Unit 2: Investment and Financing Decision

Investment and Financing Decision

What is Capital Budgeting?

Capital Budgeting (also known as investment decision) is the process by which a business evaluates and selects long-term investment projects that are expected to generate returns over a period of time. It involves planning and managing a firm’s long-term investments in fixed assets like machinery, buildings, or launching new products.

🎯 Objectives of Capital Budgeting

• To choose investment projects that maximize shareholder value.
• To ensure efficient allocation of capital.
• To compare different projects based on their costs and expected returns.

🔍 Features of Capital Budgeting

Capital Budgeting Techniques

Investment Decision vs Financing Decision

Example of Capital Budgeting:

• A company considers investing ₹1 crore in a solar plant.
• It evaluates the future cash flows, payback period, NPV, and IRR.
• If the project shows strong returns and aligns with company goals, it is accepted.

In Short, Capital Budgeting is a strategic decision-making tool that ensures the business invests in the right projects that yield long-term profitability and help in wealth creation.

Nature of Investment Decisions

Investment decisions (also called capital budgeting decisions) involve choosing where to allocate capital for long-term growth. These are strategic decisions that shape the future direction and profitability of the business.

🔍 Key Features of Investment Decisions

Types of Investment Decisions

Goal: Maximize shareholder wealth by selecting projects that offer the best return for a given level of risk.

Risk Analysis in Investment Decisions

Risk analysis in investment decisions is the process of identifying, assessing, and managing the uncertainty and variability in future returns from an investment. Since investment decisions involve future cash flows, they are risky and require proper evaluation.

Types of Risks in Investment Decisions

Tools and Techniques for Risk Analysis

Example: If a company plans to launch a new smartphone:

• It faces market risk (customer acceptance), cost risk (raw materials), and competition risk.

Risk analysis will help the company decide:

• Is the project too risky?
• Should we invest less/more?
• What’s the minimum acceptable return?

📈 Conclusion

• Investment decisions are about choosing projects that will add long-term value.
• Risk analysis helps reduce uncertainty and supports informed decision-making.
• Together, they ensure that businesses invest wisely and profitably.

Concept of Opportunity Cost

Opportunity Cost is the value of the next best alternative that is forgone when a decision is made. It is the cost of missing out on the benefits you could have received from the option not chosen.

🔍 Key Points

Example: Imagine you have ₹50,000

• Option A: Invest in stock market and earn 10% return.
• Option B: Invest in fixed deposit and earn 7% return.
• If you choose Option A, the opportunity cost is the 7% return from Option B that you didn’t receive.

📝 So, Opportunity Cost = Benefit of next best alternative foregone

🧠 Importance of Opportunity Cost in Business:

• Helps in better decision-making.
• Encourages optimal use of limited resources.
• Useful in capital budgeting and project selection.
• Promotes awareness of hidden costs.

📈 Real-World Examples

Opportunity Cost is a fundamental economic concept that helps individuals and businesses make wise, informed, and profitable decisions by considering what they must give up

Cost of Debenture

The Cost of Debenture** is the effective rate of interest a company pays on the money raised through debentures. It is a part of the cost of debt, and helps determine a firm’s Weighted Average Cost of Capital (WACC).

🔍 What is a Debenture?

A debenture is a type of long-term debt instrument used by companies to borrow money from the public with a promise to pay fixed interest regularly and repay the principal at maturity.

🧮 Formulas

🔸 Before-Tax Cost of Debenture

K d = Cost of debenture

𝐼 =Annual interest payment

𝑁𝑃 = Net proceeds from the issue of debenture

🔸 After-Tax Cost of Debenture:

𝑇 = Tax rate

Interest on debentures is tax-deductible, so after-tax cost is usually lower than before-tax cost.

📌 Example: A company issues ₹1,00,000 worth of debentures at 10% interest rate. Tax rate = 30% ,Annual Interest = ₹10,000, Net Proceeds = ₹1,00,000

After-tax cost:

Why After-Tax?

Because interest paid on debentures is deducted from taxable income, the actual cost to the company is reduced after taxes.

🎯 Importance of Knowing Cost of Debenture

Advantages vs Disadvantages

In Short, The Cost of Debenture is a critical concept in financial management, as it helps firms understand the real cost of raising debt capital, especially when tax savings are considered. It's essential for evaluating financing strategies.

Equity Capital

Equity Capital is the money raised by a company by issuing ordinary shares (equity shares) to investors. Shareholders become owners of the company and get a share in the profits.

🔍 Features of Equity Capital

Example: If a company issues 10,000 equity shares at ₹100 each, it raises ₹10,00,000 as equity capital.

Preference Capital

Preference Capital is the money raised by issuing preference shares, which provide a fixed dividend and have priority over equity shares in payment of dividends and during liquidation.

🔍 Features of Preference Capital

Example: If a company issues 5,000 preference shares at ₹100 each with 10% dividend, it pays ₹50,000 as fixed annual dividend.

Comparison Table: Equity Capital vs Preference Capital

Conclusion

• Equity capital is best for long-term ownership, higher returns, and control.
• Preference capital offers steady income to investors with lower risk but no control.
• Companies use a mix of both based on their financial needs and capital structure goals.

Composite Cost of Capital (WACC)

Composite Cost of Capital** is the average cost of all sources of capital (like equity, preference shares, debentures, and retained earnings) weighted according to their proportion in the company’s capital structure. It is also called Weighted Average Cost of Capital (WACC).

🔍 Why is it Important?

• It tells how much a company is paying on average for using the money invested by investors and lenders.
• Helps in evaluating investment decisions – if a project's return is higher than WACC, it's profitable.

🧮 WACC Formula

Where:

Each component is weighted by its proportion in total capital.

Example: A company has the following capital structure

Now, calculate WACC

So, the Composite Cost of Capital (WACC) is 10.1%.

🎯 Uses of Composite Cost of Capital

The Composite Cost of Capital gives a realistic estimate of a company’s overall cost of funding, considering all sources of capital. It is crucial for making strategic financial decisions

Cash Flows as Profit

Cash flow refers to the actual movement of cash in and out of a business. It shows how much cash is generated and used during a specific period. While profit is the accounting income, cash flow focuses only on real cash transactions.

🔍 Key Difference Between Cash Flow and Profit

Why Cash Flow is Considered as Profit in Finance:

• Even if a business shows a profit on paper, it can fail due to lack of cash.
• Cash flow is the real measure of a firm’s ability to pay bills, invest, and survive.

💡 Example: A company earns ₹1,00,000 in profit but hasn't received the payments yet. Cash flow will be zero — this can lead to financial problems despite profits.

Components of Cash Flows (According to Cash Flow Statement)

Cash flows are divided into three main activities under Accounting Standard AS-3 or IFRS:

1. Operating Activities: Day-to-day business activities.

Includes:

• Cash receipts from sales
• Payments to suppliers and employees
• Income tax payments
• Receipts of interest/dividends (if operating activity)

✅ Shows how much cash the company generates from core business operations.

2. Investing Activities: Deals with purchase/sale of long-term assets and investments.

Includes:

• Purchase/sale of property, plant, and equipment
• Investment in other companies
• Loans given or received (non-operating)
• Interest and dividend received (if investing activity)

✅ Reflects how the company is growing and investing its resources.

3. Financing Activities: Deals with changes in capital structure.

Includes:

• Proceeds from issuing shares or debentures
• Repayment of loans
• Dividend payments
• Interest paid (if financing activity)

✅ Shows how the company finances its operations (equity or debt).

📝 Summary Table:

While profit is an accounting concept, cash flow is the actual cash in hand — essential for operations and survival. Understanding the components of cash flows helps in analyzing a firm’s liquidity, solvency, and sustainability.

Capital Budgeting Decisions

Capital Budgeting refers to the process of planning and evaluating long-term investments in fixed assets like land, machinery, plants, or projects. It helps in deciding whether to invest in a project by comparing expected future cash inflows with initial cost.

🎯 Why Capital Budgeting is Important?

Types of Capital Budgeting Decisions

1. Accept-Reject Decisions: Decide whether a project is acceptable based on return (Yes or No).

2. Mutually Exclusive Projects: Choosing one among several alternatives (e.g., machine A or B).

3. Capital Rationing: Choosing projects under limited financial resources.

4. Replacement Decisions: Replacing old assets with new ones for efficiency.

Methods of Evaluating Capital Budgeting Decisions

Example: A project costs ₹5,00,000 and gives ₹1,50,000 annually for 5 years. If the company wants a 10% return:

Calculate NPV, IRR, and PBP. If NPV > 0 or IRR > 10%, project is accepted.

📌 Factors Affecting Capital Budgeting Decisions

In Short, Capital Budgeting is a strategic tool used to evaluate investment opportunities that shape the future direction and profitability of a company. Making informed capital budgeting decisions ensures efficient use of funds and maximizes shareholder wealth

Net Present Value (NPV)

NPV is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. It tells whether a project will add value to the business or not.

🔍 NPV Formula:

Example: A company is investing ₹1,00,000 in a project that will generate ₹30,000 per year for 5 years. Discount rate = 10%.

Let’s calculate NPV:

Result: Since NPV is positive, the project is acceptable.

Internal Rate of Return (IRR)

IRR is the discount rate at which the NPV = 0. It represents the expected rate of return from the project.

IRR is the rate where the project breaks even.

🔍 IRR Formula:

There is no direct formula for IRR. It is found by trial and error, interpolation, or using a financial calculator or Excel.

We use this equation:

Example Using Interpolation: Let’s use the same data:

Initial investment 

𝐶0 = ₹1,00,000

Cash inflow per year = ₹30,000

Time = 5 years

Now try IRR at 15%:

Now interpolate

Result: IRR ≈ 15.24%

Since IRR > 10% (cost of capital), project is acceptable.

📝 Comparison Table

Conclusion

• Use NPV when you want the total value addition in rupees.
• Use IRR when you want to know the expected return rate of a project.
• Both tools are essential for capital budgeting and investment decisions.

Benefits of Using Excel