01_Adv Issues in Cap Budgeting

8/18/2019 01_Adv Issues in Cap Budgeting

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Example - 1: Selling under-valued stocks to finance project

No. of Shares o/s 100 crores

Value / share 100 Rs.

Mkt Price / share 80 Rs. Shares under-valued by the arket

Mkt value of fir 8!000 Rs. "rore

# $!%00 Rs. "rore

& 3,800 Rs. "rore

#&R 1.11

'he fir faces the follo(in) investent o**ortunity

+nitial +nvestent 100 crore Rs.

NPV 10 crore Rs.

Since #&R is already hi)h! the fir decides to fund this by raisin) fresh e,uity.

No. of shrs to beissued by the fir 1.% "1$/"

ain to eistin)

shareholders due to *ro2ect 10 NPV

3oss to eistin) share-

holders for issuin) stock

at belo( true value % Rs. "rore c%045Value - Price6

Net )ain/loss to eistin)

Shareholders 516 Rs. "rore "%7 - "%

Net )ain/loss to eistin)

Shareholders *er share 50.16 Rs. "70/"$


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Example - !: "#$ versus %&& - #rojects 'it( )ifferent Scale

Note: These involve RANKING with CONVENTIONAL PROJECTS

'here are t(o *ro2ects - 9 : ; - (ith si)nificant differences in

scale of the *ro2ect 5in ters of investent : cash flo(s6

-9 ">-; Note that the conflict disaea!s

0 510.06 5100.06 at a hi"he! cost of caital of

1 7. 70.0 #$%&'( ) #$%&*( +than #*(,%

% $. 7.0

7 .0 $.0

$ . .0

NPV $.8 17.? S&3&"' PR@A&"' ;

+RR 77.= %0.88= S&3&"' PR@A&"' 9

Example - *: "#$ versus %&& - #rojects 'it( Same Scale

Note: These involve RANKING with CONVENTIONAL PROJECTS

-9 ">-;

0 5100.06 BBB

1 0.0 70.0

% $0.0 77.0

7 7%.0 $.0

$ 70.0 .0

NPV 11.?% 1%.0 S&3&"' PR@A&"' ;

+RR %1.$1= %0.%7= S&3&"' PR@A&"' 9

Example - 3!: +sing t(e #rofitailit %ndex to (oose #rojects

9 fir 5say ;ooks*ace 3td.6 is facin) the follo(in) seven alternative

*ro2ects to choose fro durin) the net one year. 'he fir has a total

investable ca*ital of Rs. 100 crore that it can that it can *ool fro

all sources 5internal : eternal! debt : e,uity6.

#roject %nitial %nvt. "#$

5Rs. "rore6 5Rs. "r.6


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9 % 10

; $0 %0

"

# 100 %

& 0 1

> 0 %0

7 %0

iven the inforation above! ho( should the fir select the *ro2ects!

and (hich *ro2ects should it selectC

'o resolve this! (e co*ute the P+ of each *ro2ect! and find the rank of each.

#roject %nitial %nvt. "#$ PI Ran-.PI

5Rs. "rore6 5Rs. "r.6

9 % 10 0.$0 /

; $0 %0 0.0 &

" 1.00 #

# 100 % 0.% 0

& 0 1 0.70 *

> 0 %0 0.%? 1

7 %0 0. 2

Net! (e arran)e the *ro2ects in order of descendin) /ascendnin)

a)nitude of P+ 5RankDP+6E

onstraint / &s. 100 crore

#roject %nitial %nvt. "#$ PI Ran-.PI "uD+nvt

5Rs. "rore6 5Rs. "r.6 5Rs. "rore6

" 1.00 #

7 %0 0. 2 $0; $0 %0 0.0 & 80

9 % 10 0.$0 / 10

& 0 1 0.70 *

> 0 %0 0.%? 1

# 100 % 0.% 0

iven the investable resource of Rs. 100 crore! the fir can ado*t

only the first three *ro2ects 5"! : ;6.

'hen the fir is left (ith un-utiliFed investent ca*acity of Rs. %0 crore.

Example - 3*: +sing t(e #rofitailit %ndex to (oose #rojects - 'it( #roject )ependence

Since ; has to be undertaken! (e eclude ;Gs *ro2ect cost 5Rs. $0 crore6.


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" 1.00 #

7 %0 0. 2 $0

9 % 10 0.$0 &

& 0 1 0.70 /

> 0 %0 0.%? *

# 100 % 0.% 1

+f it can stretch itGs finances a little bit to )arner

an additional resource of Rs. crore! it can

ado*t *ro2ect 9 as (ell

uestion is: '(at are t(e trade-offs2

Example - : 4odified %nternal &ate of &eturn 54%&&6 - computation

3et us consider the follo(in) *ro2ect.

lo(s 700

+nvestent 51!0006

'hus! M+RR for this *ro2ect is co*uted as follo(sE

M+RR %1.%7=

5+RR %$.8?= 6


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Example - 7: as( lo's of a Service - %nstalling a 9elecom Sstem

'he fir ust instal a teleco syste to carry out its business

+t has t(o alternatives - one (ith hi)her initial cost but lesser

aintenance cost. 'he other alternative involves lo(er initial

cost but hi)her annual aintenance cost.

Note that this is a case of iniiFin) cost.

#iscount rate of fir 10=

5Rs. "rore6

Vendor-1 Vendor-% Vendor-1 Vendor-%

5PV6 5PV6

+nvestent -%0 -70

">1 -8 -7 1 5.%6 5%.76

">% -8 -7 % 5.16 5%.$86

">7 -8 -7 7 5.016 5%.%6

">$ -8 -7 $ 5.$6 5%.06"> -8 -7 5$.?6 51.86

NPV 50.776 5$1.76

Hence Vendor-% should be selected.

Example - : Euivalent !nnuities 4et(od

+nvestents and cash flo(s of the t(o *ro2ects areE

#iscount Rate 1= 1%= 7$.

Iear Pro2ect 9 Pro2ect ;

0 -100 -10

1 $0 7

% $0 7

7 $0 7

$ $0 7

$0 7

7

7

8 7

? 710 7

NPV 7$. $.

3ifetie 10

&,v 9nnuity 10.%? 8.$

Equivalent Annuity= NPV ∗r

(1− (1+r )−n)


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;


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r

+r )−n)


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all ong ? S(ort

Strike Price 5J6E 0

Strike #ate 'Preiu

Pay-@ff-3o Pay-@ff-Short Put @*tion

70 17 -17

71 1% -1%

7% 11 -11

77 10 -10

7$ ? -?

7 8 -8

7 -

7 -78 -

7? $ -$

$0 7 -7

$1 % -%

$% 1 -1

$7 0 0

$$ -1 1

$ -% %

$ -7 7

$ -$ $

$8 -

$? - 0 -

1 -

% -

7 -

$ -

#ut ong ? S(ort

Strike Price 5J6E 0Strike #ate '

Preiu

Pay-@ff-3o Pay-@ff-Short "all @*tion

$0 -

$1 -

$% -

S*ot Price 5S'6

S*ot Price 5S'6

25 30 35

-15

-10

-5

0

5

10

15

Pay-Off-Long Put O


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$7 -

$$ -

$ -

$ -

$ -

$8 -

$? - 0 -

1 -

% -

7 -$ $

$ -7 7

-% %

-1 1

0 0

8 1 -1

? % -%

0 7 -7

1 $ -$% -

7 -

$ -

8 -8

35 40 45 50 55

-10

-8

-6

-4

-2

0

2

4

6

8

10

Pay-Off-Long Call Option Pay-Off-Sho


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40 45 50 55 60

tion Pay-Off-Short Put Option


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60 65 70

rt Call Option


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"ause Nuber of firs Percent of total

#ebt liit i*osed by outside a)reeent 10 10.=

#ebt liit *laced by ana)eent eternal to fir 7 7.%=

?.1=

Restrictive *olicy i*osed on retained earnin)s % %.1=

Maintenance of tar)et &PS or P& ratio 1$ 1$.?=

'@'93 ?$ ---

SourceE #aodaran! 9**lied "or*orate >inance! 7/e!


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e*rint %01% by


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'heory Practice Source of Rationin)

1. Pro2ect discovery 9 business uncovers 9 business believes! Lncertainty about

a )ood investent )iven the underlyin) true value of

o**ortunity. uncertainty! that it *ro2ects ay causehas a )ood *ro2ect. rationin).

%. +nforation 'he business 'he business #ifficulty in

revelation conveys inforation atte*ts to convey conveyin)

about the *ro2ect to inforation to inforation to

financial arkets. financial arkets. arkets ay cause

rationin).

7. Market res*onse >inancial arkets >inancial arkets 'he )reater the

believe the firK ay not believe the credibility )a*! the

i.e.! the inforation announceent. )reater the rationin)

is conveyed *roble.credibly.

$. Market efficiency 'he securities 'he securities lotation costs 'here are no costs 'here are si)nificant 'he )reater the

5or 'ransaction costs6 associated (ith costs associated flotation costs! the

raisin) funds for (ith raisin) funds lar)er (ill be the

*ro2ects. for *ro2ects. ca*ital rationin) *roble.

SourceE #aodaran! 9**lied "or*orate >inance! 7/e!


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01_Adv Issues in Cap Budgeting

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