Introduction to Project Financing

Project finance

Project finance is the long-term financing of a specific project (such as a hydropower plant, road or pipeline) in which the lenders and investors look mainly at the cash flow and assets of the project itself, not at the balance sheet of the sponsors, for repayment of the debt and return on equity. A separate legal entity (special purpose vehicle, SPV) is usually formed for the project.

Main features: separate project company (SPV), non-recourse or limited recourse debt, high debt-equity ratio, cash flow as the basis of repayment, risk sharing by many parties through contracts, and long term.

Sources of financing

Determinants of capital structure decision

1. Cash flowability: the ability to generate enough cash to pay interest and repay debt. Stable, high cash flow allows more debt (measured by interest coverage and debt service coverage ratio).
2. Leverage / trading on equity: if the return on investment is higher than the interest rate, more debt increases EPS; if lower, it reduces it.
3. Cost of capital: debt is cheaper because interest is tax deductible; the structure with the lowest weighted average cost of capital is preferred.
4. Control: issuing new equity dilutes the control of existing owners, so they may prefer debt.
5. Flexibility: the firm should keep unused borrowing capacity for future needs.
6. Marketability and timing: condition of the capital market, investor demand, and the best time for share or bond issue.
7. Size and stage of the firm: large, established firms have easier access to debt and equity.
8. Nature of the business: stable-demand projects (e.g. hydropower with PPA) can carry more debt than cyclical businesses.
9. Legal and tax factors: limits on debt-equity ratio by regulators, tax rate, covenants of lenders.
10. Risk (business and financial): high business risk needs less debt.

A suitable example: a hydropower project with a long-term power purchase agreement has stable cash flow, so it can use about 70:30 debt-equity; a project with uncertain revenue should use less debt.

Project finance

Project finance is the long-term financing of a specific project (such as a hydropower plant, road or pipeline) in which the lenders and investors look mainly at the cash flow and assets of the project itself, not at the balance sheet of the sponsors, for repayment of the debt and return on equity. A separate legal entity (special purpose vehicle, SPV) is usually formed for the project.

Features of a sound capital structure

1. Simplicity: easy to understand and manage.
2. Profitability: gives maximum return to shareholders at minimum cost of capital.
3. Solvency: debt is within the firm's ability to pay interest and principal.
4. Flexibility: can be changed when needs change, with spare borrowing capacity.
5. Control: keeps control with the existing owners.
6. Conservatism: does not take excess debt, risk is kept low.
7. Liquidity and marketability: securities can be sold easily in the market.
8. Adequate capital: enough funds for fixed and working capital.
9. Legal compliance: follows the Companies Act and regulatory limits.

Factors to be considered in the capital structure decision (with example)

1. Cash flowability: the ability to generate enough cash to pay interest and repay debt. Stable, high cash flow allows more debt (measured by interest coverage and debt service coverage ratio).
2. Leverage / trading on equity: if the return on investment is higher than the interest rate, more debt increases EPS; if lower, it reduces it.
3. Cost of capital: debt is cheaper because interest is tax deductible; the structure with the lowest weighted average cost of capital is preferred.
4. Control: issuing new equity dilutes the control of existing owners, so they may prefer debt.
5. Flexibility: the firm should keep unused borrowing capacity for future needs.
6. Marketability and timing: condition of the capital market, investor demand, and the best time for share or bond issue.
7. Size and stage of the firm: large, established firms have easier access to debt and equity.
8. Nature of the business: stable-demand projects (e.g. hydropower with PPA) can carry more debt than cyclical businesses.
9. Legal and tax factors: limits on debt-equity ratio by regulators, tax rate, covenants of lenders.
10. Risk (business and financial): high business risk needs less debt.

Example: a company needs Rs 10 crore. It can raise it by (a) all equity, or (b) Rs 6 crore debt at 10% and Rs 4 crore equity. With EBIT = Rs 2 crore, tax 25%:

$$\begin{aligned} \text{(b) interest} &= 6 \times 10\% = 0.6\ \text{crore}, \quad EAT = (2 - 0.6)\times 0.75 = 1.05\ \text{crore}\\ \text{(a) EAT} &= 2 \times 0.75 = 1.5\ \text{crore} \end{aligned}$$

With shares of Rs 100, (a) has 10 lakh shares, EPS = Rs 15; (b) has 4 lakh shares, EPS = Rs 26.25. Because the return on investment (20%) is higher than the interest (10%), debt raises EPS (leverage). But it would also increase financial risk if the EBIT fell, which is why cash flowability and the other factors must be checked.

Concept

Capital structure is the mix of long-term sources of funds (equity shares, preference shares, retained earnings and long-term debt) used by a firm to finance its total capital. Capital structure planning is the process of deciding the best proportion of these sources so that the cost of capital is lowest and the value of the firm and return to shareholders are highest.

A firm can finance with ordinary shares, preference shares, retained earnings, debentures and loans. Planning decides the debt-equity ratio so that the weighted average cost of capital (WACC) is minimum and the EPS and value of the firm are maximum, with acceptable risk.

Objectives

• Maximise shareholders' wealth
• Minimise the cost of capital
• Maintain liquidity and flexibility
• Keep control and reduce financial risk

Example

Total capital needed = Rs 10 lakh.

Plan A is safest but gives low EPS; plan C has high EPS if profits are good but high risk when profit falls. The planner selects the plan which balances return and risk, for example plan B, by using the determinants such as cash flowability, cost, control and flexibility.

Steps

1. Estimate the total capital requirement.
2. Find the available sources and their costs.
3. Compare different mixes by EPS-EBIT analysis and cost of capital.
4. Check risk, control, flexibility and legal limits.
5. Select the optimal capital structure and review it from time to time.

Cash flowability and capital structure

Cash flowability is the ability of a firm to generate enough cash from operations to meet fixed obligations such as interest and loan instalment. It is measured by the interest coverage ratio (EBIT / interest) and the debt service coverage ratio. If cash flow is stable and strong (for example a hydropower plant with a long-term power purchase agreement), a firm can use more debt in its capital structure. If cash flow is uncertain, more equity should be used, because debt payment is compulsory but dividend is not.

Capital structure planning and debt-equity ratio

Capital structure is the mix of long-term sources of funds (equity shares, preference shares, retained earnings and long-term debt) used by a firm to finance its total capital. Capital structure planning is the process of deciding the best proportion of these sources so that the cost of capital is lowest and the value of the firm and return to shareholders are highest.

The debt-equity ratio is

$$\text{Debt-equity ratio} = \frac{\text{Long-term debt}}{\text{Shareholders' equity}}$$

• A high ratio means high leverage: cheap funds and higher EPS in good times, but high financial risk and a fixed burden.
• A low ratio means low risk but higher cost of capital and lower EPS.
• Infrastructure projects normally use 70:30 or 75:25 debt-equity, while lenders and regulators may set the limit.
• The planner selects the ratio that gives the lowest weighted average cost of capital and the highest EPS with acceptable risk.

Data

• Ordinary shares: 5,000 x Rs 100 = Rs 500,000
• Preference capital: Rs 3,00,000 at 12%
• Loan: Rs 2,00,000 at 10%
• EBIT = Rs 3,50,000; tax rate = 25%

EPS

$$\begin{aligned} \text{Interest} &= 200,000 \times 10\% = 20,000\\ \text{EBT} &= 350,000 - 20,000 = 330,000\\ \text{Tax} &= 25\% \times 330,000 = 82,500\\ \text{EAT} &= 330,000 - 82,500 = 247,500\\ \text{Preference dividend} &= 300,000 \times 12\% = 36,000\\ \text{Earnings for equity} &= 247,500 - 36,000 = 211,500\\ EPS &= \frac{211,500}{5,000} = 42.30 \end{aligned}$$

Book value

Book value per share = net worth belonging to ordinary shareholders / number of ordinary shares. No reserves or retained earnings are given, so net worth equals the ordinary share capital (preference capital and loan are not part of it).

$$BV = \frac{500,000}{5{,}000} = 100.00$$

Answer: EPS = Rs 42.30 per share; book value = Rs 100.00 per share.

Project financing

Project finance is the long-term financing of a specific project (such as a hydropower plant, road or pipeline) in which the lenders and investors look mainly at the cash flow and assets of the project itself, not at the balance sheet of the sponsors, for repayment of the debt and return on equity. A separate legal entity (special purpose vehicle, SPV) is usually formed for the project.

Structures of project financing

1. Non-recourse financing: lenders look only at the project's cash flow and assets; sponsors are not liable for the debt. Risk is high, so it needs strong contracts and guarantees.
2. Limited-recourse financing: the sponsors give limited guarantees (e.g. during construction or for completion) and the project cash flow repays the debt. This is the most common form.
3. Full-recourse financing: the sponsors guarantee the full debt (similar to corporate finance).
4. Special purpose vehicle (SPV) / project company: the sponsors form a separate company holding the contracts, assets and debt.
5. BOT / BOOT / BOO structures: a private company builds, owns, operates and transfers the project after the concession period (used for hydropower, roads, bridges).
6. Public-private partnership (PPP) and joint venture: government and private sector share investment, risk and revenue.
7. Syndicated loans and bond-based structures to share the lending amount among many lenders.

 Sponsors --equity--> [ SPV / Project company ] <--loan-- Lenders
                          |           ^
         EPC contract <---+           +--- offtake (PPA) contract

Steps of capital structure planning

1. Estimate the total capital requirement of the project.
2. Identify the available sources (equity, preference, debt) and their costs.
3. Analyse the cash flowability and the risk of the project.
4. Prepare alternative capital structures and compare them by EPS-EBIT analysis and cost of capital.
5. Check control, flexibility, legal and lender conditions.
6. Select the optimum structure and arrange the funds.
7. Review the structure regularly.

Concept

Project finance is the long-term financing of a specific project (such as a hydropower plant, road or pipeline) in which the lenders and investors look mainly at the cash flow and assets of the project itself, not at the balance sheet of the sponsors, for repayment of the debt and return on equity. A separate legal entity (special purpose vehicle, SPV) is usually formed for the project.

Main characteristics

• Separate project entity (SPV) with its own assets, contracts and accounts.
• Non-recourse or limited-recourse debt: repayment is from the project revenue.
• High leverage: commonly 70 to 80% debt.
• Risk allocation by contracts: construction (EPC), supply, offtake/PPA, operation and insurance contracts share the risk among those who can best manage it.
• Long tenor, often 10 to 20 years or more.
• Detailed feasibility and financial model with debt service coverage ratio (DSCR) checks.

Example

A private hydropower company builds a 30 MW plant. It forms an SPV, signs a PPA with the Nepal Electricity Authority, gets 70% of the cost as bank loans and 30% as sponsors' equity. The PPA revenue pays the loan instalments.

Why it is used

It allows big infrastructure to be built without putting the full risk on the sponsors or the government, and attracts private and foreign capital.

Are preference shares a source of project finance?

Yes. Preference shares are a source of long-term finance that has features of both equity and debt. The holders get a fixed rate of dividend, paid before any dividend to ordinary shareholders, and priority in repayment if the company is liquidated, but usually they have no voting right.

• Advantages: no obligation to pay if profit is not enough (for non-cumulative shares), no dilution of control, no security required, and it increases the base for borrowing.
• Disadvantages: dividend is not tax-deductible (paid from after-tax profit), so the cost is higher than debt; it is more costly than loan; it creates a fixed claim before ordinary shares.
• Types: cumulative, non-cumulative, redeemable, convertible and participating.

So a project can raise part of its capital through preference shares when it wants funds without losing control and without compulsory repayment.

Determinants of capital structure decision

1. Cash flowability: the ability to generate enough cash to pay interest and repay debt. Stable, high cash flow allows more debt (measured by interest coverage and debt service coverage ratio).
2. Leverage / trading on equity: if the return on investment is higher than the interest rate, more debt increases EPS; if lower, it reduces it.
3. Cost of capital: debt is cheaper because interest is tax deductible; the structure with the lowest weighted average cost of capital is preferred.
4. Control: issuing new equity dilutes the control of existing owners, so they may prefer debt.
5. Flexibility: the firm should keep unused borrowing capacity for future needs.
6. Marketability and timing: condition of the capital market, investor demand, and the best time for share or bond issue.
7. Size and stage of the firm: large, established firms have easier access to debt and equity.
8. Nature of the business: stable-demand projects (e.g. hydropower with PPA) can carry more debt than cyclical businesses.
9. Legal and tax factors: limits on debt-equity ratio by regulators, tax rate, covenants of lenders.
10. Risk (business and financial): high business risk needs less debt.

Large projects (hydropower, highways, airports, pipelines) need big long-term funds, which are usually raised from a combination of sources.

1. Sponsors' equity: the owners' own contribution, normally 20 to 30% of the cost.
2. Commercial bank loans and syndicated loans: many banks share the large loan.
3. Multilateral and bilateral institutions: World Bank, ADB, JICA, EXIM banks give long-term, low-interest loans.
4. Government funding: budget, grants and viability gap funding; Employees Provident Fund and Citizen Investment Trust invest in Nepali projects.
5. Bonds and debentures: long-term borrowings from the public and institutions.
6. Public offering of shares (IPO): common in Nepali hydropower companies, with part reserved for local people.
7. Supplier's credit and export credit for imported equipment.
8. Public-private partnership and BOT: the private party raises funds and recovers them from operation.
9. Leasing and venture capital for equipment and risky ventures.

The choice is based on the cost, risk, tenor, control and the project's cash flow.

Sources of project financing

Steps in the capital budgeting process

1. Identification of investment opportunities: generate project ideas (new product, replacement, expansion).
2. Screening and preliminary evaluation: reject unsuitable ideas.
3. Estimation of cash flows: estimate initial cost, annual inflows, outflows and salvage value.
4. Evaluation: apply techniques (payback, ARR, NPV, IRR, PI).
5. Selection and approval: choose the best project(s) under budget; top management approves.
6. Financing and implementation: arrange funds, plan and execute.
7. Monitoring and control: compare actual with forecast and take action.
8. Post-audit (review): check the results and learn.

Net present value (NPV)

Net present value (NPV) is the difference between the present value of all cash inflows and the present value of all cash outflows, discounted at the required rate of return (cost of capital).

$$NPV = \sum_{t=1}^{n}\frac{CF_t}{(1+k)^t} + \frac{S}{(1+k)^n} - I_0$$

where $CF_t$ is net cash flow in year $t$, $k$ is the discount rate, $S$ is salvage value and $I_0$ is the initial investment.

• Decision rule: accept if NPV > 0; reject if NPV < 0; for mutually exclusive projects choose the highest NPV.
• Advantages: considers the time value of money, all cash flows and the size of the project; gives the gain in money terms; additive.
• Limitations: needs a correct discount rate; harder to explain; ranking can be misleading for projects of different size and life.

Conventional finance vs project finance

Numerical

The project life and discount rate are not given. Assumptions: life = 5 years, discount rate = 10%, straight-line depreciation, and tax is ignored.

• Net annual cash flow = 10,00,000 - 2,00,000 = Rs 800,000
• Depreciation = (25,00,000 - 5,00,000)/5 = Rs 400,000 per year
• Average annual profit = 800,000 - 400,000 = Rs 400,000

ARR

$$\begin{aligned} \text{Average investment} &= \frac{25{,}00{,}000 + 5{,}00{,}000}{2} = 1,500,000\\ ARR &= \frac{400,000}{1,500,000} \times 100 = 26.67\% \end{aligned}$$

NPV (annuity factor at 10%, 5 years = 3.7908; PV factor at year 5 = 0.6209)

$$\begin{aligned} PV_{inflow} &= 800,000 \times 3.7908 + 500,000 \times 0.6209 = 3,343,090\\ NPV &= 3,343,090 - 2,500,000 = 843,090 \end{aligned}$$

Profitability index

$$PI = \frac{3,343,090}{2,500,000} = 1.337$$

Simple payback period

$$\text{Payback} = \frac{25{,}00{,}000}{8{,}00{,}000} = 3.125\ \text{years} \approx 3\ \text{years}\ 2\ \text{months}$$

Answer: ARR = 26.67%; NPV = Rs 843,090; PI = 1.337; payback = 3.125 years. NPV is positive and PI is more than 1, so the project is acceptable.

A sound capital structure gives the highest value to the firm with an acceptable risk. Its main features are:

1. Simplicity: easy to understand and manage.
2. Profitability: gives maximum return to shareholders at minimum cost of capital.
3. Solvency: debt is within the firm's ability to pay interest and principal.
4. Flexibility: can be changed when needs change, with spare borrowing capacity.
5. Control: keeps control with the existing owners.
6. Conservatism: does not take excess debt, risk is kept low.
7. Liquidity and marketability: securities can be sold easily in the market.
8. Adequate capital: enough funds for fixed and working capital.
9. Legal compliance: follows the Companies Act and regulatory limits.

An example is a firm with a debt-equity ratio of about 1:1, interest cover above 3, and some borrowing capacity kept for the future.

Importance of capital structure planning

1. Minimises the cost of capital, which raises the value of the firm.
2. Maximises EPS and shareholders' wealth by using leverage properly.
3. Ensures liquidity and solvency, so interest and loans are paid on time.
4. Keeps control of the owners.
5. Gives flexibility for future financing and growth.
6. Reduces financial risk and helps the firm to survive in bad times.
7. Improves the credit rating and the confidence of investors.

Determinants (in brief)

1. Cash flowability: the ability to generate enough cash to pay interest and repay debt. Stable, high cash flow allows more debt (measured by interest coverage and debt service coverage ratio).
2. Leverage / trading on equity: if the return on investment is higher than the interest rate, more debt increases EPS; if lower, it reduces it.
3. Cost of capital: debt is cheaper because interest is tax deductible; the structure with the lowest weighted average cost of capital is preferred.
4. Control: issuing new equity dilutes the control of existing owners, so they may prefer debt.
5. Flexibility: the firm should keep unused borrowing capacity for future needs.
6. Marketability and timing: condition of the capital market, investor demand, and the best time for share or bond issue.
7. Size and stage of the firm: large, established firms have easier access to debt and equity.
8. Nature of the business: stable-demand projects (e.g. hydropower with PPA) can carry more debt than cyclical businesses.
9. Legal and tax factors: limits on debt-equity ratio by regulators, tax rate, covenants of lenders.
10. Risk (business and financial): high business risk needs less debt.

Capital structure planning

Capital structure is the mix of long-term sources of funds (equity shares, preference shares, retained earnings and long-term debt) used by a firm to finance its total capital. Capital structure planning is the process of deciding the best proportion of these sources so that the cost of capital is lowest and the value of the firm and return to shareholders are highest.

Cash flowability

The ability of the firm to generate sufficient cash to pay interest, tax, loan instalments and dividends. Measured by interest coverage ratio (EBIT/interest) and debt service coverage ratio. Strong, stable cash flow permits more debt; weak cash flow needs more equity.

Leverage ratio

The leverage ratio shows how much debt the firm uses compared to equity (debt-equity ratio, debt ratio = debt/total capital).

• Positive leverage: if return on investment is greater than the interest rate, debt increases EPS (trading on equity).
• High leverage increases the risk of default if earnings fall.

A suitable level is chosen from the earnings and the risk the firm can bear.

Flexibility

The capital structure should allow the firm to raise more funds when needed, without difficulty and at an acceptable cost. This needs unused borrowing power, low fixed commitments, and options like redeemable or convertible securities.

Marketability

It is the ease with which the firm can sell its securities in the capital market. It depends on the condition of the market (boom or recession), investor demand, the firm's reputation and the timing of issue. In a strong share market, equity is issued; when share prices are low, debt is preferred.

Capital budgeting

Capital budgeting is the process of planning, evaluating and selecting long-term investment projects whose benefits come over several years (such as a new plant, road or building), by comparing the cash outlay with the expected future returns.

Features

1. Involves a large investment of funds.
2. Benefits and costs are spread over many years (long term).
3. The decision is generally irreversible or very costly to reverse.
4. High risk and uncertainty because it depends on forecasts.
5. Affects the future profitability and growth of the firm.
6. Needs careful analysis of cash flows, not accounting profit alone.
7. Taken by top management.

Process in short

1. Identification of investment opportunities: generate project ideas (new product, replacement, expansion).
2. Screening and preliminary evaluation: reject unsuitable ideas.
3. Estimation of cash flows: estimate initial cost, annual inflows, outflows and salvage value.
4. Evaluation: apply techniques (payback, ARR, NPV, IRR, PI).
5. Selection and approval: choose the best project(s) under budget; top management approves.
6. Financing and implementation: arrange funds, plan and execute.
7. Monitoring and control: compare actual with forecast and take action.
8. Post-audit (review): check the results and learn.

Importance of capital budgeting

1. Large funds are committed for a long period.
2. Decisions are irreversible; a wrong decision may cause heavy loss.
3. It decides the future growth and profit of the firm.
4. It affects the firm's risk and its cost of capital.
5. Funds are limited, so projects have to be ranked.
6. It needs a long-term forecast of demand, cost and technology.

Techniques for evaluating projects

Non-discounting (traditional) methods: payback period and accounting rate of return (ARR).

Discounting methods: net present value (NPV), internal rate of return (IRR), profitability index (PI) and benefit-cost ratio.

Discounting methods consider the time value of money and are more reliable; NPV is the most commonly recommended.

Capital budgeting decision

Capital budgeting is the process of planning, evaluating and selecting long-term investment projects whose benefits come over several years (such as a new plant, road or building), by comparing the cash outlay with the expected future returns.

Importance

1. Large funds are committed for a long period.
2. Decisions are irreversible; a wrong decision may cause heavy loss.
3. It decides the future growth and profit of the firm.
4. It affects the firm's risk and its cost of capital.
5. Funds are limited, so projects have to be ranked.
6. It needs a long-term forecast of demand, cost and technology.

Net present value

Net present value (NPV) is the difference between the present value of all cash inflows and the present value of all cash outflows, discounted at the required rate of return (cost of capital).

$$NPV = \sum_{t=1}^{n}\frac{CF_t}{(1+k)^t} + \frac{S}{(1+k)^n} - I_0$$

where $CF_t$ is net cash flow in year $t$, $k$ is the discount rate, $S$ is salvage value and $I_0$ is the initial investment.

• Decision rule: accept if NPV > 0; reject if NPV < 0; for mutually exclusive projects choose the highest NPV.
• Advantages: considers the time value of money, all cash flows and the size of the project; gives the gain in money terms; additive.
• Limitations: needs a correct discount rate; harder to explain; ranking can be misleading for projects of different size and life.

Capital budgeting and its importance

Capital budgeting is the process of planning, evaluating and selecting long-term investment projects whose benefits come over several years (such as a new plant, road or building), by comparing the cash outlay with the expected future returns.

1. Large funds are committed for a long period.
2. Decisions are irreversible; a wrong decision may cause heavy loss.
3. It decides the future growth and profit of the firm.
4. It affects the firm's risk and its cost of capital.
5. Funds are limited, so projects have to be ranked.
6. It needs a long-term forecast of demand, cost and technology.

Methods of evaluating projects financially

• Payback period: time to recover the initial investment; simple, but ignores the time value of money and cash flows after payback.
• ARR: average profit / average investment; ignores the time value.
• NPV: present value of inflows less outflows at the required rate.
• IRR: the discount rate that makes NPV zero.
• PI: PV of inflows / initial investment.
• B/C ratio: PV of benefits / PV of costs.

Most reliable method

The NPV method is the most reliable. It uses all cash flows over the project life, considers the time value of money, directly measures the increase in the firm's wealth, and avoids the multiple-IRR and ranking problems. IRR and PI are also good, but they can give wrong ranking for mutually exclusive projects of different size or cash-flow pattern.

Capital budgeting

Capital budgeting is the process of planning, evaluating and selecting long-term investment projects whose benefits come over several years (such as a new plant, road or building), by comparing the cash outlay with the expected future returns.

Needs and importance

1. Large funds are committed for a long period.
2. Decisions are irreversible; a wrong decision may cause heavy loss.
3. It decides the future growth and profit of the firm.
4. It affects the firm's risk and its cost of capital.
5. Funds are limited, so projects have to be ranked.
6. It needs a long-term forecast of demand, cost and technology.

Capital budgeting is needed for expansion, replacement of old assets, new products, research, safety and environmental projects.

Steps

1. Identification of investment opportunities: generate project ideas (new product, replacement, expansion).
2. Screening and preliminary evaluation: reject unsuitable ideas.
3. Estimation of cash flows: estimate initial cost, annual inflows, outflows and salvage value.
4. Evaluation: apply techniques (payback, ARR, NPV, IRR, PI).
5. Selection and approval: choose the best project(s) under budget; top management approves.
6. Financing and implementation: arrange funds, plan and execute.
7. Monitoring and control: compare actual with forecast and take action.
8. Post-audit (review): check the results and learn.

Process (flow)

 Idea -> Screening -> Cash-flow estimate
                         |
        Evaluation (payback, ARR, NPV, IRR, PI)
                         |
        Selection and approval -> Financing
                         |
        Implementation -> Control -> Post-audit

Evaluation criteria: accept projects with NPV > 0, IRR > required rate, PI > 1, and acceptable payback; rank by NPV when funds are limited (capital rationing).

Capital budgeting is the process of planning, evaluating and selecting long-term investment projects whose benefits come over several years (such as a new plant, road or building), by comparing the cash outlay with the expected future returns.

The capital budgeting process:

1. Identification of investment opportunities: generate project ideas (new product, replacement, expansion).
2. Screening and preliminary evaluation: reject unsuitable ideas.
3. Estimation of cash flows: estimate initial cost, annual inflows, outflows and salvage value.
4. Evaluation: apply techniques (payback, ARR, NPV, IRR, PI).
5. Selection and approval: choose the best project(s) under budget; top management approves.
6. Financing and implementation: arrange funds, plan and execute.
7. Monitoring and control: compare actual with forecast and take action.
8. Post-audit (review): check the results and learn.

The process is repeated for each investment proposal, and the final choice must be consistent with the firm's strategy and available funds.

Capital budgeting is the process of planning, evaluating and selecting long-term investment projects whose benefits come over several years (such as a new plant, road or building), by comparing the cash outlay with the expected future returns.

Steps in capital budgeting

1. Identification of investment opportunities: generate project ideas (new product, replacement, expansion).
2. Screening and preliminary evaluation: reject unsuitable ideas.
3. Estimation of cash flows: estimate initial cost, annual inflows, outflows and salvage value.
4. Evaluation: apply techniques (payback, ARR, NPV, IRR, PI).
5. Selection and approval: choose the best project(s) under budget; top management approves.
6. Financing and implementation: arrange funds, plan and execute.
7. Monitoring and control: compare actual with forecast and take action.
8. Post-audit (review): check the results and learn.

The steps form a cycle, because the lessons from post-audit improve future cash-flow estimates and decisions.

Capital budgeting decision

Capital budgeting is the process of planning, evaluating and selecting long-term investment projects whose benefits come over several years (such as a new plant, road or building), by comparing the cash outlay with the expected future returns. The capital budgeting decision is the decision to accept, reject or rank such investments on the basis of their expected cash flows and return.

ARR or return on equity

Accounting rate of return (ARR) (also return on investment or return on equity) measures the average annual accounting profit as a percentage of the investment.

$$ARR = \frac{\text{Average annual profit after tax}}{\text{Average investment}} \times 100, \qquad \text{Average investment} = \frac{I_0 + S}{2}$$

Accept the project if ARR is more than the minimum required rate. It is simple and uses accounting data, but it ignores the time value of money and uses profit instead of cash flow. Return on equity (ROE) is similar: net profit after tax divided by shareholders' equity.

Example: investment Rs 100, salvage Rs 20, average profit Rs 12 gives average investment = 60 and ARR = 12/60 = 20%.

Measures the Government should take to attract the private sector in hydropower

1. Keep a stable, clear policy and law (Electricity Act, Hydropower Development Policy) that will not change suddenly.
2. A one-window system for licence, EIA, land and approvals, to reduce delay.
3. Bankable PPAs with fair tariff, annual escalation and payment guarantee by the Nepal Electricity Authority; a clear power export policy.
4. Transmission lines and access roads built by the government or shared in time.
5. Tax incentives: tax holiday, reduced royalty in early years, VAT and custom duty relief on equipment.
6. Easy financing: concessional long-term loans, hydropower bonds, a currency-risk hedging scheme and guarantees from the government.
7. Land acquisition and security support, and help with local community issues.
8. Risk-sharing: support for geological, hydrological and political risk, with insurance schemes.
9. Transparent licensing and protection of investors' rights, with dispute settlement.
10. Local benefit sharing (royalty to local government and shares to locals) to reduce local opposition.

Capital budgeting decision and its importance

Capital budgeting is the process of planning, evaluating and selecting long-term investment projects whose benefits come over several years (such as a new plant, road or building), by comparing the cash outlay with the expected future returns. The capital budgeting decision is the choice to accept, reject or rank such investments.

Importance:

1. Large funds are committed for a long period.
2. Decisions are irreversible; a wrong decision may cause heavy loss.
3. It decides the future growth and profit of the firm.
4. It affects the firm's risk and its cost of capital.
5. Funds are limited, so projects have to be ranked.
6. It needs a long-term forecast of demand, cost and technology.

ARR calculation

Assumptions: the income given is the annual income before depreciation and tax; the printed list has only four values for five years, so the year-5 income is taken as Rs 20,000 (same as year 4); depreciation by the straight-line method.

$$\text{Annual depreciation} = \frac{100{,}000 - 20{,}000}{5} = 16,000$$ $$\begin{aligned} \text{Average annual profit} &= \frac{15,000.00}{5} = 3,000.00\\ \text{Average investment} &= \frac{100{,}000 + 20{,}000}{2} = 60,000\\ ARR &= \frac{3,000.00}{60,000} \times 100 = 5.00\% \end{aligned}$$

Answer: ARR = 5.00% (on average investment). The project is accepted if this is more than the firm's required rate of return.

Sources of project finance

Investment decision

Data: investment = Rs 3,00,000; annual return = Rs 50,000 for 8 years; salvage = Rs 10,000. The required rate is not given, so 10% is assumed as the cost of capital; the return is treated as annual profit before depreciation, and tax is ignored.

1. ARR

$$\begin{aligned} \text{Depreciation} &= \frac{300{,}000 - 10{,}000}{8} = 36,250\\ \text{Average profit} &= 50{,}000 - 36,250 = 13,750\\ \text{Average investment} &= \frac{300{,}000 + 10{,}000}{2} = 155,000\\ ARR &= \frac{13,750}{155,000} \times 100 = 8.87\% \end{aligned}$$

2. Payback period

$$\text{Payback} = \frac{300{,}000}{50{,}000} = 6.0\ \text{years}$$

3. IRR: find $i$ at which $-300{,}000 + 50{,}000\,(P/A,i,8) + 10{,}000\,(P/F,i,8) = 0$. By trial and interpolation, IRR = 7.37%.

4. Profitability index (at 10%; annuity factor = 5.3349, PV factor = 0.4665)

$$\begin{aligned} PV_{inflow} &= 50{,}000 \times 5.3349 + 10{,}000 \times 0.4665 = 271,411\\ PI &= \frac{271,411}{300{,}000} = 0.905, \quad NPV = -28,589 \end{aligned}$$

Answer: ARR = 8.87%, payback = 6.0 years, IRR = 7.37%, PI = 0.905. The IRR is below 10% and PI is below 1, so the investment is not recommended at a 10% cost of capital. It would be acceptable only if the required rate were below about 7.4%.

Importance of capital budgeting

1. Large funds are committed for a long period.
2. Decisions are irreversible; a wrong decision may cause heavy loss.
3. It decides the future growth and profit of the firm.
4. It affects the firm's risk and its cost of capital.
5. Funds are limited, so projects have to be ranked.
6. It needs a long-term forecast of demand, cost and technology.

Feasibility of the project

Net annual cash flow = 25,00,000 - 4,50,000 = Rs 2,050,000. Salvage value of Rs 40,00,000 is received at the end of year 5. MARR = 15%.

Method 1: Present worth (net present value)

$$\begin{aligned} (P/A, 15\%, 5) &= 3.3522, \quad (P/F, 15\%, 5) = 0.4972\\ PW &= -1{,}00{,}00{,}000 + 2,050,000 \times 3.3522 + 40{,}00{,}000 \times 0.4972\\ &= -1,139,375 \end{aligned}$$

PW is negative, so the project is not feasible at MARR = 15%.

Method 2: Internal rate of return

Solve $-1{,}00{,}00{,}000 + 20{,}50{,}000\,(P/A,i,5) + 40{,}00{,}000\,(P/F,i,5) = 0$.

• At $i = 10\%$: PW = 254,798 (positive)
• At $i = 15\%$: PW = -1,139,375 (negative)

By interpolation/trial, IRR = 10.83%, which is less than MARR = 15%, so the project is not feasible.

(Check by benefit-cost ratio: $B/C = \dfrac{PV\ \text{of benefits}}{PV\ \text{of costs}} = 0.901 < 1$; the annual worth = -339,893.)

Answer: PW = Rs -1,139,375 and IRR = 10.83% < 15%; the project is not feasible.

MARR is not given, so 10% per year is assumed for present worth and B/C. Annual cash flows are treated as end-of-year benefits with no salvage value.

Formulas

$$\begin{aligned} \text{Payback} &= \frac{I}{A}\\ PW &= -I + A\,\frac{(1+i)^n - 1}{i(1+i)^n}\\ IRR:\ & PW(i) = 0\\ B/C &= \frac{A\,(P/A, i, n)}{I} \end{aligned}$$

Calculation

Example for item 1: $(P/A,10\%,15) = 7.6061$, so $PW = -60{,}000 + 12{,}000 \times 7.6061 = 31,273$ and $B/C = 1.521$. IRR is found by trial so that $PW = 0$.

Ranking (best first)

Answer: Item 3 is best by payback and IRR and Item 2 is best by present worth and B/C. All four items have PW > 0, IRR > 10% and B/C > 1. Item 2 gives the largest absolute gain; Item 3 is very small in size (Rs 2,150), so present worth is preferred for the final decision (select Item 2 if only one can be taken).

Budgeting and its importance

Budget is a detailed plan, in money and/or quantities, of the expected income and expenditure of an organisation or project for a future period. Budgeting is the process of preparing and using budgets.

1. Gives a clear plan and direction for the whole organisation.
2. Controls expenditure, because actual costs are compared with the budget (variance analysis).
3. Co-ordinates the work of departments.
4. Allocates limited resources to the most important uses.
5. Helps in forecasting the cash and fund requirement.
6. Motivates managers and gives a target for performance.
7. Helps to find problems early and to take corrective action.
8. Supports decisions of lenders and investors.

Types of budgets

Capital budgeting decision

Capital budgeting is the process of planning, evaluating and selecting long-term investment projects whose benefits come over several years (such as a new plant, road or building), by comparing the cash outlay with the expected future returns.

The decision means to accept, reject or rank projects using payback, ARR, NPV, IRR and PI.

Budgeting process

1. Set the organisation's objectives and long-term plan.
2. Identify the key (limiting) factor, such as sales or funds.
3. Appoint a budget committee and budget officer; give guidelines.
4. Prepare the departmental budgets (sales, production, cost, cash).
5. Review, co-ordinate and combine them into a master budget.
6. Approve by top management and communicate.
7. Implement, record actual performance and compare with budget.
8. Analyse variances, take corrective action and revise the budget if needed.

Budgeting

Budget is a detailed plan, in money and/or quantities, of the expected income and expenditure of an organisation or project for a future period. Budgeting is the process of preparing and using budgets.

Types of budget

Essentials of budgeting for a new project

1. A clear objective and strong support from top management.
2. A budget committee and budget officer with a clear authority.
3. A sound organisation structure with defined responsibility centres.
4. A good accounting and cost record system.
5. Realistic targets based on past data and forecasts.
6. Participation of the persons who will carry out the budget.
7. A budget period and a budget manual that are well defined.
8. Regular reports on variances and flexibility to revise.

For a new project there are no past data, so estimates from feasibility study, market survey, similar projects and supplier quotations are used, with a contingency.

Purpose of budgeting for a new project

1. To estimate the total project cost and the funds required (capital, working capital).
2. To arrange the financing and the timing of fund release.
3. To control cost during design and construction.
4. To allocate funds to activities and work packages.
5. To forecast cash flow and avoid shortage.
6. To measure performance (planned vs actual) and take corrective action.
7. To get approval from the owner, lenders or government.
8. To compare alternatives and check the viability of the project.

• Budget: Budget is a detailed plan, in money and/or quantities, of the expected income and expenditure of an organisation or project for a future period. Budgeting is the process of preparing and using budgets.

• Sales budget: an estimate of the quantity and value of sales for a future period, by product, area and month, prepared on the basis of past sales, market survey and forecast. It is the starting point of all budgets because sales are usually the key factor.

• Production budget: an estimate of the quantity of goods to be produced in a period.

$$\text{Production} = \text{Sales} + \text{closing stock} - \text{opening stock}$$

It is the base for the material, labour and overhead budgets.

• Cash budget: a forecast of cash receipts and payments in a period, showing the expected cash balance. It helps to plan borrowing or investment of surplus cash.

• Fixed budget: a budget prepared for one level of activity and not changed even if the actual activity differs. It is suitable for stable conditions and fixed costs, but is not useful for control if output changes.

• Flexible budget: a budget that is designed to change with the level of activity; it gives the budgeted cost at different capacity levels (fixed costs remain, variable costs change). It is more useful for control and comparison.

Purpose of a budget

1. Gives a clear plan and direction for the whole organisation.
2. Controls expenditure, because actual costs are compared with the budget (variance analysis).
3. Co-ordinates the work of departments.
4. Allocates limited resources to the most important uses.
5. Helps in forecasting the cash and fund requirement.
6. Motivates managers and gives a target for performance.
7. Helps to find problems early and to take corrective action.
8. Supports decisions of lenders and investors.

Project budget

A project budget is the estimate of the total cost of a project (design, land, materials, labour, equipment, overhead, contingency) divided by activity and time period. It is the baseline against which cost performance is measured, and is used to arrange funds and approve the project.

Operation budget

An operating (operation) budget shows the expected revenue and expenses of regular business activity for a year: sales, production, material, labour, overhead and administration. It gives the budgeted profit, and is the basis for the master budget.

Sales budget

An estimate of the sales volume and revenue in the budget period, by product and region. It is the base for all other budgets.

Cash budget

A forecast of the expected cash receipts and payments in a period, to show the cash surplus or shortage and to plan borrowing or investment.

Advantages of budget

1. Planning and clear targets.
2. Control through variance analysis.
3. Coordination among departments.
4. Efficient use of resources and reduced waste.
5. Early warning of cash shortage.
6. Motivation and responsibility of managers.
7. Basis for credit and loan.
8. Better decision making and performance evaluation.

Budgetary control

Budgetary control is a system in which budgets are prepared for each department or function, actual results are compared with the budgets, differences (variances) are analysed, and corrective action is taken so that the objectives are achieved.

 Plan (budget) -> Operate -> Compare actual with budget
       ^                              |
       +---- Corrective action <-- Variance analysis

Objectives

1. To plan and set clear targets for each department.
2. To coordinate the activities of departments.
3. To control income and expenditure.
4. To fix responsibility for performance.
5. To measure performance and find weak areas.
6. To use resources efficiently and reduce waste.
7. To guide management in decisions and in cash planning.

Advantages

• Defines responsibility and promotes team work.
• Gives early warning through variances.
• Reduces cost and increases profit.
• Helps in planning cash and borrowing.
• Gives a basis for performance evaluation.

Essential conditions for applying a budget

1. A clear objective and strong support from top management.
2. A budget committee and budget officer with a clear authority.
3. A sound organisation structure with defined responsibility centres.
4. A good accounting and cost record system.
5. Realistic targets based on past data and forecasts.
6. Participation of the persons who will carry out the budget.
7. A budget period and a budget manual that are well defined.
8. Regular reports on variances and flexibility to revise.

Budgetary control is a technique of managerial control in which budgets are prepared for the future period, actual performance is recorded and compared with the budgets, variances are analysed, and corrective action is taken.

Steps

1. Set the objectives and the budget period.
2. Prepare the budgets for sales, production, cost and cash, and combine them into a master budget.
3. Record actual results.
4. Compare and find the variances.
5. Take corrective action and revise the budgets if needed.

Objectives and advantages

• Planning, coordination and control of activities.
• Fixing responsibility and measuring performance.
• Controlling cost, increasing efficiency and profit.

Limitations

• Estimates may be wrong, so the budget may not be realistic.
• Needs time, cost and trained staff.
• Can make managers inflexible if used rigidly.
• Does not replace management judgement.

A budget is a financial and/or quantitative plan for a future period. Budgets are classified as follows.

Main budgets

1. Sales budget: expected sales in quantity and value; the base for other budgets.
2. Production budget: quantity to be produced = sales + closing stock - opening stock.
3. Material, labour and overhead budgets: cost of inputs for the planned production.
4. Cash budget: expected receipts and payments, with the closing balance.
5. Capital expenditure budget: plan for the purchase of long-term assets.
6. Master budget: the summary of all budgets, with budgeted profit and loss and balance sheet.
7. Fixed budget: for one level of activity only.
8. Flexible budget: changes with the level of activity; better for control.

Project finance is the long-term financing of a specific project (such as a hydropower plant, road or pipeline) in which the lenders and investors look mainly at the cash flow and assets of the project itself, not at the balance sheet of the sponsors, for repayment of the debt and return on equity. A separate legal entity (special purpose vehicle, SPV) is usually formed for the project.

Data

• 500 ordinary shares at Rs 100 = Rs 50,000
• 300 preference shares at Rs 100 = Rs 30,000 at 15%
• Loan Rs 30,000 at 12%
• EBIT = Rs 40,000; tax = 40%

EPS

$$\begin{aligned} \text{Interest} &= 30,000 \times 12\% = 3,600\\ \text{EBT} &= 40,000 - 3,600 = 36,400\\ \text{Tax} &= 40\% \times 36,400 = 14,560\\ \text{EAT} &= 36,400 - 14,560 = 21,840\\ \text{Preference dividend} &= 30,000 \times 15\% = 4,500\\ \text{Earnings for equity} &= 21,840 - 4,500 = 17,340\\ EPS &= \frac{17,340}{500} = 34.68 \end{aligned}$$

Book value

Book value per share = net worth belonging to ordinary shareholders / number of ordinary shares. No reserves or retained earnings are given, so net worth equals the ordinary share capital (preference capital and loan are not part of it).

$$BV = \frac{50,000}{500} = 100.00$$

Answer: EPS = Rs 34.68 per share; book value = Rs 100.00 per share.

Data

• 500 ordinary shares at Rs 100 = Rs 50,000
• Preference shares Rs 30,000 at 15%
• Loan Rs 30,000 at 12%
• EBIT = Rs 40,000; tax = 20%

Assumption: the whole profit available to ordinary shareholders is paid as dividend (so dividend per share = EPS).

$$\begin{aligned} \text{Interest} &= 30{,}000 \times 12\% = 3,600\\ \text{EBT} &= 40{,}000 - 3,600 = 36,400\\ \text{Tax} &= 20\% \times 36,400 = 7,280\\ \text{EAT} &= 36,400 - 7,280 = 29,120\\ \text{Preference dividend} &= 30{,}000 \times 15\% = 4,500\\ \text{Earnings for ordinary shareholders} &= 29,120 - 4,500 = 24,620\\ \text{Dividend per share} &= \frac{24,620}{500} = 49.24 \end{aligned}$$

Answer: Dividend per ordinary share = Rs 49.24.

Data

• Share capital = Rs 4,00,000; assuming face value Rs 100 per share, number of shares = 4,000
• Preference share = Rs 2,00,000 at 12%
• Loan = 15,00,000 - 4,00,000 - 2,00,000 = Rs 900,000 at 8%
• EBIT = Rs 3,00,000; tax = 20%

$$\begin{aligned} \text{Interest} &= 900,000 \times 8\% = 72,000\\ \text{EBT} &= 300,000 - 72,000 = 228,000\\ \text{Tax} &= 20\% \times 228,000 = 45,600\\ \text{EAT} &= 228,000 - 45,600 = 182,400\\ \text{Preference dividend} &= 200,000 \times 12\% = 24,000\\ \text{Earnings for equity} &= 182,400 - 24,000 = 158,400\\ EPS &= \frac{158,400}{4,000} = 39.60 \end{aligned}$$

Answer: EPS = Rs 39.60 per share (with shares of Rs 100 each).

Data

• Ordinary shares: 4,000 x $100 = $400,000
• Preference shares = $300,000 at 18%
• Loan = 1,000,000 - 400,000 - 300,000 = $300,000 at 15%
• EBIT = $200,000; tax = 20%

EPS

$$\begin{aligned} \text{Interest} &= 300,000 \times 15\% = 45,000\\ \text{EBT} &= 200,000 - 45,000 = 155,000\\ \text{Tax} &= 20\% \times 155,000 = 31,000\\ \text{EAT} &= 155,000 - 31,000 = 124,000\\ \text{Preference dividend} &= 300,000 \times 18\% = 54,000\\ \text{Earnings for equity} &= 124,000 - 54,000 = 70,000\\ EPS &= \frac{70,000}{4,000} = 17.50 \end{aligned}$$

Book value

Book value per share = net worth belonging to ordinary shareholders / number of ordinary shares. No reserves or retained earnings are given, so net worth equals the ordinary share capital (preference capital and loan are not part of it).

$$BV = \frac{400,000}{4{,}000} = 100.00$$

Answer: EPS = $17.50 per share; book value = $100.00 per share.

Data

• Ordinary shares: 2,000 x Rs 100 = Rs 200,000
• Preference share = Rs 1,50,000 at 18%
• Loan = 5,00,000 - 2,00,000 - 1,50,000 = Rs 150,000 at 14%
• EBIT = Rs 1,00,000; tax = 25%

EPS

$$\begin{aligned} \text{Interest} &= 150,000 \times 14\% = 21,000\\ \text{EBT} &= 100,000 - 21,000 = 79,000\\ \text{Tax} &= 25\% \times 79,000 = 19,750\\ \text{EAT} &= 79,000 - 19,750 = 59,250\\ \text{Preference dividend} &= 150,000 \times 18\% = 27,000\\ \text{Earnings for equity} &= 59,250 - 27,000 = 32,250\\ EPS &= \frac{32,250}{2,000} = 16.12 \end{aligned}$$

Book value

Book value per share = net worth belonging to ordinary shareholders / number of ordinary shares. No reserves or retained earnings are given, so net worth equals the ordinary share capital (preference capital and loan are not part of it).

$$BV = \frac{200,000}{2{,}000} = 100.00$$

Answer: EPS = Rs 16.125 per share (about Rs 16.12); book value = Rs 100.00 per share.

Sources of project finance for a construction company

• Equity: promoters' capital, ordinary shares, public issue, retained earnings
• Preference shares
• Debt: bank and financial institution loans, debentures
• Others: supplier credit, leasing, equipment financing, government and donor support, advance from clients

Data

• Ordinary shares: 2,000 x Rs 100 = Rs 200,000
• Preference share = Rs 2,50,000 at 16%
• Loan = 6,00,000 - 2,00,000 - 2,50,000 = Rs 150,000 at 15%
• EBIT = Rs 1,25,000; tax = 30%

EPS

$$\begin{aligned} \text{Interest} &= 150,000 \times 15\% = 22,500\\ \text{EBT} &= 125,000 - 22,500 = 102,500\\ \text{Tax} &= 30\% \times 102,500 = 30,750\\ \text{EAT} &= 102,500 - 30,750 = 71,750\\ \text{Preference dividend} &= 250,000 \times 16\% = 40,000\\ \text{Earnings for equity} &= 71,750 - 40,000 = 31,750\\ EPS &= \frac{31,750}{2,000} = 15.88 \end{aligned}$$

Book value

Book value per share = net worth belonging to ordinary shareholders / number of ordinary shares. No reserves or retained earnings are given, so net worth equals the ordinary share capital (preference capital and loan are not part of it).

$$BV = \frac{200,000}{2{,}000} = 100.00$$

Answer: EPS = Rs 15.88 per share; book value = Rs 100.00 per share.

Data

• Ordinary shares: 3,500 x Rs 100 = Rs 350,000
• Preference share = Rs 4,00,000 at 12%
• Debt = Rs 2,50,000 at 10%
• Total = 3,50,000 + 4,00,000 + 2,50,000 = Rs 10,00,000 (checks)
• EBIT = Rs 8,00,000; tax = 20%

EPS

$$\begin{aligned} \text{Interest} &= 250,000 \times 10\% = 25,000\\ \text{EBT} &= 800,000 - 25,000 = 775,000\\ \text{Tax} &= 20\% \times 775,000 = 155,000\\ \text{EAT} &= 775,000 - 155,000 = 620,000\\ \text{Preference dividend} &= 400,000 \times 12\% = 48,000\\ \text{Earnings for equity} &= 620,000 - 48,000 = 572,000\\ EPS &= \frac{572,000}{3,500} = 163.43 \end{aligned}$$

Book value

Book value per share = net worth belonging to ordinary shareholders / number of ordinary shares. No reserves or retained earnings are given, so net worth equals the ordinary share capital (preference capital and loan are not part of it).

$$BV = \frac{350,000}{3{,}500} = 100.00$$

Answer: EPS = Rs 163.43 per share; book value = Rs 100.00 per share.

Capital structure

Capital structure is the mix of long-term sources of funds (equity shares, preference shares, retained earnings and long-term debt) used by a firm to finance its total capital. Capital structure planning is the process of deciding the best proportion of these sources so that the cost of capital is lowest and the value of the firm and return to shareholders are highest.

Data and assumptions

• Existing capital Rs 10,00,000: share (40%) = Rs 4,00,000 and loan (60%) = Rs 6,00,000 at 12% (interest Rs 72,000).
• Face value of a share is taken as Rs 100. EBIT of Rs 5,00,000 is the same for all options; tax = 30%.
• All three options raise Rs 20,00,000 (the amounts add up in each case).

EPS for each option

Interest = 72,000 + interest on new loan. EAT = (EBIT - interest) x 0.70. Earnings for equity = EAT - preference dividend.

Working for option (i): shares = (4,00,000 + 8,00,000)/100 = 12,000; interest = 72,000 + 12,00,000 x 14% = 2,40,000; EBT = 2,60,000; EAT = 1,82,000; EPS = 1,82,000/12,000 = 15.17.

Answer: EPS is Rs 15.17 for (i), Rs 12.91 for (ii) and Rs 10.69 for (iii). Option (i) gives the highest EPS and is the best option.

Data and assumptions

• Existing: 4,000 shares at Rs 100 (Rs 4,00,000) and loan Rs 6,00,000 at 10% (interest Rs 60,000).
• Additional capital is Rs 10,00,000 in both options (the printed "$" and "6000,000" are read as Rs and Rs 6,00,000). Option (i): 4,000 shares (Rs 4,00,000) + loan Rs 6,00,000 at 10%. Option (ii): 2,000 shares (Rs 2,00,000) + preference Rs 3,00,000 at 12% + loan Rs 5,00,000 at 12%.
• EBIT = Rs 3,50,000; tax = 30%. Selection is by the highest EPS.

Working for option (ii): shares = 4,000 + 2,000 = 6,000; interest = 60,000 + 5,00,000 x 12% = 1,20,000; EBT = 2,30,000; EAT = 2,30,000 x 0.70 = 1,61,000; preference dividend = 3,00,000 x 12% = 36,000; earnings for equity = 1,25,000; EPS = 1,25,000/6,000 = 20.83.

Answer: EPS (i) = Rs 20.12, EPS (ii) = Rs 20.83. Option (ii) gives the higher EPS and is selected. The difference is small; if the firm wants to avoid fixed preference dividend or more financial risk, the choice can be reviewed, but on EPS basis option (ii) is best.

Definition

Capital budgeting is the process of planning, evaluating and selecting long-term investment projects whose benefits come over several years (such as a new plant, road or building), by comparing the cash outlay with the expected future returns.

Importance

1. Large funds are committed for a long period.
2. Decisions are irreversible; a wrong decision may cause heavy loss.
3. It decides the future growth and profit of the firm.
4. It affects the firm's risk and its cost of capital.
5. Funds are limited, so projects have to be ranked.
6. It needs a long-term forecast of demand, cost and technology.

Examples of capital budgeting decisions are building a new hydropower plant, buying a crusher plant, replacing old equipment and expanding a factory.