 per cent. The net present value for Project X can be calculated by referring to present value table (Table C at the end of the book}, The calculations are shawn below : NPV= Rs 900+ Rs800+ Rs 700+ Rs 600+ Rs500 (1+ 40) (1+ 2071+ 20% (1+ 20} +10 | -Rs 2,500 NP’ {Rs 900 (PVF;, 19) * Rs 800 (PVF:, 10) + Rs 700 (PVEs, 10) + Rs 600 (PVEs, 10) + Rs 500 (PVFS, 10)] - Rs 2,500 NPV = [Rs 900 x 0.909 + Rs 800 x0.826 + Rs 700 x 0.751 + Rs 600.683 + Rs 500 x 0.620] - Rs 2,500 NP Rs 2,725 Rs 2,500 = + Rs 225 Project X's_present value of cash inflows (Rs 2,725) is greater than that of cash outflow Indien School of Petroleum Poge 45 This doce abe pmpriaar propeg of Tein Sle a) Pan ait att rated wader the Gandy loan pe in the docensoo {RS 2,500), Thus, it generates a positive net present value (NPV=#is 225). Project X adds to the wealth of owners; therefore, itshould be accepted. ‘The equation for the net present value can be written as follows: where Ci, Cin represent net cach inflows in year 1, 2.. k is the opportunity cost cif capilal, Co is ihe initial cost of the investment and 1 is the expected life of the investment Itshould be noted that the cost of capital, & is assumed ta be known and is constant, Why NPV is Important? ‘A question may be raised: Why a financial manager should invest Rs 2.500. in Project X2 Project X should be undertaken if it is best for the company's shareholders; they would like their shares to be as valuable as possible. Let us assume that the total market value of a hypothetical company is Rs 10,000, which includes Rs 2500 cash that can be invested in Project X. Thus the value of the company's other assets must be Rs 7,500. ‘The company has to decide whether it should spend cash and accept Project X ot to keep the cash and reject Project X. Clearly Project X is destrable since its PV (Rs 2,725) is greater than the Rs 2.500 cash. If Project X is accepted, the total market value of the firm will be: Ks 7/500 + PV of Project X = Rs 7500 + Res 2,725 = Rs 10,225; that is, en increase by Rs 225, The company’s tolal market value would remain only Rs 10,000 if Project X is rejected. Why should the PV of Project X reflect in the company's market value? To answer this question, lot us assume that a new company X with Project X as (he only asset is formed, ‘What is the value of the company? ‘We know from the earlier discussion that the mazket value of a company’s shares fs equal to the present value of the expected dividends, Since Project X is the only asset of Company X, the expected dividends would be equal to the forecasted cash flows from Prajaet X. Invastors would “discount the forecasted dividends at a rate of return expected on securities equivalent in risk to ‘company X. The rate used. by investors to discount dividends isexactly the rate which we should tase to discount cash flows of Project X. The caleulation of the PV of Project X isa replication of the process which shareholders will be following in valuing the shares of company 2. Once we Find out the value of Project X as a separate venture, we can add it to the value of other assets to find out the portfolio value. ‘The difficult part in the calculation of the PV of an investment project is the precise measurement of the discount tate. Funds available with a company can either be invested in projects or given to shareholders. Sharcholders can invest funds distributed to them in financial assets, Therefare, the discount rate is the opportunity cost of investing in projects rather than in capital markets, Obviously, the opportunity cost concept makes sense when Indian School of Fetrofeum Page 46 "Ths dune the propria papel of Icon Stab f atu aul te iat preci ack te Caney Clee gen he cutfinancial assets are of equivalent risk as compared to the project. An alternate interpretation of the positive net present value of an investment is that it represents the maximum amount a firm would bexeady to pay for purchasing the opportunity of making investment, or the amount at which the firm would be willing to sell the right to invest without being financially worse-off. The net present value (Rs 225) can also be interpreted to represent the amount the firm could raise at the required rate of return (10%), in addition to the initial cash outlay (Rs 2500), to distribute immediately to its shareholders and by the end of the projects' life to have paid off all the capital raised and return on it. The point is illustrated by the calculations shown in Table 1. Table 1, Interpretation Of Net Present Value “Amount Return on | Totalamount | Repayment [Balance outstanding | outstanding | outstanding | from cash at |Outstanding in the beginning| amountat1o% | flows theend Year| Re Rs Re Re IRE a 2,725.00 27250 2,997.50 900 12,097.50 2 2,097.50 209.75 2,307.25 800 }1,507.25 3 1,507.25 150.73 1,657.98 700 1957.98 oe 997.98, 95.80 1,053.78 600 453.78 EJ 453.78, 45.38 A996 500. (0.87)! “Rounding off error. Calculations in Table 1 are based on the assumption that the firm chooses to receive the cash benefit resulting from the investment in the year it is made. Any pattern of cash receipts, such that the net present value is equal to Rs 225, ean be selected. Thus, if the firm raises Rs 2,500 (the initial outlay) instead of Rs 2,725 (initial outlay plus net present value) at 10 per cent rate of return, at the end of fifth year after having paid the principal sum together with interest, it would be left with Rs 363, whose present value at the beginning of the first year at 10 per cent ant rate is Rs 225, It should be noted that the gain to sharcholders would be more if the rate of raising money is less than 10 per cent. PR ens Jt 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 (MPV < 0, The market value of the firm's 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 Tale higher than the opportunity cost of capital. Aproject 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 NPY=0 Tndian Schoat of Petroleum Page 47 ‘Ths Aimer she pps propey of adios S oa of Prmeum and it ents pred ender be ‘Confit Chica in tbe dosentiD The NFV method can be used to select between mutually exclusive projects; the one with the higher MPV should be selected. Using the NPV method, projects would be ranked in order of net present values; that is, first rank will be given to the project with highest positive net present value and so on. PEM RU CN Pen Moses TCU NPV is the true measure of an investment's profitability. The NPV method, therefore, provides the most acceptable investment rule. First, it recognizes the time value of money—a rupee received today is worth more than a rupee received tomorrow. Second, it uses all cash flows occurring over the entire life of the project in calculating its worth, The NPV method relies on estimated cash flows and the discount rate rather than any arbitrary assumptions, or subjective considerations. Third, the discounting process facilitates measuring cash flows in terms of present values; that is, in terms of current rupee. ‘Therofore, the NPV's of projects can be added. For example, NPV (A + B) = NPV (A) + NPV (B). This is called the walue additivity principle, and it implics that if we know the NPV's of separate projects, the value of the firm will increase by the sunt of their NPV's. We can also say that if we know values of separate assets, the firm's value can simply be found by adding their values. The value additivity is an important property of an investment criterion because it means that each project can be evaluated, indepencient of others, on its own merit. We will see later on that the unlue additivity principle is not applicable in the altemative investment criteria, Fourth, the NPV method is always consistent with (he objective of maximizing the charcholdere' wealth. This is the greatest virtucof the method. The NPV method is easy to use (/forecasted cash flows and the discount rate are known. In practice, it is quite diffieult to obtain the ostimates of cash flows due to uncertainty and to precisely measure the discount rate, Further, eaution needs to be applied in using the NPV method when altemative projects with unequal lives, or under funds constraint are ‘evaluated. These problems are discussed in detail in later chapter. It should be noted that the ranking of investment propects as per the NPV rule is not independent of the discount rates} Let us consider two projacts—A and B—both costing Rs 50 each, Project A returns Rs 100 after one year and Rs 25 after two years, on the others hand, Project B returns Rs 30 after one year and Rs 100 after two years, 4). Nate that k is also known as the required rate of return, or the cutoff, or hurdie sate. 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 cost of capital. Thus the IRR acceptance mules are: Accept r>k Reject rk ‘May accept rk ‘The reasoning for the acceptance rule becomes clear if we plot NPV's and discount rates for the project given in Table 2 om a graph like Fig, 1, Itcan be seen that if the discount vate is less than 16 percent IRR, then the project has positive NPV; if it is equal to IRR, the project has a zero NPV; and if it is greater than IRR, the project has negative NPV. Thus, when we compare IRR of the project with the opportunity cost of capital, we are in fact trying to ascertain whether the project's NPV is positive or not. In ease of independent projects” IRR and NPV rules will give the same results if the firm has no shortage of funds, NPV Profile NPV ('a00s) 12 10 8 IRR = 16%ARe Evaluation of IRR Method Like the NPV method, the IRR method recognizes the time value of money, and it considers all cash flows occurring over the entire life of the, project to calculate its rate of return. It generally gives the same acceptance rule as the NPV method. It is consistent with the shareholders’ wealth maximization objective. IRR rule can, however, give misleading and inconsistent results when the NPV of a project does not decline with discount rates. It alsa fails to indicate a correct choice between mutually exclusive projects under certain situations, Unlike in the case of the NPV method, the value additivity principle does not hold when the IRR method is used IRRs of projects do not add. Thus, for Projects A and B, IRR (A) + IRR (5) need not equal to IRR (4 + B), Consider the following example: Project, Co a NPV@10% IRR% A -100 41200 +91 20.0 B “100 4168 +2,7 120 A+B 250, +288 +118 152 Itean be seen from the example that NPV's of projects add: NPV (A) + NPV(B) = NPV (A + B)=9.1 +27 =118, while IRR (A) + IRR (B)* IRR (A + B) = 20% + 12% * 15.2% Profitability Inde: Yet another time-adjusted method of evaluating the investment proposals is the bene- fitcost (B/C) ratio or profitability index (PI), It is the radio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one, The formula to calculate benefit-cost ratio or profitability index is.as follows: PI=P¥ of cash inflows = PV (Cy jal cash outlay Co Indian School of Petroleum Page 53 Thi dame ithe prepritary propery of Tan Sel of Parr adits watt ected we the Crnfediay Can! nthees ih pierce ‘The initial cash outlay of a project is Rs 100,000 and it can generate cash inflow of Rs 40,000, Rs 30,000, Rs 50,000 and Rs 20,000 in year 1 through 4. Assume a 10 per cent rate of discount. The PV of cash inflows at 10 per cent discount rate is: PV = Rs 40,000 (PVFi2o)Rs30,000 (PVF2.19) + Rs 50,000 (PVFs1n) + Rs 20,000 (PVF sn) = Rs 40,000 x 909 + Rs 30,000 x 826 + Rs 50,000 x .751 + Rs 20,000 x 683, NPV = 5 112.350 - Rs 100,000 = Rs 12,350 Pl= Rsi12350 © P= 1.1235 Rs 100,000 aes The following are the Pl acceptance rales: Accept PI>1 Reject Pi 0), The market value of the firm's share is expected to increase by the project's positive NPV. Between the mutually exclusive projects, the one with the highest NPV will be chosen. ‘The internal rate of return (IRR) is that discount rate at which the project's net present value is zero. Under the IRR rule, the project will be accepted when its internal rate of return is higher than the opportunity cost of capital (IRR> 0). Bath IRR and NPV methods account for the time value of money and are generally consistent with the wealth maximization objective. They give same accept-reject results in case of conventional independent projects. Profitability index (PI) is the ratio of the present value of cash inflows to initial cash outlay. It is a variation of the NPY rule. PI specifies that the project should be accepted when it has a profitability index greater than one (Pl> 10) since this implies a positive NPV. A conflict of ranking can arise between the NPV and Ff rules in case of mutually exclusive projects, Under such a situation, the NNPV rule should be preferred since it is consistent with the wealth maximization principle, ‘In practice, two other methods have found favor with the business executives. They are the Payback (PB) and accounting rate of return (ARR) methods. PB is the number of years required to recoup the initial cash outlay of an investment project. The project would be accepted if its payback is less than the standard payback. The greatest limitation of this method is that it does not consider the time value of the conditions of constant cash flows and a long life of the ‘project, the reciprocal of payback can be a good approximation of the project's rate of return. ARR is found out by dividing the average profit after-tax by the average amount of investment. A project is accepted if its ARR is greater than a cut off rate (arbitrarily selected), This method is based on accounting flows rather than cash flows; therefore, it does not account for the time value of money. Like PB, itis also not consistent with the objective of the shareholders! wealth maximization. Inafan Schaat of Petroleum Page 61 ‘Tr draoment ete propriety property of Ladin Siluot of Ptrdcne and it eomtetr protested ander be “Canfestinity Clausen inthe ocimeatChapter I Risk Analysis of Capital Budgeting En Introduction The purpose of this chapter is to discuss the techniques of analyzing investment decisions under tisk, First we shall explain some conventional ways of handling risk. After pointing out the limitation of these methods, we shall emphasize the need and utility of sensitivity analysis, it is increase and statistical tools in analyzing investment decisions under risk. Risk exists because of the inability of the decision maker to be perfect forecasts. Forecasts cannot be made with perfection or certainty, since the future events on which they depend are uncerlain. An investment is not risk the weekend specify a unique sequence of cash flows worried, But the trouble is that cash flows cannot be forecast accurately, and alternative sequences of cash flows can occur depending on the future events. Thus, risk arises in investment evaluation because we cannot anticipate the occurrence of the possible future events with certainty, and consequently, cannot tmake any correct prediction about the cash flow statements, A large number of events influence forecasts. These events can be grouped in different ways. The particular grouping. of events will be useful for purposes. We may, for example, consider three broad categories of events influence in the investment forecasts PRR eee entrcnes ‘This category may by the of the events influence the general level of business activity, The level of business activity might be affected by such events as intemal and external economic and political situation, the government's monetary and fiscal policies, social conditions ete, Meters This category of events May affect all companies in an industry. For example, companies in industry would be affected by the industrial relations in the industry, by innovations, by change in the material cost etc. Ee eee This category of events may be effect only a company. The change in management, strike in the company, and natural disaster such as flood or fire may affect directly a particular company, Indian Schaot of Petroteum Page 62 ‘hes dacumeas is the propria property af Indian School of Petradam end its oats potted under the ‘Capit Classe gen in the onesent,iw {n formal terms, the risk associated with an investment may be defined as the variability that is likely to occur in the future returns from the investment. For example, if a person investssay Rs 20,000 in short term the government bonds, which are expected to he yield 6% return, he can accurately estimate the return on the investment. Such an investment is zelatively risk free. The teason for this belief is that the government will not fail and will pay interest regularly and repay the amount invested. It is for this reason that the rate of interest paid on government securities such as the short-term Treasury bills is the risk free rate of interest. Instead of investing Rs 20,000 in government securities, if the investor purchases shares of a company, then it is not possible to estimate future return accurately. The retamn could be negative, zero or some extremely large figuro Because of the high degree of the variability associated with the returns, this investment will be considered relatively risky. ‘Thus, risk is associated with the variability of future returns of a project. The greater the variability of the expected returns, the riskier the project. Risk can, however, be measured more precisely. The most common measures the risk that standard deviation and coefficient of variation are discussed later. RU Sele ean io Handle Ris! ‘A number of techniques of handling tisk are used by managers in practice. They range from simple rules of thumb to sophisticated statistical techniques. The following other popular, non- ‘conventional techniques of handling risk in capital budgeting: 1. Payback Period 2 Riskeadjusted discount zate 3. Certainty Equivalent Method. Let us leam more about these methods. Payback is one of the oldest and commonly used methods for explicitly recognizing risk associated with an investment project. This methed, as applied in practice, is more an attempt to allow for risk in capital budgeting decision rather than a method to measure profitability. Business firms using this method usually prefer short payback to longer ones, and often establish guidelines that firm accepts only investments with some maximum payback period, say three or five years, The merit of payback period is its simplicity, Also payback makes an allowance for risk by (focusing attention on the near term fulure and thereby emphasizing the liquidity of the firm through recovery of capital, and (3) by favoring short term projects over what may be riskier, longer term projects, {t should be realized, however, that the payback period, as a method of risk analysis is usoful only in allowing for a special type of risk, the risk that a project will go exactly as planned for a certain period and will then suddenly cease altogether and be worth nothing. It is essentially suited to the Indian School of Petroleum This dosent i the reprctanypeapety of Fin Sl of Peele and itr omleut preted dete *Colidertiaky Clan docemea.eg assessment of risks of time nature. Once a payback period has been calculated, the decision maker would compare it with his own assessment of the project's likely economic life, and if the latict exceeds the former, he would accept the project; This is a useful procedure only if the forecasts of cash flows associated with the project are likely to be unimpaired fora certain period. The risk that a Project will suddenly cease altogether after a certain period may arise due to reasons such as civil war in a country, closure of the business due to an indefinite strike by the workers, introduction of a new product by a competitor which captures the whole marke! and natural disasters such as flood or fire. Such risks undoubtedly exist but they, by no means, constitute a large proportion of the commonly encountered business risks. The usual risk in business is not that a project will go as forecasted for a period and then collapse altogether; rather the normal business risk is that the forecasts of cash flows will go wrong due to lawer sales higher cost etc. Further, even as a method for allowing risks of time nature, it ignores the time value of cash flows. For example, two projects with, say a four-year payback period are at very different risks if in one case the capital is reeavered evenly over the four years, while in the other it is recovered in the last year. Obviously, the second project is more risky, If both cease after three years, the first project would have recovered three-fourths of its capital, while all capital would be lost in the case of second project. Given the uncertainly element, it may well be that a four year payback period based ‘on fairly certain estimates might be preferred to a three-year payback period calculated with vory ‘uncertain estimates, For a long time the economic theorists have assumed that, to allow for risk, the businessman required a premium over and above an alternative which was risk-free. Accordingly, the more uncertain the retums in the future, the greater the risk and the greater the premium required, Based on this reasoning, it is proposed that the risk premium be incorporated into the capital budgeting analysis through the discount rate, ‘That is, if the time preference for money is to be recognized by discounting estimated future cash flows, at some risk-free rate, to their present value, then, to allow for the riskiness of those future cash flows a risk premium rate may be added to risk-free discount rate. Such a composite discount rate will allow for both time preference and risk preference and will be sum of the risk-free rate and the risk-premium rate reflecting the investor's attitude towards risk. The risk adjusted discount rate method can be formally expressed as follows: Where kis a risk-adjusted rate. That is: Kekyt+k, Where kris the risk free rate of return and kr is the risk premium. Indian Sehoot of Petroleum Page 64 This dames i she rcpt pop adie Shel ua ent tread ade te Confection ie earPee eee eT ECCI e SG oe ABé The risk- adjusted discount rate accounts for risk by varying the discount rate depending on the clegree of risk of investment projects, A higher rate will be used for riskier projects and a lower rate {or less dsky projects, The net present value will decrease with increasing k, indicating that the riskier a project is perceived, the less likely it will be accepted. IF the riskefree rate is assumed to be 10 per cent, some rate would be added to it, say 5 per cent, as compensation for the risk of the investment, and the composite 15 per cent rate would be used to discount the cast flows, Consider an investment project costing Rs 50,000 initially and expected to generate cash flows in years one Urough four of Rs 25,000, Rs 10,000 and Rs 10,000, What is the project's NPV if it is expected to generate certain cash flows? Assume a 10 per cent risk free rate. The net prosent value for the project, using a 10 per cent risk-free discount rate, is: NPV=- Rs 50,000+ Rs 25,000 + Rs 20,000 + Rs 10,000 + Rs 10,000 = Rs 3,509 (1410) (e107 4105 @+.10)" Taek brciect is risky, than a higher sate should be used to allow for the perceived risk. Assuming, this rate to be 15 per cent, the net present value of the project will be: = Rs 50,000+ Rs 25,000 + Rs 20,000+ Rs 10,000 + Rs 10,000= - Rs 845 (415) O15 (leas) (415) Thus, we observe that the project would be accepted when no allowance for tisk is granted, but it i Unacceptable if a risk-promium is added to the discount rate. In contrast to the net present value method, ifa firm Uses the internal rate of return method, then to allow for perceived risk of an investment project, the internal rate of return for the project should be compared with the risk adjusted minimum required rate of return. If the internal rate of return is higher than this adjusted rate, the project would be accepted, Otherwise it should be rejacted. maces The following are the advantages of risk-adjusted discountod rate methad: 1 Itis simple and can be easily understood. 2 Ithasa great deal of intuitive appeal for risk-averse businessman. 3 Itincorporates an attitude (risk-aversion) towards uncertainty. ‘This approach, however suffers from the following limitations; 1 There is no easy way of deriving a riskeadjusted discount rate, As discussed earlier, CAPM provides for a basis of calculating the risk-adjusted discount rate. [ts use hae yet to pickup in practice Indian Schoal of Petroteum Page 65 sacrament tt pregrtary paery of Ion Sea f Petra ales preted ander th ‘Confident Cg he dot,on i 2 It does not make any risk adjustment in the numerator for the cash flows that are forecast over the future years. 3 It is based on the assumption that investors are risk-averse. Though it is generally true, there do exist risk-seekers in the world, Such people do not demand premium for assuming risks; they are willing lo pay a premium to take risks. Accordingly, the composite discount rate would be reduced, not increased, as the level of risk increases. (OST EHas wae tener Yet another common procedure for dealing with risk in capital budgeting is to reduce the forecasts ‘of cash flows to some conservative levels, For example, if an investor, according to his “best estimate,” expects a cash flow of Rs 60,000 next year, he will apply an intuitive correction factor and may work with Rs 40,000 to be on the safe side. In formal way, the certainty equivalent approach may be defined as: n NPV= 5 a NCF, t=0 (14k) Where, NCF, = the forecasts of net cash flow without risk-adjustment y= the risk-adjustment factor or the certainty-equivalent coefficient ky = risk-free rate, assumed to be constant for all periods. ‘The certainty-equivalent coefficient, Or assumes value between 0 and 1, and varies inversely with risk, A lower (it will be used if greater risk is perceived and a higher i, will be used if lower risk is anticipated, The coefficients are subjectively or objectively established by the decision maker. These ‘coefficients reflect decision-maker's confidence in obtaining a particular cash flow in period t. For ‘example, a cash flow of Rs 20,000 may be estimated in the next year, but if the investor feels that ‘only 80 per cent of it is a certain amount, then the certainty-equivalent coefficient will be 0.80. That is, he considers only estimated cash flows by the certainty-equivalent coefficients. ‘The certainty-equivalent coofficiont can be determined as a relationship between the certain cash flowsand the risky eash flows. That is a, = NCF* = Certain net cash flow NC Risky net cash flow For example, if one expected a risky eash flow of Rs 80,000 in period t and considers a certain cash flow of Rs 60,000 equally desirable, then ar will be 0.75= 60,000/ 80,000. Indian Schoot of Petroleum Page 66 This doamsas i the peoprieiay propery of Iason Schwa of Petro and tx contets preted amr he Canidetity Cure gon in he icine.Grn To illustrate the certainty-equivalent approach, let us consider a project which costs Rs 6,000 and has cash flows of Rs 4,000, Rs 3,000, Rs 2,000 and Rs 7,000 in years 1 through 4. Let us assume further that the associated a t factors are estimated to be : do = 1.00, a1 =.90, a2 = 70, a1= 50and a4 =.30, and the risk-free discount rate is 10 per cent. The net present value will be: NPV = 1.0-(-6,000) + 0.90 (4,000) + 0,70. (3,000) + .50 (2,000) + 0.30 (1,000) = - Rs 37 (1.10) (14107 (1-108 08 The project would be rejected as it has.a negative net present value. 1 the internal rate of return method is used, we will ealculate that rate of discount which equates the present value of certainty-equivalent cash inflows with the present value of certainty-equivalent cash outflows. The rate so found will be compared with the minimum required risk-free rate, Project will be accepted if the internal rate is higher than the minimum rate; otherwise it will be unacceptable, AEE Resets er peels The certainty-equivalent approach explicitly recognizes risk, but the procedure for reducing the forecasts of cash flows is implicit and likely to be inconsistent from one investment to another. Further, this method suffers from many dangers in a large enterprise. First, the forecaster, expecting the recluction that will be made in his forecasts, may inflate them in anticipation. This will no longer give forecasts acearding to “best estimate.” Second, if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate the original forecast or to make it ultra conservative. Third, by focusing explicit attention only on the gloomy outcomes, chances are increased for passing by some goad investinents. In the evaluation of an investment project, we work with the forecasts of cash flows. Forecasted cash flows depend on the expected revenue and costs. Further, expected revenue is a functan of sales volume and tit selling price. Similarly, sales volume will depend on the market size and the firm's market share. Costs include variable costs which depend on sales volume and unit variable cost and fixed costs. The net present value or the internal rate of return of project is determined by analyzing the after-tax cash flows arrived at by combining forecast of each variable. It is difficult to arrive at accurate and unbiased forecast of each variable. We cannot be certain about the outcome of any of these variables. The reliability of the NPV or IRR of the project will depend on the reliability of the forecasts underlying the estimated of net cash flows. To determine the reliability of the project's NPV or IRR, we can work out how much difference it Indian School of Petroteum Page 67 ‘This octet the prop propery of Udon Sebwo of Petree adit cones pote wader the Cnfeetay Clem ge i he doconent= : = = ~ => = = > > > = > * > “ > > > > . > , , , eo, ARe Puakes if any of these forecasts goes wrong, We can change each of the forecast, one ata timo, to, at least, ree values: pessimistic, expected, optimistic. The NPV of the project is recatewlated under these different assumptions, This method of recaleulating NPV or IRE by changing each farecast is called sensitivity analysis, Sensitivity alysis is a way of analyzing, change in the project's NEV (or IRR) for a given change in One Of the Varicbles, It indicated how sensitive a projects NPV (or TRR) is to changes in particular vasiable. The more sensitive the NPV, the more critical the variable, The following three steps are involved in the use of sensitivity analysis, 3 _ Wdentification of all those variable which have an influence on the project NPV (or IRR) 3 Definition ofthe underlying (mathematical) relationship betwen the eriskice S Analysis of the impact of the change in each of the varisbles oe the project NPV, The decision maker, while performing sensitivity analysis, computes the project's NPV (or IRR) for eh forecast under three assumptions (a) pessimistic, (6) expected, and (©) optimistic, It allows him ip.aek what if” question. For example, what is the NPV if volume inereosct cf decreases? What is the NEV if variable cost or fixed cost increases of decreases? What i the nike if the selling price Hie ie ntcaa wecesses? What's the NPV if the project is delayed on outlay escalates o¢ the project's We is mote or less than anticipated? A whole range of questions ean be answered with the help of Table 1. Expected Values of Variables Underlying the New Plant 1. Investment (Rs “000) 10.000 2. Sales volume (units ‘000) "1,000 3. Unitselling price (Rs) 6 4. Unit variable cost (Rs) 6.78 5. Annual fixed cost (Rs’000) 4,000 & Depreciation (%) 331/3% WD 7. Corporate tax rate (%) 50% 8 __Discountrate % 12% dndian School of Petrateum Page 68 die ghareet ith proprio pot of nen Schoo of Pes ae it eet prot ude te “Ginfiaitiy Clare gen om tbe loco,TFT FFFFF FTEs h Table 2 Net Cash Flows of the Project ‘Cash Flows (Rs “000) Year 0 1 2 3 4 5 6 7 a Investment -10,000 2. Revenue 15,000 15,000 18,000 15,000 15,000 15,000 15,000 3, Variable enst 6,750 6,730 6,750 6,750 6,750 6,750 6,750 4. Fixed cost 4000 4,000 4,000 4,000 4,000 4000 4,000 5. Depreciation 3333 2,202 1481 «988658439203 6 EBIT(2-3-4-5) S17 2,028 2,769 3,262 3592 3811 3,957 pmetes 459° 1014 1385 1,681 1,796 1,905 1,979 & PAT@-7) 458 1014 (1,384 1631 1,796 1905 1,978 9% -NCF(I#5+8) = 10,000 3,791 3,236 «2865 2619 © 2,455 2345 2.272 The project's NPV at 12 per cent discount rate and IRR are as follows: NPV =+32,76,000 IRR= 229% ‘Since NPV is positive (or IRR > discount rate), the project can be undertaken. Taw confident is the Financial manager about his forecasts of various variables? Before he takes a decision, he may like to know NPV changes ifany of the forecasts goes wrong. A sensitivity analysis can be conducted with regard to volume, price, costs elc. In order to do so, we must obtain pessimistic and optimistic estimates of the underlying variables. Let Pessimistic and optimistic values for volume, price and costs: ‘Table 3 Forecasts Under Different Assumptions tus assume the following Variable Pessimistic Expected Optimistic 1. Volame {unils‘000) 750 1000) 1250 2 Units selling price (Rs) 13.50 15 165 3. Units variable (Rs) 7425 675 6.078 4 Annual fixed costs (Rs '000) 4500 4,000 3,200 Hf we change each variable (holding others constant), the project's NPV are recalculated in Table 4 Indian School of Petroleum camer Page 69 TIE Ghat i Hs feeprclary pret of daca Saal of Perl ad it events pated ner he ‘Conflavesiaiy Clas ien i be(details calculations not shown). Table 4 Sensitivity Analysis Under Different Assumptions Net Fresent Value (Rs (000) Variable Pessimistic Expected Optimistic 1 Volume 0) 3276 7082 2 Units selling price (147) 3276 6699 3, Units variable 1736 3276 4816 4 Annual fixed costs, 1451 3276 880 ‘Table 4 shows the project's NPV when each variable is set to its pessimistic and optimistic values. The project does not seem to be that attractive with change in assumptions. The most critical variables is sales volume followed by the units selling price. If the volume declines by 25 per cent (to 7,50,000 units), NPV of the project becomes negative (- Rs 14,30,000). Similarly, if the unit selling Price falls by 10 per cent (to Rs 13.50), NPV is - Rs 147,000. Sensitivity analysis has the following advantages: 1 Itcompels the decision maker to identify the variables which affect the cash flow forecasts. This helps him in understanding the investment project in totality. 2 It indicates the critical variables for which additional information may be obtained. The decision maker can consider actions which may help in strengthening the weak spots in the project. 3 Ithelps to expose inappropriate forecasts, and thus guides the decision maker te concentrate on relevant variables. Letus emphasize that sensitivity analysis is not a panacea for the project's all uncertainties. It helps one to understand the project better, It has the following limitations. 1 It does not provide clear cut results, The terms ‘optimistic’ and ‘pessimistic’ could mean different things to different persons in an organization, Thus the range of Values suggested may be inconsistent. 2 _ It fails to focus on the interrelationship between variables, For example, sale volume may be related to price and cost. A price cut may lead to high sales and low operating cost. Scenario Analysis} The simple sensitivity analysis assumes that the variables are independent. In practice, the variables Will be interrelated, One way out is to analyze the impact of alternative combinations of variables, Indian Schost of Petroteum Page 70 This dames i he propria peopery of Ii School of Petre adie coments pte ander te "Confdetiaty Claas ica ix the draestoon ia} \Re The decision maker can develop some plausible scenarios, For instance, in our example, it may be possible to increase volume to 12,50,000 units (25 per cent inerease) if the company reduces unit selling price to Rs 13.50 (10 per cent reduction), resorts to aggressive advertisement campaign, thereby increasing unit variable cost to Re7.10 (5 per cent increase) and fixed cost to Rs 44,00,000 (10 per cent increase), Table 5 shows that his scenario generates a positive NPV of Rs 1821,364. More plausible scenarios could be thought out and analyzed to arrive at a final judgment about the project. TABLES Scenario Analysis Variables Expected Scenario Assumptions 7 Volume (units 000) 7,000 1,250 2, Price (Rs) 15.0 135 3. Units variable cost (Rs) 695 71 4, Fixed cost (Rs “000) 4,000 4400 5. NPV(Rs‘oa0) 3,276 1,793 NEY calculation for scenario: NPY = [(1250 (13.5 - 7.1) ~ 4400) 5 x4.5638+3578] - 10,000 82148443578 — 10,000 = 1792.84 flee echniques to Handle Risk Statistical techniques are analytical tools for handling risky investments. These techniques drawing from the fields of mathematics, logic, economic and psychology enable the decision-maker to make decisions under uncertainty. The concept of probability is fundamental to the use of the risk analysis techniques. How is probability defined? How are probabilities estimated? How are they used in the risk analysis techniques? How do statistical techniques help in resolving the complex problem of analyzing risk in capital budgeting? We attempt to answer these questions in this section. ELE The most crucial information for the capital budgeting decision is a forecast of future cash flows. A typical forecast is single figure for a period. This is referred to as “best estimate” or “most likely” forecast. But the questions are: to what extent can one rely on this single figure? How is this figure arrived at? Does it reflect risk? Infact, the decision analysis is limited in two ways by this single figure forecast. Firstly, we do not know the chances of this figure actually occurring, ie. uncertainty surrounding this figure. In other words, we do not know the range of the forecast and the chance or the probability estimates associated with figures within this range. Secondly, the meaning of best estimates or most likely is not very clear. It is not known whether it is mean, median or mode. For these reason, a forecaster should not give just one estimate, but a range of associated probability a probability distribution, indian School of Petrateum Page 71 ‘This arn i the proprstay propery af Indie Sobaol of Peto dl itr ontnts preted ner she “Confidential gem i the eer_oeererereaeeeee eee eee eee eee eC CeCTeTee a, igh Probability may be described as a measure of someone's opinion about the likelihood that an event ‘will occur. [fan event is certain to occut, we say that it has a probability of 1 of occurring, If an event is certain not to occur, we say that its probability of occurring is 0, Thus, probability of all events to occur lies between 0 and 1. A probability distribution may consist of a number of estimates, But in the simple form it may consist of only a few estimates. One commonly used form employs only the “high, low and best guess” estimates, or “the optimistic, most likely and pessimistic” estimates. For example, the annual cash flows expected from a project could be Rs 2,00,000 or Rs 1.70,000 or Rs 80,000: ee Assumption ‘Annual cash flows (Rts) Best guess 2,00,000 High guess 41,70,000 Low guess 80,000 Jt can easily be seen that this is an improvement over the single figure forecast. But still some more information can be disclosed, What does the forecaster feel about the occurrence of these estimates? Are these forecasts equally likely? The forecast should describe more accurately his degree of confidence in his forecasts; that is, he should describe his feelings as to the probability of these estimates occurring. For example, he snay assign the following probabilities to his estimates: Assumption Annual cash flows (Rs) Probability Best guess 2,00,000 20 High guess 1,70,000 60 Low guess 80,000 20 ihe forecaster considers the chance or probability of the annual eash flows being eilher Rs 2,00,000 (enaximyum) oF Rs 80,000 (minimum) 20 per cont each, There is a 60 per cent probability that annual ash flows may be Rs 1,70,000. The additional information provided by the forecaster is useful in assessing more clearly the impact of a variable, which may assume different values, on th profitability of an investment. A pertinent question is: How to obtain probability distributions? Ee Leese The classical probability theory assumes that no statemént whatsoever can be made about the Probability of

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