FINANCIAL MANAGEMENT
1. What is payback period? List the two important limitations of this approach.
It is defined as the number of years required to recover the initial cash outlay invested in a project.
Payback period= Initial Investment
…………………………..
Annual cash inflow
Limitations:
 It does not account time value.
 Cash flow beyond payback period.
2. List the phases of capital budgeting process.
Identification---Assembling ----Decision Making ----Preparation of Performance Review--Implementation.
3. Why is capital budgeting so important to management?
Capital budgeting is of paramount importance as the framework of future development and the major
determinant of efficiency and competitive power of a firm .it relates to fixed or long term assets that are in
operation and yield network over a period of time. It involves a current outlay in return for a series of
anticipated future benefits. Outlay is return for a series of anticipated future benefits.
4. What are the merits of payback period?

It is simple to understand and easy to calculate.

Its calculation costs less while the other sophisticated techniques require lot of analyst time and even use
of computers.

This method is ideally suitable in those industries where the risk of obsolescence’s high.
5. What are the Components of capital budgeting:

Cash inflow.

Cash outflow.

Cost of capital.
6. Define internal rate of return:
The IRR is the discount rate at which the NPV for a project equals zero. This rate means that the present
value of the cash inflows for the project would equal the present value of its outflows.
7.What is NPV?
Npv is net present value. The NPV may be described as the summation of the present value of operating
cash inflow minus the summation of present values of the cash inflows. The present value is computed using
cost of capital as a discount rate. The project will be accepted in case the NPV is positive.
8. What is risk free rate?
Risk free rate is the rate at which the future cash inflows are the discounted there is no risk from the
project. The implies that it takes in to account only the time factor in discounting.
Mr.M.Arivazhagan,Asst Professor., Shivani School of Business Management
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FINANCIAL MANAGEMENT
9. What are the need of capital budgeting?

Heavy investment

Permanent commitment of funds

Long term effect on profitability

Irreversible in nature.

Difficult to make investment decisions.
10. Write the concept of capital rationing.
A firm should accept all investment projects with a positive NPV in order to maximize the wealth of the
shareholders .it is the allocation of funds to most profitable projects due to limitations on the availability of
finance.
Capital Rationing occurs when a constraint (or budget ceiling) is placed on the total size of capital
expenditures during a particular period.
11. What is trading on equity?
“Trading on equity” describes the practices of using barrowed funds carrying a fixed change in the
expectation of obtaining a higher return to the equity holders. Use of fixed charge source of funds over owned
funds are as trading on equity.
1.
Part-B (16 Marks)
What is capital budgeting? Explain the methods of evaluating capital expenditure proposals.
Capital budgeting (or investment appraisal) is the planning process used to determine whether an
organization's long term investments such as new machinery, replacement machinery, new plants, new
products, and research development projects are worth pursuing.
Methods or techniques of capital budgeting:
Non-discounted cash flow technique:
1. Payback period.
2. Accounting rate of return.
Discounted cash flow method:
1.
2.
3.
4.
Net present value method.
Internal rate of return.
Discounted payback.
Profitability index.
Mr.M.Arivazhagan,Asst Professor., Shivani School of Business Management
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FINANCIAL MANAGEMENT
Payback period:
PBP is the period of time required for the cumulative expected cash flows from an investment project to
equal the initial cash outflow.
Payback period= Initial Investment
……………………
Annual cash inflow
Merits of payback period:

It is simple to understand and easy to calculate.

Its calculation costs less while the other sophisticated techniques require lot of analyst time and even use
of computers.
This method is ideally suitable in those industries where the risk of obsolescence’s high
Limitations:
 It does not account time value.
 Cash flow beyond payback period.
Internal rate of return:
IRR is the discount rate that equates the present value of the future net cash flows from an investment
project with the project’s initial cash outflow.
PV factor= Initial investment
………………….
Average cash inflow
Net Present Value Method:
NPV is the present value of an investment project’s net cash flows minus the project’s initial cash
outflow.
 Discount cash inflows to their present value and then compare with capital outlay required by the
investment
 Discount rate (hurdle rate or required rate of return) - required minimum rate of return given riskiness of
investment
 Proposal is acceptable when NPV is ≥ zero
 The higher the NPV, the more attractive the investment.
Profitability index:
PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash
outflow.
Mr.M.Arivazhagan,Asst Professor., Shivani School of Business Management
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FINANCIAL MANAGEMENT
PI= Total present of cash inflow
…………………………
*100
Total present of cash out flow
Accounting rate of return:
It takes in to account, the accounting concept of profit,(ie profit after depreciation and tax)and not the cash
inflows. The project which yields the highest rate of return is selected.
ARR=average annual profit
………………… ….
*100
Original investment
ARR=average annual profit
………………… ….
*100
Average investment
Merits:
1. It is simple to understand and easy to calculate.
2. This method gives due weightage to the profitability of the project.
3. Rate of return may be readily calculated with the help of accounting data.
Demerits:
1. It uses accounting profits and not the cash inflows in appraising the project.
2. It ignores the time value of money. Profits earned indifferent periods are valued equally.
3. It considers only the rate of return and not the life of the project.
2. Significance of Cost of Capital:
Cost of capital is considered as a standard of comparison for making different business decisions. Such
importance of cost of capital has been presented below.
1. Making Investment Decision:
Cost of capital is used as discount factor in determining the net present value. Similarly, the actual rate
of return of a project is compared with the cost of capital of the firm. Thus, the cost of capital has a
significant role in making investment decisions.
2. Designing Capital structure:
The proportion of debt and equity is called capital structure. The proportion which can minimize the cost
of capital and maximize the value of the firm is called optimal capital structure. Cost of capital helps to
design the capital structure considering the cost of each sources of financing, investor's expectation,
effect of tax and potentiality of growth.
3. Evaluating the Performance:
Cost of capital is the benchmark of evaluating the performance of different departments. The department
Mr.M.Arivazhagan,Asst Professor., Shivani School of Business Management
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FINANCIAL MANAGEMENT
is considered the best which can provide the highest positive net present value to the firm. The activities
of different departments are expanded or dropped out on the basis of their performance.
4. Formulating Dividend Policy:
Out of the total profit of the firm, a certain portion is paid to shareholders as dividend. However, the
firm can retain all the profit in the business if it has the opportunity of investing in such projects which
can provide higher rate of return in comparison of cost of capital. On the other hand, all the profit can be
distributed as dividend if the firm has no opportunity investing the profit. Therefore, cost of capital plays
a key role formulating the dividend policy.
Components of Cost of Capital:
The individual cost of each source of financing is called component of cost of capital. The component of
cost of capital is also known as the specific cost of capital which includes the individual cost of debt,
preference shares, ordinary shares and retained earnings. Such components of cost of capital have been
presented below:
A. Cost Of Debt
* Cost of perpetual or irredeemable debt
* Cost of non-perpetual or redeemable debt
* Cost of debt issued on redeemable condition
* Cost of callable debt
B. Cost Of Preference Share
* Cost of perpetual preference Share
* Cost of redeemable preference Share
C. Cost of ordinary/equity shares or common stock
D. Cost of retained earnings.
Mr.M.Arivazhagan,Asst Professor., Shivani School of Business Management
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