UNIT II (Investment and Financing Decision)

“Concept of Opportunity Cost, Cost of; Debenture, Preference and Equity capital, Composite
Cost of Capital, Cash Flows as Profit and components of Cash Flows, Capital Budgeting
Decisions, Calculation of NPV and IRR, Excel Application in Analysing Projects.”

Opportunity Cost : Opportunity cost is the profit lost when one alternative is selected
over another. The concept is useful simply as a reminder to examine all reasonable
alternatives before making a decision. For example, you have 1,000,000/- and choose to
invest it in a product line that will generate a return of 5%. If you could have spent the money
on a different investment that would have generated a return of 7%, then the 2% difference
between the two alternatives is the foregone opportunity cost of this decision.
Opportunity cost does not necessarily involve money. It can also refer to alternative uses of
time. For example, do you spend 20 hours learning a new skill, or 20 hours reading a book?
Examples of Opportunity Cost:
The term is commonly applied to the decision to expend funds now, rather than investing the
funds until a later date. Examples are:
Go on vacation now, or save the money and invest it in a house.
Go to college now, in hopes of generating a large return from the college degree several years
in the future.

Composite Cost of Capital= Cost of Debenture + Cost of Preference Share Capital+

Cost of Equity Share capital

Cost of debenture:
Case: Conditions of Issue Conditions of Redemption
1 Issued at par Redeemable at par
2 Issued at discount Redeemable at par
3 Issued at premium Redeemable at par
4 Issued at par Redeemable at premium
5 Issued at discount Redeemable at premium
6 Issued at premium Redeemable at premium
Cost of Equity Share Capital: Cost of Equity is the rate of return a company pays out
to equity investors. A firm uses cost of equity to assess the relative attractiveness of
investments, including both internal projects and external acquisition opportunities.
To measure the cost of equity shares we have to follow the following ways:-
1) Dividend yield method or Price ratio method
In this the minimum rate of cost of equity shares will be equal to the “present value of future
dividend per share with current price of a share”.
Cost of equity shares= Dividend per equity/ Market price
For example: if there is a company which issues shares of Rs. 200 each a premium of ₹10.
The company pays 20% dividend to equity shareholders for the past five years and expects to
maintain the same in the future also. Compute the cost of equity capital. Will it be different if
market price of equity share is Rs. 260?
The solution can be found out by our formula which says
Cost of equity shares= Dividend per equity/ Market price
= 20*100/210= 9.52%
If the market price of equity share is Rs. 260.
=20* 100/260 = 7.69%

Cost of Preference Share Capital: The cost of preference share capital is the
dividend committed and paid by the company. This cost is not relevant for project
evaluation because this is not the cost of obtaining additional capital. To determine the cost
of acquiring the marginal cost, we will be finding the yield on the preference share based on
the current market value of the preference share.
Cost of pref. share capital’s formula is given below.

Cost of Pref. Share capital (Kp) = amount of preference dividend/ Preference share
capital

Kp = D/P

If we have obtained this preference share capital after some adjustments like
premium or discount or pay some cost of floatation, at that time, it is our duty to
deduct discount and cost of floatation or add premium in par value of pref. share
capital.
 In adjustment case cost of pref. share capital will change and we can
calculate it with following way:-

Kp = D/ NP

D = Annual pref. dividend,

NP = Net proceed = Par value of Pref. share capital – discount – cost of floatation
Or NP = Par value of pref. share capital + Premium

Cash Flows as Profit:

Cash Flow:- Cash Flow (CF) is, the increase or decrease in the amount of money of a
business, institution, or individual has. In finance, the term is used to describe the amount of
cash (currency) that is generated or consumed in a given time period.

Components of Cash Flows

1. Cash flow from operating activities
2. Cash flow from investing activities
3. Cash flow from financing activities
4. Disclosure of non-cash activities, which is sometimes included when prepared
under generally accepted accounting principles (GAAP).

Cash from Operating Activities

The operating activities on the CFS include any sources and uses of cash from business
activities. In other words, it reflects how much cash is generated from a company’s products
or services.

These operating activities might include:

 Receipts from sales of goods and services

 Interest payments
 Income tax payments
 Payments made to suppliers of goods and services used in production
  Salary and wage payments to employees
 Rent payments
 Any other type of operating expenses

Cash from Investing Activities

Investing activities include any sources and uses of cash from a company’s investments.
Purchases or sales of assets, loans made to vendors or received from customers, or any
payments related to mergers and acquisitions (M&A) are included in this category. In short,
changes in equipment, assets, or investments relate to cash from investing. Changes in cash
from investing are usually considered cash-out items because cash is used to buy new
equipment, buildings, or short-term assets such as marketable securities. But when a
company divests an asset, the transaction is considered cash-in for calculating cash from
investing.

Cash from Financing Activities

Cash from financing activities includes the sources of cash from investors and banks, as well
as the way cash is paid to shareholders. This includes any dividends, payments for stock
repurchases, and repayment of debt principal (loans) that are made by the company. Changes
in cash from financing are cash-in when capital is raised and cash-out when dividends are
paid. Thus, if a company issues a bond to the public, the company receives cash financing.
However, when interest is paid to bondholders, the company is reducing its cash. And
remember, although interest is a cash-out expense, it is reported as an operating activity—not
a financing activity.

Capital
Budgeting:
CAPITAL BUDGETING
CAPITAL BUDGETING: Capital budgeting is the process of making investment decision
in long-term assets or courses of action. Capital expenditure incurred today is expected to
bring its benefits over a period of time. These expenditures are related to the acquisition &
improvement of fixes assets.
Capital budgeting is the planning of expenditure and the benefit, which
spread over a number of years. It is the process of deciding whether or not to invest in a
particular project, as the investment possibilities may not be rewarding. The manager has to
choose a project, which gives a rate of return, which is more than the cost of financing the
project. For this the manager has to evaluate the worth of the projects in-terms of cost and
benefits. The benefits are the expected cash inflows from the project, which are discounted
against a standard, generally the cost of capital.
Capital budgeting Techniques: The capital budgeting appraisal methods are techniques of
evaluation of investment proposal will help the company to decide upon the desirability of an
investment proposal depending upon their; relative income generating capacity and rank them
in order of their desirability. These methods provide the company a set of norms on the basis
of which either it has to accept or reject the investment proposal.

NET PRESENT VALUE :

Net Present Value is the difference in between the amount invested(cash out-flow) in a project
and the Proffit earned(cash inflow) from that project.

Net present value (NPV) is a financial metric that seeks to capture the total value of a
potential investment opportunity. The idea behind NPV is to project all of the future cash
inflows and outflows associated with an investment, discount all those future cash flows to
the present day, and then add them together. The resulting number after adding all the
positive and negative cash flows together is the investment's NPV. A positive NPV means
that, after accounting for the time value of money, you will make money if you proceed with
the investment.

The Formula for NPV

If there’s one cash flow from a project that will be paid one year from now, then the
calculation for the NPV is as follows:

NPV=(1+i)t Cash flow−initial investment
where:
i=Required  return  or discount rate
t=Number  of time periods
If analysing a longer-term project with multiple cash flows, then the formula for the NPV of
a project is as follows:

NPV Formula

The formula for Net Present Value is:

Where:

 Z1 = Cash flow in time 1

 Z2 = Cash flow in time 2
 r = Discount rate
 X0 = Cash outflow in time 0 (i.e. the purchase price / initial investment)