Evaluation of Financial Feasibility

Prof. Sarbesh Mishra

Finance Area, NICMAR
Hyderabad – 500 084.
 About Myself
Name : SARBESH MISHRA

Qualifications 1. B.Com (Hons)

2. Post-graduate in Commerce
3. M.Phil in Commerce
4. Ph.D. (Commerce)

Experience : Joined University of Delhi, as a

Lecturer in Commerce in 2001 and
continued till 2005 and then joined
Army Institute of Management, NOIDA
as a Senior Faculty, Finance prior to
current appointment at NICMAR.
 Related to Time (Thoughts)
† My interest is in the future because I am going to
spend the rest of my life there.
Charles Franklin Kettering, Former Head-Research, General Motors

† The man should never be ashamed to own that he

has been in the wrong, which is but saying in
other words, that he is wiser today than
yesterday.
Jonathan Swift, Famous Satiric Writer, Ireland

† Remember that time is money.

Benjamin Franklin, Noted Economist, USA
Contd….
† You can’t get caught up in things that you
can’t control…….we can’t control our selling
price. We can control our cost of
manufacturing. We can control our
efficiencies. We can control our waste.
Steven Appleton, CEO of Micro Technology

† If you don’t know where you’re going, it

doesn’t matter how you get there.
Prof. Sarbesh Mishra, NICMAR, Hyderabad
Meaning - Capital Budgeting

† It is the process of identifying,

evaluating, and selecting the
projects that require commitments
of large sums of funds and generate
benefits stretching well into future.
Features of Investment Decision
† The exchange of current funds for
future benefits

† The funds are invested in the

long-term assets.

† The future benefits will occur to

the firm over a series of years.
Importance of Investment Decision
† Influence the firm’s growth in long-
term
† They affect the risk of the firm
† They involve commitment of large
volume of funds
† They are irreversible, or reversible at
substantial loss
† They are among most difficult decisions
to make.
Types of Capital Investment
† Assets to meet regulatory, safety,
health, & environmental requirement.

† Assets to enhance operating efficiency

and/or increase revenue.

† Assets to enhance competitive

effectiveness.
Investment Evaluation Criteria
ƒ Estimation of Cash flows.

ƒ Estimation of required rate of

return (Opportunity cost of capital)

ƒ Application of decision rule for

making the choice
Cash Flows
† Cash inflows or outflows occur at three
stages of capital investment project
1. Project Initiation (For beginning operations,
Working Capital needs, Replacement of asset)
2. Project Operation (Operating Expenditure, Addl.
Working capital need, inflow of cash generated by the
investment)
3. Final Project Disposal (Cash inflows or
outflows related to investment’s disposal, Cash inflows
from the release of working capital no longer committed to
the investment)
 Opportunity Cost
† Opportunity cost is the cost incurred (sacrifice)
by choosing one option over the next best
alternative (which may be equally desired). Thus,
opportunity cost is the cost of pursuing one choice
instead of another.

† The opportunity cost of capital is the

expected return forgone by bypassing of other
potential investment activities for a given
capital. It is a rate of return that investors
could earn in financial markets otherwise
referred as second best alternative
Investment appraisal Techniques
Traditional Techniques
† Payback Period Method
† Accounting Rate of return Method
Discounted Cash flow Technique
1. Net Present Value method (NPV)
2. Internal Rate of Return Method (IRR)
3. Profitability Index Method (PI)
Traditional Techniques
Payback Period Method
† Payback is the number of years required to
recover the original cash outlay invested in a
project.

† Payback = Initial Investment

Annual Average Cash Flows

Project would be accepted if its payback period is

less than the maximum or standard payback
period set by management.
Accounting Rate of Return (ARR)
† This measures the profitability of an
investment.

ARR = Average Income

Average Investment

Projects with higher ARR over the minimum

rate established by the management will be
accepted.
DCF Techniques
† It explicitly recognizes the time value of
money.

† Cash flows arising at different time periods

differ in their value and are comparable
when their present values are found out.

† The compound interest rate is used for

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

n
Ct
NPV = Ʃ - C0
t=1 (1+k)t
C1, C2 ….. Represent cash inflow in year 1,2 ….,
k is the opportunity cost of capital
C0 is the initial cost of investment
n is the expected life of the investment
* k is assumed to be known and is constant
 Acceptance Rule

1. Accept the project when NPV is positive

2. Reject the project when NPV is negative

3. May accept the project when NPV is zero.

Higher the NPV, the better it is.

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

† Profitability index is the ratio of the

present value of cash inflows, at the
required rate of return, to the initial cash
outflow of the investment.
Risk Analysis in Capital Budgeting
Uncertainty arises from the lack of previous
experience and knowledge. Attached factors
are:
1. Date of Completion
2. Level of capital outlay required
3. Level of selling price
4. Level of sales volume
5. Level of revenue
6. Level of Operating Costs
7. Taxation Rules
Probability and Expected Values
† The probability of a particular outcome
of an event is simply the proportion of
times this outcome would occur if the
events were repeated a great number of
times.
† Expected Values – It results from the
multiplication of each possible outcome of
an event by the probability of that
outcome occurring.
 Total Risk = Systematic Risk +
Unsystematic Risk
† Systematic Risk † Unsystematic Risk
1. Part of risk which can’t 1. Diversifiable and arises
be diversified otherwise from unique uncertainties.
known as Market Risk.
2. Companies workers
declares strike, R&D
2. Change in the interest rate expert leaves the
policy, increase in inflation, company, formidable
RBI promulgate restrictive competitor enters to the
credit policy, Govt. market, Company loses
increases or reduces capital big contract in a bid,
gains tax, etc. Unavailability of adequate
raw materials, Govt.
increases customs duty on
materials used by the
company, etc.
Business Risk and Financial Risk
† Business risk talks about how it invests
its funds i.e. type of projects which it
undertakes while financial risk is
determined by how it finances these
investments.
Business risk gets influenced by – Company’s
competitive position, industries in which it operates, the
company’s market share, rate of growth of market and
stage of maturity.
Financial risk gets influenced by – Interest cover,
Operating leverage (Contribution upon operating profit) ,
and cash flow adequacy.
Risk Adjusted Discounted Rate
† The capital asset pricing model (CAPM) has
provided an approach to determine project
required rate of return with risk
consideration.
† A measure of risk developed in the portfolio
theory is beta (β).
RADR = Rf + Ri (K0 – Rf)
Rf = Risk free rate
K0 = Cost of Capital
Ri = Risk index of the project
THANK
YOU