Module 2fgjjvksblshjsjbb JNSVSBN

MBA Semester – II / Corporate Finance (CF) Assisted by: Bhavin A.
Popat
Module 2: Understanding Investment Decisions
 Introduction
In the first chapter we had discussed the three important functions of financial management
which are Investment Decisions, Financing Decisions and Dividend Decisions. So far, we
have studied Financing decisions in previous chapters. In this chapter, we will discuss the
second important decision area of financial management which is Investment Decision.
Investment decision is concerned with optimum utilization of fund to maximize the wealth of
the organization and in turn the wealth of its shareholders. Investment decision is very
crucial for an organization to fulfil its objectives; in fact, it generates revenue and ensures
long term existence of the organization. Even the entities which exist not for profit are also
required to make investment decision though not to earn profit but to fulfil its mission.
As we have seen in the financing decision chapter, each rupee of capital raised by an entity
bears some cost, commonly known as cost of capital. It is necessary that each rupee raised is
to be invested in a very prudent manner.
 Purpose / Features / Importance of Capital Budgeting

The capital budgeting decisions are important, crucial and critical business decisions due to
the following reasons:
(i) Substantial expenditure: Investment decisions are related with fulfillment of long-
term objectives and existence of an organization. To invest in a project(s), a substantial
capital investment is required.
Based on size of capital and timing of cash flows, sources of finance are selected. Due to huge
capital investments and associated costs, it is therefore necessary for an entity to make such
decisions after a thorough study and planning.
(ii) Long time period: The capital budgeting decision has its effect over a long period of
time. These decisions not only affect the future benefits and costs of the firm but also
influence the rate and direction of growth of the firm.
(iii) Irreversibility: Most of the investment decisions are irreversible. Once the decision is
implemented, it is very difficult and reasonably and economically not possible to reverse the
decision.
The reason may be upfront payment of amount, contractual obligations, technological

impossibilities etc.
(iv) Complex decisions: The capital investment decision involves an assessment of future
events, which in fact is difficult to predict.
Further, it is quite difficult to estimate in quantitative terms, all the benefits or the costs
relating to a particular investment decision.
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MBA Semester – II / Corporate Finance (CF) Assisted by: Bhavin A. Popat
 Types of Investment Decisions
There are many ways to classify the capital budgeting decision. Generally capital investment
decisions are classified in two ways. One way is to classify them on the basis of firm’s existence.
Another way is to classify them on the basis of decision situation.
(1) On the basis of Firm’s existence
The capital budgeting decisions are taken by both newly incorporated firms as well as by
existing firms. The new firms may require decision making in respect of selection of a plant
to be installed. Whereas the existing firm may require taking decisions to meet the
requirement of new environment or to face the challenges of competition. These decisions
may be classified as follows:
Replacement and Modernisation decisions: The replacement and modernisation

decisions aims to improve operating efficiency and reduce cost.
Generally, all types of plant and machinery require replacement either because the economic
life of the plant or machinery is over or because it has become technologically outdated. The
former decision is known as replacement decision and latter is known as modernisation
decision. Both replacement and modernisation decisions are called as cost reduction
decisions.
Expansion decisions: Existing successful firms may experience growth in demand of their
product line. If such firms experience shortage or delay in the delivery of their products due
to inadequate production facilities, they may consider proposal to add capacity to existing
product line.
Diversification decisions: These decisions require evaluation of proposals to diversify

into new product lines, new markets etc. for reducing the risk of failure by dealing in
different products or by operating in several markets.
(2) On the basis of decision situation
The capital budgeting decisions on the basis of decision situation are classified as follows:
Mutually exclusive decisions: The decisions are said to be mutually exclusive if two or
more alternative proposals are such that the acceptance of one proposal will exclude the
acceptance of the other alternative proposals. For instance, a firm may be considering
proposal to install a semi-automatic or highly automatic machine. If the firm installs a semi-
automatic machine, it excludes the acceptance of proposal to install highly automatic
machine.
Accept-Reject decisions: The accept-reject decisions occur when proposals are

independent and do not compete with each other. The firm may accept or reject a proposal
on the basis of a minimum return on the required investment. All those proposals which give
a higher return than certain desired rate of return are accepted and the rest are rejected.
Contingent decisions: The contingent decisions are made when the proposals are
dependable proposals. The investment in one proposal requires investment in one or more
other proposals. For example, if a company accepts a proposal to set up a factory in remote
area, it will have to invest in infrastructure, like building of roads, houses for employees etc.

 Capital Budgeting Techniques
In order to maximise the return to the shareholders of a company, it is important that the
best or most profitable investment projects are selected. Results of making a bad long-term
investment decision can be devastating in both financial and strategic terms. Proper care is
required for investment project selection and evaluation.
There are a number of techniques available for appraisal of investment proposals,

Organisations may use any one or more of capital investment evaluation techniques. Some
organisations use different methods for different types of projects while others may use
multiple methods for evaluating each project.
The techniques discussed below are Payback Period, Accounting Rate of Return (ARR), Net
Present Value (NPV), Profitability Index (PI), Internal Rate of Return (IRR), Discounted
Payback Period and Modified Internal Rate of Return (MIRR).
(1) Traditional or Non Discounting Techniques
These techniques of capital Budgeting does not discount the future cash flows. There are two
such traditional techniques namely Payback Period and Accounting Rate of Return.
(A) Pay Back Period
Time required to recover the initial cash-outflow is called pay-back period. The payback
period of an investment is the length of time required for the cumulative total net cash flows
from the investment to equal the total initial cash outlays. At that point in time (payback
period), the investor has recovered all the money invested in the project.
Steps in Payback period technique:
(a) The first step in calculating the payback period is determining the total initial capital
investment (cash outflow).
(b) The second step is calculating/estimating the annual expected after-tax cash flows
over the useful life of the project.
(1) Uniform Cash Flows: When the cash inflows are uniform over the useful life of the
project, the number of years in the payback period can be calculated using the following
equation:
P1: Suppose a project costs INR 20,00,000 and yields annually a profit of INR 3,00,000
after depreciation @ 12½% (straight line method) but before tax at 50%.
The first step would be to calculate the cash inflow from this project. The cash inflow is
calculated as follows:

(2) Non Uniform Cash Flows: When the annual cash inflows are not uniform, the cumulative
cash inflow from operations must be calculated for each year. The payback period shall be
corresponding period when total of cumulative cash inflows is equal to the initial capital
investment. However, if exact sum does not match, then the period in which it lies should be
identified. After that we need to compute the fraction of the year. This method can be
understood with the help of an example:
P2: Suppose XYZ Ltd. is analyzing a project requiring an initial cash outlay of INR 2,00,000
and is expected to generate cash inflows as follows:
Year Annual Cash Inflows

(INR)
1 80,000
2 60,000
3 60,000
4 20,000
It’s payback period shall be computed by using cumulative cash flows as follows:

(B) Accounting Rate of Return or Average Rate of Return (ARR)
The accounting rate of return of an investment measures the average annual net income of
the project (incremental income) as a percentage of the investment.
Accounting rate of return (ARR) = Average annual profit after taxes X 100
Average investment over the life of the project
The numerator is the average annual net income generated by the project over its useful life.
The denominator can be either the initial investment (including installation cost) or the
average investment over the useful life of the project.

P3: A project requiring an investment of INR 10,00,000 and it yields profit after tax and
depreciation which is as follows:
Years Profit after tax and depreciation (INR)
1 50,000
2 75,000
3 1,25,000
4 1,30,000
5 80,000
Total 4,60,000
Suppose further that at the end of the 5th year, the plant and machinery of the project can be
sold for INR 80,000. DETERMINE Average Rate of Return.
P4: Determine the average rate of return from the following data of two machines, A and B.
Particulars Machine A Machine B
Cost 56,125 56,125
Annual Estimated income after depreciation and

income tax (Depreciation on SLM Basis)
Year 1 3,375 11,375
Year 2 5,375 9,375
Year 3 7,375 7,375
Year 4 9,375 5,375
Year 5 11,375 3,375
36,875 36,875
Estimate Life in Years 5 5
Estimated Salvage Value 3,000 3,000
(2) Discounting Techniques
Discounting techniques consider time value of money and discount the cash flows to their
Present Value. These techniques are also known as Present Value techniques. These are
namely Net Present Value (NPV), Internal Rate of Return (IRR) and Profitability Index (PI),
Discounted Payback Period.
First, let us discuss about Determination of Discount rate and it will be followed by the four
techniques.
Theoretically, the discount rate or desired rate of return on an investment is the rate of
return the firm would have earned by investing the same funds in the best available
alternative investment that has the same risk.
(A) Net Present Value Technique
The net present value technique is a discounted cash flow method that considers the time
value of money in evaluating capital investments. An investment has cash flows throughout
its life, and it is assumed that an amount of cash flow in the early years of an investment is
worth more than an amount of cash flow in a later year.
The net present value method uses a specified discount rate to bring all subsequent cash
inflows after the initial investment to their present values (the time of the initial investment
is year 0).
Net present value = Present value of net cash inflow - Total net initial
investment
Since it might be possible that some additional investment may also be required during the
life time of the project, then appropriate formula shall be:
Net present value = Present value of cash inflows - Present value of cash outflows
Decision Rule:
If NPV ≥ 0 Accept the Proposal
If NPV ≤ 0 Reject the Proposal
The NPV method can be used to select between mutually exclusive projects; the one with the
higher NPV should be selected.
P5: COMPUTE the net present value for a project with a net investment of INR 1,00,000 and
net cash flows for year one is INR 55,000; for year two is INR 80,000 and for year three is
INR 15,000. Further, the company’s cost of capital is 10%. [PVIF @ 10% for three years are
0.909, 0.826 and 0.751].
P6: ABC Ltd. is a small company that is currently analyzing capital expenditure proposals for
the purchase of equipment; the company uses the net present value technique to evaluate
projects. The capital budget is limited to INR 500,000 which ABC Ltd. believes is the
maximum capital it can raise.
The initial investment and projected net cash flows for each project are shown below. The
cost of capital of ABC Ltd is 12%.

You are required to COMPUTE the NPV of the different projects.
Project Project Project Project
A B C D
(INR) (INR) (INR) (INR)
Initial Investment 200,000 190,000 250,000 210,000
Project Cash Inflows:
Year 1 50,000 40,000 75,000 75,000
2 50,000 50,000 75,000 75,000
3 50,000 70,000 60,000 60,000
4 50,000 75,000 80,000 40,000
5 50,000 75,000 100,000 20,000
(B) Profitability Index / Desirability Factor / Present Value Index Method (PI)
In certain cases, we have to compare a number of proposals, each involving different

amounts of cash inflows.
One of the methods of comparing such proposals is to work out what is known as the
‘Desirability factor’, or ‘Profitability Index’ or ‘Present Value Index Method’.
Mathematically the PI is calculated as below;
Sum of Discounted Cash Inflows
PI = --------------------------------------------------------------------------------
Initial Cash Outlay or Discounted Cash Outflow (as the case may be)
Decision Rule:
If PI ≥ 1 Accept the Proposal
If PI ≤ 1 Reject the Proposal
In case of mutually exclusive projects, project with higher PI should be selected
P7: Suppose we have three projects involving discounted cash outflow of INR5,50,000,
INR75,000 and INR 1,00,20,000 respectively. Suppose further that the sum of discounted
cash inflows for these projects are INR 6,50,000, INR 95,000 and INR 1,00,30,000
respectively. CALCULATE the desirability factors for the three projects.
(C) Internal Rate of Return Method (IRR)
The internal rate of return method considers the time value of money, the initial cash
investment, and all cash flows from the investment. But unlike the net present value method,
the internal rate of return method does not use the desired rate of return but estimates the
discount rate that makes the present value of subsequent cash inflows equal to the initial
investment. This discount rate is called IRR.
IRR Definition: Internal rate of return for an investment proposal is the discount rate that
equates the present value of the expected cash inflows with the initial cash outflow.
This IRR is then compared to a criterion rate of return that can be the organization’s desired
rate of return for evaluating capital investments.
Calculation of IRR: The procedures for computing the internal rate of return vary with the
pattern of net cash flows over the useful life of an investment.
Situation 1: For an investment with uniform cash flows over its life:
P8.1: A Ltd. is evaluating a project involving an outlay of INR 10,00,000 resulting in an

annual cash inflow of INR 2,50,000 for 6 years. Assuming salvage value of the project is
zero; DETERMINE the IRR of the project.
P8.2: A Ltd. is evaluating a project involving an outlay of INR 10,00,000 resulting in an

annual cash inflow of INR 2,50,000 for 6 years. Assuming salvage value of the project is
zero; DETERMINE the IRR of the project.
Situation 2: For an investment with uneven cash flow over its life:
P9: CALCULATE the internal rate of return of an investment of INR 1,36,000 which yields
the following cash inflows:
Year Cash
Inflows
(INR)
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
Find out IRR.
Acceptance Rule: The use of IRR, as a criterion to accept capital investment decision involves
a comparison of IRR with the required rate of return known as cut-off rate.
The project should the accepted if IRR is greater than cut-off rate. If IRR is equal to cut- off
rate the firm is indifferent. If IRR less than cut off rate the project is rejected. Thus,
If IRR ≥ Cut-off Rate or Accept the Proposal

WACC
If IRR ≤ Cut-off Rate or Reject the Proposal

WACC

(D) Discounted Pay Back Period Method
This is similar to Payback period under the non-discounting method except that the cash
flows here are discounted at predetermined rate and the payback period so calculated is
called Discounted payback period. One of the most popular economic criteria for evaluating
capital projects is the payback period. Payback period is the time required for cumulative
cash inflows to recover the cash outflows of the project.
This technique is considered superior to simple payback period method because it takes into
account time value of money.
P10: For example, a INR 30,000 cash outlay for a project with annual cash inflows of INR
6,000 would have a payback period of 5 years (INR 30,000 / INR 6,000).
The problem with the Payback Period is that it ignores the time value of money. In order to
correct this, we can use discounted cash flows in calculating the payback period as follows:
Year Cash Flow PVF@15% PV Cumulative PV
(INR) (INR) (INR)
1 6,000 0.870 5,220 5,220
2 6,000 0.756 4,536 9,756
3 6,000 0.658 3,948 13,704
4 6,000 0.572 3,432 17,136
5 6,000 0.497 2,982 20,118
6 6,000 0.432 2,592 22,710
7 6,000 0.376 2,256 24,966
8 6,000 0.327 1,962 26,928
9 6,000 0.284 1,704 28,632
10 6,000 0.247 1,482 30,114
The cumulative total of discounted cash flows after ten years is INR 30,114. Therefore, our
discounted payback is approximately 10 years as opposed to 5 years under simple payback. It
should be noted that as the required rate of return increases, the distortion
between simple payback and discounted payback grows.
P11: Homework: Find out IRR using the following information
Year Annual CFAT
Machine A Machine B
1 14000 22000
2 16000 20000
3 18000 18000
4 20000 16000
5 25000 17000

 Capital Rationing
As discussed earlier, if project has positive NPV, it should be accepted with an objective of
maximisation of wealth of shareholders. However, there may be a situation due to resource
(capital) constraints (rationing) a firm may have to select some projects among various
projects, all having positive NPVs. Broadly two scenarios may influence the method of
evaluation to be adopted.
(i) Projects are independent of each other and are divisible in nature: In such
situation, NPV rule should be modified and accordingly projects should be ranked on
the basis of ‘NPV per rupee of Capital ’method.
(ii) Projects are not divisible: In such situation, projects shall be ranked on the basis of
absolute NPV and should be mixed up to the point available resources are exhausted.
P12: Shiva Limited is planning its capital investment programme for next year. It has five
projects all of which give a positive NPV at the company cut-off rate of 15 percent, the
investment outflows and present values being as follows:
Project Investment NPV @ 15%

(INR) (INR)
A (50,000) 15,400
B (40,000) 18,700
C (25,000) 10,100
D (30,000) 11,200
E (35,000) 19,300
The company is limited to a capital spending of INR 1,20,000.
You are required to ILLUSTRATE the returns from a package of projects within the capital
spending limit. The projects are independent of each other and are divisible (i.e., part-
project is possible).
P13: Alpha Company is considering the following investment projects:
Cash Flows (INR)
Projects C0 C1 C2 C3
A -10,000 +10,000
B -10,000 +7,500 +7,500
C -10,000 +2,000 +4,000 +12,000
D -10,000 +10,000 +3,000 +3,000

(a) ANALYSE and rank the projects according to each of the following methods:
(i) Payback, (ii) ARR, (iii) IRR and (iv) NPV, assuming discount rates of 10 and 30 per
cent.
(b) Assuming the projects are independent, which one should be accepted? If the projects
are mutually exclusive, IDENTIFY which project is the best?
P14: X Limited is considering purchasing of new plant worth INR 80,00,000. The expected
net cash flows after taxes and before depreciation are as follows:
Year Net Cash Flows

(INR)
1 14,00,000
2 14,00,000
3 14,00,000
4 14,00,000
5 14,00,000
6 16,00,000
7 20,00,000
8 30,00,000
9 20,00,000
10 8,00,000
The rate of cost of capital is 10%. You are required to CALCULATE:
(i) Pay-back period
(ii) Net present value at 10 discount factor
(iii) Profitability index at 10 discount factor
(iv) Internal rate of return with the help of 10% and 15% discount
factor

 Dividend and Dividend Policy
As we had already discussed in Chapter 1 (Scope and Objectives of Financial Management),

Financial Management is the process of making financial decisions so as to increase the
value of the firm.
Long term Finance function decisions broadly covers three areas:
i. Financing decision
ii. Investment decision
iii. Dividend decision
So far, we had already discussed the first two decisions that are Financing and Investment
decisions in earlier chapters. In this chapter, we will discuss the "Dividend decision" which is
one of the most important areas of management decisions.
Dividend Decision is easy to understand but difficult to implement. Let us understand this
with the help of an example, suppose a company, say X limited, which is continuously paying
the dividend at a normal growth rate, earns huge profits this year. Now the management
have to decide whether it should continue to pay dividend at normal rate or to pay at an
increasing rate. Why this dilemma?
The reason is that, if the management decides to pay higher dividend, then it might be
possible that next year, the company will not achieve such higher growth rate, resulting in
lower dividend payment in comparison to previous year. However, if the company decides to
stay on the normal rate of dividend, then surplus amount of retained earnings would remain
idle which will result in over capitalization, if no other opportunity exist to utilize the idle
funds.
Dividend is that part of Profit After Tax (PAT) which is distributed to the shareholders
of the company. Further, the profit earned by a company after paying taxes can be used for:
i. Distribution of dividend, or
ii. Retaining as surplus for future growth
 Factors affecting Dividend Policy
The dividend policy is affected by the following factors:
1. Availability of funds: If the business is in requirement of funds, then retained earnings

could be a good source. The reason being the saving of floatation cost and prevention of
dilution of control which happens in case of new issue of equity shares to public.
2. Cost of capital: If the financing requirements are to be executed through debt

(relatively cheaper source of finance), then it would be preferable to distribute more
dividend.
On the other hand, if the financing is to be done through fresh issue of equity shares, then it
is better to use retained earnings as much as possible.

3. Capital structure: An optimum Debt Equity ratio should also be considered for the
dividend decision.
4. Stock price: Stock price here means market price of the shares. Generally, higher
dividends increase market value of shares and low dividends decrease the value.
5. Investment opportunities in hand: The dividend decision is also affected if there are
investment opportunities in hand. In that situation, the company may prefer to retain more
earnings.
6. Internal rate of return (IRR): If the internal rate of return (IRR) is more than the cost
of retained earnings (Kr), it is better to distribute the earnings as much as possible.
7. Trend of industry: The investors depend on some industries for their regular dividend
income. Therefore, in such cases, the firms have to pay dividend in order to survive in the
market.
8. Expectation of shareholders: The shareholders can be categorised into two categories:

(i) those who invests for regular income, & (ii) those who invests for growth. Generally, the
investor prefers current dividend over the future growth.
 Theories of Dividend
(1) Dividend’s Irrelevance Theory
MODIGLIANI and MILLER (MM) HYPOTHESIS:
Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller in 1961.
MM approach is in support of the irrelevance of dividends i.e. firm’s dividend policy has no
effect on either the price of a firm’s stock or its cost of capital.
According to MM hypothesis
 Market value of equity shares of a firm depends solely on its earning power and is not
influenced by the manner in which its earnings are split between dividends and retained
earnings.
 Market value of equity shares is not affected by dividend size.
Assumptions of MM Hypothesis
MM hypothesis is based on the following assumptions:
(1) Perfect capital markets
(2) No Taxes
(3) Fixed investment policy
(4) No floatation or transaction cost
(5) Risk of uncertainty does not exist

Situations under MM Hypothesis
Keeping in mind assumptions under MM Hypothesis, firms may have three possible
situations regarding the payment of dividend as follows:
1. Firm pays cash dividends from Reserve & Surplus: In this situation, the
shareholders receive cash (dividend) from the firm, thereby, reducing the cash balance of
the firm. There is only transfer of asset (cash) from one pocket to another pocket of the
shareholders with no net gain or loss. So, payment of cash dividend will not affect the
value of the firm.
2. Firm pays cash dividends from new issue of shares: If the firm does not have
sufficient cash available for dividend, it will issue new shares and therefore will use the
amount received for the payment of dividend. Here, shareholders receive cash (dividend)
but suffer an equal amount of capital loss due to dilution of control over the assets of the
company and dilution in earning per share. With the increase in the total number of
shares, earning per share will also reduce. Thus, there is no change in the wealth of
shareholders.
3. Firm does not pay any dividend: When the firm doesn’t pay any dividend, but
shareholder want to receive cash, then shareholder may sell part of his/her shareholding
in market. Therefore, the cash received in the hands of the shareholder may be known as
“home-made dividend”. In this situation also, the shareholder receives cash (capital
receipt) but lose in the form of capital loss due to dilution of control over the assets of the
company among the existing and new shareholders. Hence, there will be no gain or loss
and the value of the firm will remain unchanged.
Let us understand the different possible situations through an example as below
P. 15 For the year ending 31st March 2021, Dev Ltd. has 2 lakhs outstanding equity shares
with market price of ` 10 per share with no other external borrowings since the company
follows no borrowing policy. The company has used all its retained earnings for capital
expenditure. The company also pays a constant dividend of ` 3 per share and its cost of
capital is 10%.
Analyze both situations i.e. when dividends are (i) not paid and (ii) paid.
(2) Dividend’s Relevance Theory
(a) WALTER’S MODEL
Assumptions of Walter’s Model
Walter’s approach is based on the following assumptions:
 All investment proposals of the firm are to be financed through retained earnings only.
 ‘r’ rate of return & ‘Ke’ cost of capital are constant.
 Perfect capital markets: The firm operates in a market in which all investors are rational
and information is freely available to all.
 No tax or tax discrimination
 No floatation or transaction cost
 Perpetual life
The relationship between dividend and share price based on Walter’s formula is shown below
Market Price (P) = D + r/Ke (E-d) divided by Ke
Walter’s Model explains why market prices of shares of growing companies are high even
though the dividend paid out is low. It also explains why the market price of shares of certain
companies which pay higher dividends and retain very low profits is also high.
As explained above, market price is dependent upon two factors; firstly, the quantum of
dividend and secondly, profitable opportunities available to the company in investing the
earnings retained.
It is obvious that when a company retains a part of its profits, it has to think in terms of the
cost of such retention. Retention of profits depends upon whether it is cheaper and more
profitable for shareholders of the company to have corporate earnings retained in the
business or get the same in the form of cash dividend.
This involves a comparison between the cost of retained earnings and the cost of distributing
them. The cost of retained earnings, therefore, involves an opportunity cost, i.e., the benefits
which shareholders forego in terms of leaving the funds in the business.
P 16 XYZ Ltd. earns INR 10/ share. Capitalization rate and return on investment are 10% and
12% respectively.
DETERMINE the optimum dividend payout ratio and the price of the share at the payout.
P 17 The following figures are collected from the annual report of XYZ Ltd.:
Net Profit INR 30 lakhs
Outstanding 12% preference shares INR 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%
COMPUTE the approximate dividend pay-out ratio so as to keep the share price at INR 42 by
using Walter’s model?
(B) GORDEN’S MODEL
According to Gordon’s model, dividend is relevant and dividend policy of a company affects
its value.

Assumptions of Gordon’s Model
This model is based on the following assumptions:
 Firm is an all equity firm i.e. no debt.
 IRR will remain constant, because change in IRR will change the growth rate and
consequently the value will be affected. Hence this assumption is necessary.
 Ke will remains constant, because change in discount rate will affect the present
value.
 Retention ratio (b), once decide upon, is constant i.e. constant dividend payout
ratio will be followed.
 Growth rate (g = br) is also constant, since retention ratio and IRR will remain
unchanged and growth, which is the function of these two variable will remain
unaffected.
 Ke > g, this assumption is necessary and based on the principles of series of sum of
geometric progression for ‘n’ number of years.
All investment proposals of the firm are to be financed through retained earnings only
The following formula is used by Gordon to find out price per share
Where,
P = Price per Share
E1 = Earning per Share
b = Retention Ratio ( 1- b) = Pay out ratio
Ke = Cost of Capital
r = IRR
g = Growth rate
According to Gordon’s model, when IRR is greater than cost of capital, the price per
share increases and dividend pay-out decreases.
On the other hand, when IRR is lower than the cost of capital, the price per share decreases
and dividend pay-out increases.

P 18 The following figures are collected from the annual report of XYZ Ltd.:
Net Profit INR 30 lakhs
Outstanding 12% preference shares INR 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%
CALCULATE price per share using Gordon’s Model when dividend pay-out is (i) 25%;
(ii) 50% and (iii) 100%
 Basics of Decision Tree Analysis (only theory)
Self Learning and Self Explanatory Video
https://www.youtube.com/watch?v=a5yWr1hr6QY
@ END OF MODULE 2 @

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MBA Semester – II / Corporate Finance (CF) Assisted by: Bhavin A.

 Purpose / Features / Importance of Capital Budgeting

The reason may be upfront payment of amount, contractual obligations, technological

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(1) On the basis of Firm’s existence

Replacement and Modernisation decisions: The replacement and modernisation

Diversification decisions: These decisions require evaluation of proposals to diversify

(2) On the basis of decision situation

Accept-Reject decisions: The accept-reject decisions occur when proposals are

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There are a number of techniques available for appraisal of investment proposals,

(1) Traditional or Non Discounting Techniques

(A) Pay Back Period

Steps in Payback period technique:

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Year Annual Cash Inflows

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(B) Accounting Rate of Return or Average Rate of Return (ARR)

Average investment over the life of the project

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Years Profit after tax and depreciation (INR)

Particulars Machine A Machine B

Cost 56,125 56,125

Annual Estimated income after depreciation and

Year 1 3,375 11,375

Year 2 5,375 9,375

Year 3 7,375 7,375

Year 4 9,375 5,375

Year 5 11,375 3,375

Estimate Life in Years 5 5

Estimated Salvage Value 3,000 3,000

(2) Discounting Techniques

(A) Net Present Value Technique

If NPV ≥ 0 Accept the Proposal

If NPV ≤ 0 Reject the Proposal

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In certain cases, we have to compare a number of proposals, each involving different

Mathematically the PI is calculated as below;

Sum of Discounted Cash Inflows

If PI ≥ 1 Accept the Proposal

If PI ≤ 1 Reject the Proposal

In case of mutually exclusive projects, project with higher PI should be selected

(C) Internal Rate of Return Method (IRR)

P8.1: A Ltd. is evaluating a project involving an outlay of INR 10,00,000 resulting in an

P8.2: A Ltd. is evaluating a project involving an outlay of INR 10,00,000 resulting in an

Find out IRR.

If IRR ≥ Cut-off Rate or Accept the Proposal

If IRR ≤ Cut-off Rate or Reject the Proposal

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P11: Homework: Find out IRR using the following information

Year Annual CFAT

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Project Investment NPV @ 15%

The company is limited to a capital spending of INR 1,20,000.

P13: Alpha Company is considering the following investment projects:

Cash Flows (INR)

B -10,000 +7,500 +7,500

C -10,000 +2,000 +4,000 +12,000

D -10,000 +10,000 +3,000 +3,000