Unit-3: Project Selection

Project Cash Flows

 Project Cash Flows
 Estimates of cash flows are a key element in investment
evaluation
 Forecasting project cash flows involves estimations by various
departments:
1. Capital outlays by engineering & product development
department
2. Revenue projections by the marketing
3. Operating costs by Production, Cost Accountants, Purchase,
Personnel, tax experts & others
 Forecasts should be based on
a. A set of consistent economic assumptions
b. Focused on relevant variables
c. Minimise the biases
 Elements of Cash Flows
 The relevant cash flows are the incremental after-
tax cash flows associated with the project
 Comprises of :
a. Initial investment – initial investment on capital
expenditure & net working capital
b. Operating Cash inflows – after-tax cash inflows
from the operations of the project during its
economic life
c. Terminal Cash inflow – after tax cash flow from the
liquidation of the project at the end of its economic
life and release of working capital
 Time Horizon for Cash Flows
of a Plant
 It is the minimum of the following:
1. Physical life – The period for which the plant
actually performs
- Supplier provides the information
2. Technological Life – The period for which it is not
rendered obsolete by a new plant
3. Product market life – The period for which the
plant enjoys the market
4. Investment planning horizon – The period for
which the management looks ahead for investment
- It varies with the complexity & size of the
investment
 Basic Principles of Cash Flow
Estimations
1. Separation – There are two sides of a
Project:
a. Investment
b. Financing
- The cash flows associated with each
should be separated
- Then evaluate the cost of capital
against the rate of return
 Principles (Contd.)
2. Incremental – Only the incremental cash flows shall
be considered
- Cash flows with the project Minus Cash flows
without the project
- Guidelines for estimating the incremental cash
flows:
a. Consider all incidental effects:
i) Complementary - The project may enhance the
profitability of existing activities
ii) Competitive – Reduce the profitability of existing
activities (product cannibalisation)
 Product Cannibalisation
 It is the depletion in the sales of the firm’s
existing products due to the introduction of a
new product
 The loss should be accounted as follows:
• If the competitor is likely to introduce a close
substitute to the new product the loss is not
relevant
• If there is no competition the loss is relevant
and needs to be considered
 Guidelines (Contd.)
b. Ignore Sunk Costs: Costs which are already
incurred and so is not affected by the
acceptance or rejection of the project
c. Include opportunity costs: - If a project uses
existing resources, opportunity cost is its
benefit by using it for alternative use:
i) The resource may be let out
ii) The resource may be sold
 Opportunity Costs
(iii) The resource is put for another use
(iv) If the resource has no current alternative use but
potential use (for e.g. excess capacity on a M/c)
- This if used for new product, may exhaust capacity
of the machine much earlier than actually it would
have
The Opportunity Cost = Present value of creating
capacity earlier minus Present value of creating
capacity later
- The output is likely to be reduced in future, the
opportunity cost is the loss in cash flows that
would have been otherwise generated by its sales
 Guidelines (Contd.)
d. Question the allocation of overhead costs: -
overhead costs are allocated to various products on
reasonable basis like labour hours/machine hours
- Allocated overheads may not have any relationship
with the incremental costs
e. Estimate Net Working Capital (NWC) Properly
- It is likely to change over time as out put changes
- It is the outflow when the project starts and inflow
when the project life gets over
 Principles (contd.)
3. Post-tax – important issues in assessing the tax
liability:
a. Tax rate – may be (i) average tax rate – total tax
burden as a proportion of the total income or
(ii) Marginal tax rate – tax rate applicable to the next
rupee of income
- Marginal tax rate is higher than the average tax
rate because taxe rates are normally progressive
- Income from project is marginal and so marginal
tax rate is the relevant rate for estimating the tax
liability
 Post-tax principle
b. Treatment of losses – are carried forward to be
adjusted against future profits
c. Effect of non cash charges:
(i) Depreciation
(ii) Deferred Tax & Minimum Alternative Tax

Post-tax cash flow = Profit after tax + Depreciation

& amortisation + Deferred tax liability – MAT credit
entitlement – deferred tax asset
- Deferred tax is the adjustment for the difference in
tax profit & accounting profit in the books of
account
- The difference may be permanent or temporary
 Deferred Tax & Minimum
Alternative Tax (Contd.)
- Permanent difference arises when an item is included for
calculating either taxable income or accounting profit
- Temporary difference arises when an item is included for
calculating both taxable income and accounting profit, but in
different periods
- Deferred tax is recognised when there is temporary difference
- Deferred tax liability arises when the charge in the financial
accounts is less than the amount allowed for tax purpose
- Deferred tax asset arises when the charge in the financial
accounts is more than the amount allowed for tax purpose
 MAT
- In the case of a Company, if the IT payable
is less than 18% of its book profits, MAT is
payable @ 18%
- The difference between MAT & actual IT
payable is MAT credit available for seven
years
 Principles (Contd.)
4. Consistency: Cash flows and the discount rates must be
consistent with investor group and inflation
i) Investor group – the cash flow may be estimated from the
point of view of
a. Equity shareholders & Lenders
PBIT (1-tax rate) + Depreciation & non cash charges –
capital expenditure – change in NWC
b. Equity shareholders
Profit after tax + Depreciation & other non cash charges –
preference dividend – capital expenditures – change in NWC
– repayment of debt + proceeds from debt issues –
redemption of preference capital + proceeds from preference
issue
 Discount Rate
 It must be consistent with the definition of cash
flow
i) WACC for cash flow to all investors
ii) Cost of Equity for cash flow to equity shareholders
 Inflation
i) Incorporate expected inflation in the estimates of
future cash flows & apply a nominal discount rate
ii) Estimate the future cash flows in real terms &
apply a real discount rate
 Problem Sums
Eg.1: Naveen Enterprises is considering a capital project:
 Investment will be Rs. 100 million, Rs. 80 million on plant & machinery
& Rs. 20 million on NWC
 It shall be financed by Rs. 45 million of equity capital, Rs. 5 million of
15% preference capital & Rs. 50 million of 15% debt capital
 The life of project is expected to be 5 years
 At the end of 5th year fixed assets will have a salvage value of Rs. 30
million
 The incremental revenues of the firm shall be Rs. 120 million per year
 The increase in cost other than depreciation, interest & tax shall be Rs.
80 million per year
 tax rate is 30%
 Plant & Machinery shall be depreciated at 15% per year
Project the cash flows for the above project
 Problem Sums
Eg. 2: India Pharma Ltd. is engaged in the manufacture of
pharmaceuticals. The Company is considering the manufacture of a
new antibiotic K-cin
 It is expected to have a product life cycle of 5 years
 The sales are expected to be:
Year Sales(Rs. in million)
1 100
2 150
3 200
4 150
5 100
 The capital requirement is Rs. 100 million and it will be depreciated at
the rate of 15% per year as per the WDV method. The salvage value is
Rs. 20 million
 Eg. 2 (Contd.)
 The NWC requirement is expected to be 20% of sales. At the end of 5
years the NWC is liquidated at par except an estimated loss of Rs. 5
million on account of bad debt
 The cost estimates are:
Raw material 30% of sales
Variable labour 20% of sales
Fixed annual operating & maintenance Rs. 5 million
Overhead allocation (excluding depreciation,
maintenance & interest) 10% of sales
 The manufacture of new product will require use of some of the
common facilities of the firm. The use of these facilities would call for
reduction in the production of existing products. This would lead to
reduction of Rs. 15 million of contribution margin
 The tax rate applicable is 30%
Work out the cash flows for the new project
Cash Flows for a replacement
project
 Initial investment =(Cost of new assets + NWC
required for new asset) – (After tax salvage value
realised from the old asset + NWC required for old
asset)
 Operating cash inflows =Operating cash inflows from
the new asset – Operating cash inflows from the old
asset, had it not been replaced
 Terminal cash flow =(After tax salvage value of new
asset + Recovery of NWC associated with new asset)
– (After tax salvage value of the old asset, had it not
been replaced + Recovery of NWC associated with
old asset)
 Eg. 3
Ojus Enterprises is determining the cash flow for a project
involving replacement of an old machine by a new machine.
The old machine has a book value of Rs. 4,00,000 and it can be
sold to realise a post tax salvage value of Rs. 5,00,000. It has
remaining life of five years after which its net salvage value is
expected to be Rs. 1,60,000. Depreciation is annually at 15%
under WDV. The NWC required for old machine is Rs. 4,00,000.
The new machine costs Rs. 16,00,000. It is expected to fetch a
net salvage value of Rs. 8,00,000 after 5 years. Depreciation
rate is 15% under WDV. The NWC required for the new
machine is Rs. 5,00,000. The new machine is expected to bring
a saving of Rs. 2,57,143 annually in manufacturing costs other
than depreciation. Calculate the after tax cash flow associated
with the replacement project. The tax rate is 30%
 Viewing a project from other
perspectives
 A project can be viewed from the
perspective of:
1. Equity
2. Long-term funds
3. Explicit cost funds (investor claims):
Equity & Debt(long term & short term)
4. Total resources
 Equity point of view
 Initial Investment : Equity funds committed
to the project
 Operating cash flows : PAT – Pref. dividend +
non-cash charges
 Liquidation & retirement cash flow: Net
Salvage value of Fixed & current assets –
Repayment of term loans & Working capital
advance – redemption of preference shares &
Debentures – retirement of dues
 Eg. 4
Magnum Technologies Ltd. Is evaluating an
electronics project for which the following
information has been gathered:
1. The total outlay on the project is expected to be
Rs. 50 million which consists of Rs. 30 million of
fixed assets & Rs. 20 million of current assets
2. The total outlay of Rs. 50 million is proposed to be
financed as: Rs. 15 million of equity, Rs. 20 million
of term loans, Rs. 10 million of bank finance for
working capital & Rs. 5 million of trade credit
 Eg. 4 (Contd.)
3. Term loan is repayable in five equal annual
instalments of Rs. 4 million each. The Ist instalment
will be due at the end of the Ist year & the last
instalment at the end of the 5th year. The levels of
bank finance for Working capital and trade credit
will remain at Rs. 10 million & Rs. 5 million till they
are paid back at the end of five years
4. The interest rates on the term loan & bank finance
for working capital will be 10% & 12% respectively
5. The expected revenues from the project will be Rs.
60 million per year. The operating costs, excluding
depreciation will be Rs. 42 million. The depreciation
rate on the fixed assets will be 15% as per WDV
 Eg. 4 (Contd.)
6. The net salvage value of fixed assets
and current assets at the end of year 5
will be Rs. 5 million and Rs. 20 million
respectively
7. Tax rate applicable is 30%
Calculate the cash flows of the project
from the view point of Equity
 Long Term Funds point of
view
 Initial Investment : Long term funds invested
in the project = Fixed assets + Working
Capital Margin
 Operating cash flows : PAT Before Interest on
long term debt + non-cash charges
 Terminal cash flow: Net Salvage value of
Fixed Assets & net recovery of working capital
margin
 Explicit Funds point of view
 Initial Investment : funds invested in
the project = Fixed assets + NWC
 Operating cash flows : PAT Before
Interest on debt + non-cash charges
 Terminal cash flow: Net Salvage value
of Fixed & net recovery of NWC
Total Resources point of view
 Initial Investment : Total resources
committed to the project = Fixed assets +
gross working capital
 Operating cash flows : PAT Before Interest on
debt + non-cash charges
 Terminal cash flow: Net Salvage value of
Fixed Assets & GWC
 Definition of cash flows by
financial institutions
 Initial Investment : Total resources
committed to the project = Fixed assets +
gross working capital
 Operating cash flows : PAT + non-cash
charges + Interest
 Terminal cash flow: Recovery of GWC (at
book value) + residual value of Fixed Assets
(land @ 100% & others @ 5% on initial cost)
 For IRR cash flows are considered for a
maximum project life of 12 years
 Definition of cash flows by
Planning Commission
 A project may be viewed from the point of
view of equity capital or long term funds
 Operating cash flows are calculated on gross
basis excluding depreciation, financial charges
and tax
 Cash flows are projected for the entire life of
the project or over 25 years whichever is less
 Biases in cash flow estimation
 Overstatement of profitability – is due to the
a. Cognitive biases of people–
i) Native optimism – tendency to exaggerate talents
ii) Attribution error – tendency to take credit for
positive outcomes & attribute negative outcomes
to external factors
iii) Anchoring – Once the opinion is formed, do not
change in view of reality
iv) Myopic euphoria – may become too involved and
lose proportion
v) Competitor neglect
 Overstatement of profitability
(Contd.)
b. Organisational pressures – in view of limited
resources one overstates, so that his
proposal gets accepted
c. Stretch targets – management rewards
optimistic opinions while suppresses
pessimistic ones
 Tempering optimism – should use outside
view to make the forecasts objective &
reliable
 Tempering Optimism
 Five step procedure for taking outside view as
suggested by Daniel Kahneman & Amos Tversky
1. Select a reference class
2. Assess the distribution of outcomes – determine
average outcome & measure of variability
3. Intuitively predict the project’s position in the
distribution
4. Assess the reliability of our prediction – compare with
past vide correlation
5. Correct the intuitive estimate
 Bias (Contd.)
 Putting optimism in place - Optimism
generates enthusiasm so there should
be a balance between optimism &
realism – between goals & forecasts
 Understatement of profitability –
1. Salvage values are under-estimated
Understatement of profitability
(Contd.)
2. Intangible benefits are ignored –
i) Create market position
ii) Enhance research & engineering capability
iii) Develop a distribution network

iv) Build brand loyalty

3. The value of future options is overlooked –

strategic payoff in the form of new
investment opportunities
 The Time Value of Money
 Money has time value because:
1. Individuals prefer current consumption to
future consumption
2. Capital can be employed productively to
generate positive returns
3. In inflation a rupee today represents
greater real purchasing power than a year
hence
Future compounded value of a
single amount
 FVn = PV(1+r)n
 (1+r)n is the future value interest factor
 If you deposit Rs. 1,000 today in a bank
which pays 10% interest compounded
annually. How much will the deposit
grow to after 8 years
 Future Simple value of a
single amount
 FV = PV(1+ nr)
 An investment of Rs. 1000 is invested
@12% simple interest for 5 years. How
much the investment will become.
 Doubling period
 To find out how long would it take to
double the amount at a given rate of
interest we may
i) Look at the future value interest factor
table
ii) Use thumb rule of 72 = 72/R
iii) Use thumb rule of 69 = 0.35 + 69/R
 Calculate doubling period for 10% rate of
interest
 Application of compounded
future value
 Finding the growth rate
 If the company currently has 5,000
employees ad this number is expected to
grow by 5% per year. How many employees
will your company have in 10 years?
 Phoenix Limited had revenues of Rs. 100
million in 2000 which increased to Rs. 1000
million in 2010. What was the compound
growth rate
 Present value of a single
amount

PV = FVn [1/(1+r)n]
 1/(1+r)n is the present value interest
factor (PVIFr,n)
 What is the present value of Rs. 1000
receivable 6 years hence if the rate of
discount is 10%
 Present value of an uneven
series

PVn = ∑At/(1+r)t
 Find out the present value of the following cash flows using a
discount rate of 12%
Year Cash flow
1 1,000
2 2,000
3 2,000
4 3,000
5 3,000
6 4,000
7 4,000
8 5,000
 Cost of Capital
 It is the average rate of return required by the
investors who provide capital to the company
 It is used for:
a. Evaluating investment projects
b. Determining the capital structure
 Average Cost of Capital:
It is the weighted average cost of various sources of
finance
 WACC is used as the hurdle rate in capital
budgeting
 The rate of return on investment should exceed its
cost of capital to accept the proposal
 Company & Project Cost of
Capital
a. Company cost of capital is the rate of return
expected by the existing capital providers
It reflects the business risk of existing assets
and the capital structure currently employed
b. Project cost of capital is the rate of return
expected by capital providers for a new
investment project the company proposes to
undertake
This will depend on the business risk & debt
capacity of the new project
 Cost of Debt & Preference
 Pre-tax cost of Debt:
1. Cost of debenture:
Rd = I + (F – Po)/n
0.6Po + 0.4F
I – annual interest payment
n – number of years of maturity
F – maturity value
 Sum
Eg. Face value of debenture of Multiplex Ltd. is Rs. 1,000. Coupon
rate is 12%.
Maturity period is 4 years and current market price Rs. 1,040.
2. Cost of pre-tax bank loan is the current interest the bank would
charge
3. Commercial paper (short term debt issued at discount &
redeemed at par): The cost is its implicit interest rate for the
remaining maturity period
= Face value -1
Market value
Annualised value = (1+i)raise to m – 1
m = number of times the implicit interest rate period is multiplied
to make a year
 Sum
Eg. Multiplex ltd. has outstanding
commercial paper that has a balance
maturity of 6 months. The face value of
the instrument is Rs. 10,00,000 and it is
traded in the market at Rs. 9,65,000.
 Post-tax cost of debt
= Pre-tax cost of debt (1-tax rate)
4. Cost of preference = D + (FV – MP) / n
0.4FV + 0.6MP
Eg. Following data is available for
preference stock of Multiplex Ltd.:
Face value: Rs. 100, Dividend rate:
11%, Maturity period : 5 years, Market
price : Rs. 95
 Cost of Equity
 Equity is obtained by: a. Retention of earnings &
b. Issue of additional equity
- When earnings are retained opportunity cost is
involved because Shareholders could receive the
earnings as dividend and invest the same in
alternative investment to earn a return
- When equity is obtained by retained earnings or
issue of additional equity the difference in cost of
equity is the floatation costs for issue of additional
equity
 Approaches to estimate the
cost of equity
 Capital Asset Pricing Model (CAPM):
- Investors are risk-averse so they require a higher
expected return to bear higher risk
- Total risk of a security = Unique risk + Market risk
- Unique risk arises from firm-specific factors like
development of a new product, a labour strike or
entry of a new competitor which affect the specific
firm only
- This risk can be reduced by diversifying the portfolio
- Also known as diversifiable risk/unsystematic risk
 Market Risk
- Arises from economy factors like growth
rate of GNP, level of Govt. spending,
money supply, interest rate structure
and inflation rate
- It affects all the firms
- Investors cannot avoid this risk
- Also known as non-diversifiable risk /
systematic risk
 CAPM
 It suggests that investors are compensated
only for bearing the systematic risk
 It relates the expected rate of return of an
investment (E (Ri) to its systematic risk
E (Ri) = Rf + (E (Rm) – Rf) beta i
Rf:risk-free rate, E (Rm):expected return on
the market portfolio, beta i:systematic risk of
the security
 CAPM (Contd.)
 Rf is obtained by:
a. The rate on short-term Govt. security (364-
days treasury bill) or
b. The rate on a long-term Govt. bond that
has a maturity of 10-20 years (good choice)
 Market Risk Premium (E (Rm) – Rf)
- Can be estimated on the basis of
a. Historical data
b. Forward looking data
 Historical Risk Premium
- It is the difference between the average return on
stocks and the average risk-free rate earned in the
past
- For determining the average the longest possible
historical period should be taken
- The average may be arithmetic mean or geometric
mean
- Arithmetic mean is the average of the annual rates of
return
- Geometric mean is the compounded annual return
 Forward looking risk premium
- Estimate the expected market rate of
return using the constant growth
dividend discount model
= Dividend yield + constant growth rate
- Calculate the market risk premium
= (E (Rm) – Rf)
 Beta
 The beta of an investment is the slope of the
regression relationship:
Rit = Alpha i + Beta i Rmt + e it
Rit: Return on investment i in period t
Rmt:return on market portfolio in period t
Alpha i:the intercept
e it is the error
Beta i: Cov.(Ri,Rm)/S.D. m square
Cov.(Ri,Rm) = Sum(Ri-MeanRi)(Rm-MeanRm)/n-1
S.D. m square = Sum(Rm-mean m) square/n-1
 Sum
 The rates of return on stock A and the market
portfolio for 15 periods are:
Period Ri(%) Rm(%) Period Ri(%) Rm(%)
1 10 12 9 -9 1
2 15 14 10 14 12
3 18 13 11 15 -11
4 14 10 12 14 16
5 16 9 13 6 8
6 16 13 14 7 7
7 18 14 15 -8 10
8 4 7
 Estimation issues
 Estimating the historical beta involves estimating
1. Estimation period - A longer period gives more data but the
risk profile of the company may change
- 5-year period is reasonable
2. Return interval - may be annual, monthly, weekly or daily
- Daily gives more data but introduces bias due to nontrading
- weekly/monthly returns are preferred
3. Market index – beta of a stock is estimated in relation to the
index of stock market to which it belongs may be Nifty/BSE
4. Statistical Precision – A confidence interval is set which is
estimated value plus/minus two S.E.
 Adjusting Historical Beta
 Historical Beta needs to be adjusted because – it may be influenced by
chance factors
- it may change over time
 it should be taken as the weighted average of the historical beta and
the market beta
 The weighting scheme should take into account - the historical
estimation error
- dispersion of individual firms around the average
 If the historical estimation error is large the weight assigned to the
historical beta should be small
 If the dispersion of individual firms around the average is large the
weight assigned to market beta should be small
 By balancing these factors a suitable weighting scheme should be
developed
 Merill Lynch assigns 0.66 weight to historical beta & 0.34 to average
value of marketing beta
Bond yield Plus Risk Premium
Approach
 Cost of equity = yield on long term
bonds + Risk premium
 Risk premium is determined by looking
at the operating & financial risks which
normally ranges between 2% & 6%
 Dividend Growth Model
Approach
 r = D1 + g D1 = Do(1+g)
Po Po = Current market price/share
g = growth rate
 Estimating g:
i) Relying on analyst’s forecasts: obtain multiple
estimates from different sources & then average
them
ii) - Take dividends for the preceding 5-10 years
- calculate the annual growth rates
- average them
 Sum
 The dividends for the preceding 5 years are:
Year Dividend(Rs.)
1 3
2 3.5
3 4
4 4.25
5 4.75
Find out the growth rate
 Estimating g
iii) g=(Retention rate)(ROE)
 Demerits of dividend growth model:
1. Cannot be applied to companies that
do not pay dividend/ are not listed on
the stock exchange
2. Dividends may not grow at a constant
rate
3. It does not explicitly consider risk
 Earning-Price Ratio approach
 r = E1/Po E1=expected earnings/ share for
the next year
 E1=(Eo)(1+g in earnings/share)
 Demerits:
1. Earnings may not remain constant
2. It expects dividend payout ratio to be 100%
3. Retained earnings are expected to earn a
rate of return equal to the rate of return
required by equity investors
 WACC
 WACC = WeRe + WpRp + WdRd(1-Tc)
W: respective weights of capital in total
capital structure
R: respective costs of capital
Tc: corporate tax rate
 Weighted Marginal Cost of
Capital (WMCC)
 WACC rises as the firm seeks more
capital because as suppliers provide
more capital their expectation of return
also rises
 A schedule of graph showing
relationship between additional
financing & the WACC is the weighted
marginal cost of capital schedule
 Determining the WMCC
schedule
 Estimate the cost of each source of financing for various levels
of its use through an analysis of current market conditions &
assessment of the expectations of investors & lenders
 Identify levels of total new financing at which the cost of new
capital would change given the capital structure policy BPj =
TFj/Wj
BPj =breaking point on account of financing source j
TFj =total new financing from source j at the breaking point
Wj =proportion of financing source in the capital
structure
 Calculate the WACC for various ranges of total financing
between the breaking points
 Prepare the WMCC schedule which reflects the WACC for each
level of total new financing
 Sum
 Shiva Industries plan to use equity and debt
in the proportion of 40:60. Cost of each
source of finance for various levels of use are
Source Range of new financing %
of Finance cost (Rs. In million)
Equity 0-30 18
>30 20
Debt 0-50 10
>50 11
 Determining the Optimal
Capital Budget
 Compare the expected return on
proposed capital expenditure projects
with the marginal cost of capital
schedule
 The optimal budget is the point at
which the investment opportunity curve
& the MACC curve intersect
 Sum
 In the previous example Shiva Industries schedule of
proposed capital expenditure projects for the coming
year is as follows:
Project Amount Internal Rate of
(Rs. In million) Return(%)
A 30 18
B 40 16.5
C 25 15.3
D 10 13.4
E 20 12
Find out the optimum capital budget
 Floatation cost & Cost of
Capital
 Adjust the WACC to reflect the floatation costs
Revised WACC = WACC
1-Floatation cost
 Consider floatation costs as part of the project cost

Amount to be raised=Project cost/(1-f)

Eg. The cost of equity of Prakash Ltd. is 18%. Prakash
Ltd. is considering a Rs. 200 million expansion project
which will be funded by selling additional equity. The
floatation costs will be 8% of the amount issued.
How much equity should be raised
 Weighted Average floatation
cost (WAFC)
 If there is a mixture of various sources of finance
calculate the WAFC
Fa = WrFr + WeFe + WpFp + WdFd
W =weighted proportion of respective source of
finance
F =floatation costs of respective source of finance
Eg. Phoenix Ltd. employs retained earnings, external
equity, preference capital and debt capital in the
following proportions: Wr=0.2, We=0.3, Wp=0.1 &
Wd=0.4. The floatation costs are Fr=0%, Fe=10%,
Fp=5% & Fd=4%. Find out the WAFC
 Floatation Costs & NPV
 Discount Cash flows at WACC rate
 Consider WAFC as part of the project cost

Eg. Ramesh Engineering has target debt-equity ratio of

4:5. It is evaluating a proposal to expand capacity
which is expected to cost Rs. 4.5 million & generate
after-tax cash flows of Rs. 1 million per year for the
next 10 years. The required return on the company’s
new equity is 18%. The issuance cost will be 10%.
The Debt carry a yield of 12%. The issuance cost will
be 2%. What is the NPV of the expansion project
 Factors affecting WACC
1. Outside a Firm’s Control:
i) The level of interest rates: if interest
rises cost of debt increases
ii) Market risk premium: Perceived risk of
equity stock & investor aversion to risk
affects cost of equity
iii) Tax rates: has an impact on cost of
debt
 2. Within a firm’s control
i) Investment policy: If new investment is
in assets similar to existing one WACC
would be similar
-If new investment is not similar WACC
should reflect the risk of the new
investment
ii) Capital Structure Policy
iii) Dividend policy
 Misconceptions of Cost of
Capital
1. Cost of capital is academic & impractical –is not so because it
is used to discount cash flows
2. Current liabilities are considered as capital –is not so because
it is not provided by investors of capital
3. The coupon rate on the firm’s existing debt is used as cost of
debt –use the current cost of debt
4. When estimating the market risk premium in the CAPM, the
historical average rate of return is used along with the
current risk-free rate –Use historical average rate of return
with historical risk-free rate & Expected market rate of return
with the current risk-free rate
5. The cost of equity is equal to the dividend rate or return on
equity –Cost of equity is based on the risk
 Misconceptions (Contd.)
6. Retained earnings are either cost free or cost is significantly less
than equity –opportunity cost of retained earnings is equal to the
cost of equity funds
7. Depreciation has no cost –Depreciation is treated as retained
earnings so this also involves opportunity cost
8. Book value weights may be used to calculate WACC –Weights should
be based on market values
9. The cost of capital for a project is calculated on the basis of the
specific sources of finance used for it –The cost of capital is the
contribution that the project makes to the overall debt capacity of
the firm
10. The project cost of capital is the same as firm’s WACC –Each project
has its own cost of capital which reflects its risk & its debt capacity
-The cost of capital of the firm is the weighted average of the capital
costs of various projects undertaken by the firm
 Calculation of Cost of capital
by financial institutions
 Post-tax weighted average cost of the mix of funds employed
for the project as follows:
i) Equity share capital & 15%
Retained earnings
ii) Preference share capital preference dividend rate
iii) Subsidy/incentive loans 0%
iv) Debt (except convertible debenture) post-tax rate of interest
v) Convertible debenture Convertible portion @15%
Non-convertible @ post-
tax rate of interest
The tax rate is the average applicable tax rate =
Total tax liability during the life of the project
Operating profit over the life of the project
 Sum
 The means of financing for a project is given below:
Rs. in million
Equity & cash accruals 900
Preference share capital (10%) 100
Term loans from institutions(14%) 800
Non convertible debentures(12%) 400
Convertible portion of debentures 100
Non-convertible part of convertible Debentures (10%) 100
Bank borrowings for working capital (15%) 200
The average applicable tax rate for the project is 25%. What is
the cost of capital as calculated by the financial institution?
 Investment Criteria
 Discounting:
i) NPV
ii) Benefit cost ratio
iii) Internal rate of return
 Non-discounting
i) Payback period
ii) Accounting rate of return
 Properties of NPV Rule
1. Net Present Values are additive
Implications:
a. Value of a firm = ∑ Present value of projects + ∑ NPV of expected future
projects
- First term depicts the value of assets in place
- Second term depicts the value of growth opportunities
b. When a firm terminates an existing negative NPV project the value of firm
increases
If it undertakes a new project with negative NPV the value of firm decreases
c. When a firm sells an existing project - if the price obtained is more than the
present value of the anticipated cash flows of the project the value of the
firm increases
d. If the NPV from a new project of a firm is in line with the expectations the
value of the firm will increase
e. When a firm makes an acquisition and pays a price in excess of the present
value of the expected cash flows from the acquisition, it is taking a negative
NPV project and hence the value of the firm decreases
 Properties (Contd.)
b. Intermediate Cash Flows are invested at Cost of
Capital
 NPV Calculation allows Time Varying Discount
Rates
Discount rate may change over time due to:
i) The level of interest rates may change over time
ii) The risk characteristics of the project may change
over time
iii) The financing mix of the project may vary over
time
 Properties (Contd.)
Eg. Evaluate a project involving software development. The technological
uncertainty associated with the industry leads to higher discount rates in
future. The cash flows of the project are as follows:
Discount Rate (%) Investment Cash Flow (Rs.)
-12,000
14 4,000
15 5,000
16 7,000
18 6,000
20 5,000
d. NPV of a simple Project decreases as the Discount Rate decreases – The
decrease is at a decreasing rate
 Rationale for NPV Rule
 Let us consider a choice between current consumption & future consumption
 There is a cash inflow of OA now and OB in year 1 shown by point X
 Through the capital market the wealth can be transferred across time by
lending/borrowing by the straight line CXD
 The slope of this line is (1+r)
 If OA is lent at r the returns will increase by OA(1+r)=BD
 Investment can also be done in assets
 The slope of this line is high to begin & declines progressively because the
marginal return from additional investment tends to decline
 Investment can be optimised by the possibility of investing in real assets along
with the possibility of lending & borrowing
 There is a cash flow of OA now, investment opportunity curve is AXD & the
lending-borrowing opportunity in the capital market is AL
 If you invest different amounts in real assets, the optimum investment takes us
to the highest consumption frontier where the NPV is the highest
 All lending-borrowing lines are parallel to each other
 Modified NPV
 Standard NPV is based on the assumption that the intermediate cash
flows are reinvested at a rate of return equal to the cost of capital
 Modified NPV takes into consideration that intermediate cash flows are
reinvested at a rate of return different from the cost of capital
 Calculate the terminal value of the project’s cash inflows using the
reinvestment rates which reflect the profitability of investment
opportunities
n

TV = ∑CFt(1+r’)n-t
t=1

TV - terminal value of the project’s cash inflows

CFt – cash inflow at the end of year t
r’ - re-investment rate
 Determine the modified NPV* = TV/ (1+r)n - I
 Sum
 Calculate NPV* for the given Project when the
re-investment rate is 14% assuming a cost of
capital of 10%:
Amount (Rs.)
Investment Outlay 1,10,000
Cash Inflows (Year)
1 31,000
2 40,000
3 50,000
4 70,000
 Limitations of NPV
 It is expressed in absolute terms and
not in relative terms & so does not
factor in the scale of investment
 It does not consider the life of the
project
 Benefit Cost Ratio
 BCR = PVB/I
 NBCR = PVB – I/I or BCR – 1
PVB is the present value of benefits
I is the initial investment
Eg. Measure the benefit cost ratios of the following project that has
a cost of capital of 12%:
Amount (Rs.)
Investment Outlay 1,00,000
Benefits (Year)
1 25,000
2 40,000
3 40,000
4 50,000
 Decision rule of BCR/NBCR
BCR/NBCR
>1 >0 Accept
=1 =0 Indifferent
<1 <0 Reject
Evaluation of BCR vs. NPV
 BCR measures NPV per rupee of investment & so can differentiate
between large & small investments
 Under unconstrained conditions BCR & NPV will give same results
 Under constraint BCR ranks projects correctly in the order of
decreasingly efficient use of capital
 But BCR does not aggregate several smaller projects into a package
that can be compared with a large project
 BCR is unsuitable when cash outflows occur beyond the zero year
 Internal Rate of Return
 It is the discount rate which makes its NPV equal to zero i.e. finding r in the NPV
formula
 By Trial & Error select two r (maximum difference 2) such that NPV of Cash
inflows with one r is less than I & NPV of cash inflows of another r is more than
I
 A higher r lowers the NPV value
 To find exact r between the two r’s use the formula = LR + NPV @ LR/Sum of
absolute values of both NPV X i
Eg. Following are the cash flows of a project:
Year Cash Flow (Rs.)
0 (1,00,000)
1 30,000
2 30,000
3 40,000
4 45,000
Calculate its IRR
 IRR (Contd.)
Decision Rule:
 Accept if IRR is more than the cost of capital
 Reject if IRR is less than the cost of capital
NPV & IRR:
 IRR is the point at which NPV profile crosses the x-axis
 The slope of NPV profile reflects how sensitive the project is to
discount rate changes
 NPV & IRR lead to same results if:
1. The cash flows are conventional i.e. initial cash flows are
negative & subsequent cash flows are positive
2. The project is independent i.e. it can be accepted or rejected
without comparing it with another project
 Problems with IRR
1. If the cash flows of the project are not conventional it is
difficult to define IRR
– NPV is zero at two IRR
- Positive NPV for all discount rates so no IRR exists
2. When two or more projects are compared IRR can be
misleading – IRR should be considered on incremental cash
flow
3. IRR cannot distinguish between lending or borrowing
4. IRR is difficult to apply when short term interest rates differ
from long term interest rates – Accept IRR if it exceeds the
opportunity cost of capital so difficult to compare IRR with
several opportunity costs
 Meaning of IRR
1. It represents the rate of return on unrecovered investment
balance in the project
 Unrecovered investment balance Ft = Ft-1 (1+r) + Ct
 Eg. A Project has the following cash flows
Year Cash Flow (Rs.)
0 (3,00,000)
1 0
2 4,17,000
3 1,17,000
Calculate IRR and apply on the unrecovered investment balance
2. It is the rate of return earned on the initial investment made in
the project
 Importance of IRR
 Despite its deficiencies, IRR is popular in practice
because it can be compared with inflation, interest,
cost of capital, return on equity, etc.
 NPV cannot be calculated without knowing the
discount rate but IRR can be calculated
 Pros of IRR:
1. Closely related to NPV
2. Easy to understand & Interpret
 Cons of IRR:
1. May lead to multiple rates of return
2. May result into incorrect decisions in comparing
mutually exclusive projects
 Modified IRR
 It overcomes the shortcomings of the regular IRR
 Calculate the P.V. of costs (PVC) using r
n
∑Cash Outflowt/(1+r)t
t=0

 Calculate the TV of the cash inflows expected from the project

n
TV = ∑CFt(1+r)n-t
t=0
 Determine the MIRR PVC = TV/ (1+MIRR) n
Eg. Pentagon Ltd. is evaluating a project that has the following cash flow stream:
Year 0 1 2 3 4 5 6
Cash Flow
(Rs. in million) -120 -80 20 60 80 100 12
Find MIRR if the cost of capital is 15%
 Evaluation of MIRR
 It assumes that cash flows are re-invested at the cost
of capital whereas IRR assumes that project cash
flows are re-invested at the project’s IRR
 The problem of multiple rates does not exist
 NPV & MIRR
If the mutually exclusive projects are of the same
size, both lead to same decision irrespective of
variations in life
If mutually exclusive projects differ in size NPV is a
better measure
 Urgency
 Urgent projects get priority
 Problems:
1. Difficult to determine the degree of
urgency
2. There is no objective basis – if
pursuade urgency get priority
Should not be used as investment
criteria
 Payback period
 Length of time required to recover the initial cash outlay
 When the annual cash inflow is a constant sum = initial outlay/annual
cash inflow
 Shorter payback period is more desirable
 Evaluation: Advantages:
a. It is simple both in concept & application
b. It deals with risk – risk increase in future due to uncertainity
c. Helps to overcome liquidity
Limitations:
a. It does not consider the time value of time
b. It ignores cash flows beyond the payback period
c. It is a measure of project’s capital recovery not profitability
d. It measures a project’s liquidity, it does not indicate the liquidity
position of the firm as a whole
Discounted Payback period