Monday, 30 April 2012

Sick company


The Companies Bill 2011
Our existing companies act 1956 was enacted based upon the recommendations of the Bhabha committee with an object to amend and consolidate the law relating to companies and certain other associations. The Companies Act 1956 has undergone many amendments post its enactment. The major amendments to the Companies Act, 1956, include Companies Amendment Act, 1988 and the Companies Amendment Act, 2002. The basic intention behind incorporation of the new provisions (Section 424A to 424 L) in companies act 1956 with regard to sick companies was to close the loopholes in Sick Industrial Companies Act. As many of us are aware, the Indian companies are growing day by day as providers of a wide range of goods and services at international markets and creators of employment opportunities to numerous persons. These factors persuaded Ministry of Corporate Affairs to revise and redraft existing Companies Act, 1956. The Companies bill seeks to achieve higher standards of corporate governance, corporate social responsibility and sustainable development. As a future professional one shall be aware of provisions regarding sick companies & its revival incorporated in the proposed companies bill 2011. The noteworthy provisions relating to sick companies that differentiates the companies bill 2011 from the existing companies act 1956 are analysed below.

Sections 253-269

The companies bill contains provisions with regard to revival/winding up of companies from section 253 to 269. The Companies Act 1956 deals with sick companies provisions under section 424A to 424 L

Sick company- Meaning

As per section 2(46AA) of Companies Act 1956 ‘Sick industrial company’ means an industrial company, which has at the end of any financial year

a)      accumulated losses exceeding 50% of average net worth during 4 years;
OR
b)       has failed to repay debts to its creditor(s) in 3 consecutive quarters on demand made in writing for such repayment

However, the companies bill does not define a sick company as such and provides that any company would be a ‘sick company’ where the National Company Law Tribunal (NCLT) through an order in writing decide its ability to repay the debts and declares it as a sick company subject to procedure laid down under chapter XIX of the companies bill.

The Companies Act 1956 limited to sick ‘industrial’ companies

As evident from the definition the companies bill 2011 does not limits its scope to ‘industrial companies’. That means even companies which are not in the industrial sector may opt for its revival under the new provisions.
Reference to tribunal
Under the companies Act 1956, its the company who has to submit a scheme of revival & rehabilitation at the time of making reference to the NCLT. Such reference has to be made within earliest of the following-

● 180 days after the Board of Directors came to know about sickness
● 60 days of final adoption of accounts.

along with a certificate from auditor on the panel approved by NCLT giving reasons for such reference.
Secured creditors: The important distinguishing feature enabled under companies bill sick company  provisions, is the opportunity given to the secured creditors to apply to the tribunal. The secured creditors representing 50% or more of the debt of the company and whose debt the company has failed to pay within 30 days of service of notice of demand, can apply to Tribunal for declaring the company as sick or the company who fails to repay the debt of secured creditor representing 50% or more of debt, may also apply to Tribunal for declaring itself sick. The applicant making such application can make use opportunity under companies bill to of applying for the stay of any proceeding for the winding up of the company or for execution, distress or the like against any property and assets of the company or for the appointment of a receiver in respect thereof and that no suit for the recovery of any money or for the enforcement of any security against the company shall lie or be proceeded with. The Tribunal may pass an order in respect of such an application which shall be operative for a period of 120 days.
Effect of recovery of debts under Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 : Under the Companies bill (Section 254) -

Ø      In case any reference had been made before the Tribunal and a scheme for revival and rehabilitation submitted, such reference shall abate if the secured creditors representing three-fourths in value of the amount outstanding against financial assistance disbursed to the borrower have taken measures to recover their secured debt under sub-section (4) of section 13 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.

Ø      No reference shall be made under this section if the secured creditors representing three-fourths in value of the amount outstanding against financial assistance disbursed to the borrower have taken measures to recover their secured debt under sub-section (4) of section 13 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.

Ø      Where the financial assets of the sick company had been acquired by any securitisation company or reconstruction company under sub-section (1) of section 5 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, no such application shall be made without the consent of securitization company or reconstruction company which has acquired such assets.

Determination of sickness
The companies bill provides that the Tribunal shall determine, within a period of 60 days of the receipt of an application, whether the company is a sick company or not. However, no such determination shall be made in respect of an application made by secured creditors in the manner described above unless the company has been given notice of the application and a reasonable opportunity to reply to the notice within 30 days of the receipt thereof. If the Tribunal is satisfied that a company has become a sick company, the Tribunal may after considering all the relevant facts and circumstances of the case decide a through written order whether the company is sick and may give such time to the company as it may deem fit to make repayment of the debt.

Thus, the companies bill 2011 is clear about the time limit with regard to determination of sickness of company.

Application for revival
The existing companies act 1956 uses the expression ‘inquiry into the company’ (Sections 424 B & 424 C) and provides for issue of order on completion of inquiry by tribunal including appointment of operating agency for preparation of scheme where revival/restructuring was possible; which is  different in the new companies bill. Under Companies bill 2011, on the determination of  a company as a ‘sick company’ by the Tribunal under Section 253, any secured creditor of that company or the company may make an application, to the Tribunal for the determination of the measures that may be adopted with respect to the revival and rehabilitation of such company. Such an application shall be made to the Tribunal within a period of 60 days from the date of determination of the company as a sick company by the Tribunal under section 253 and the same shall be accompanied by—
       
(a) audited financial statements of the company relating to the immediately 
      preceding financial year;
(b) such particulars and documents, duly authenticated in such manner, along with 
      such fees as may be prescribed; and
(c) a draft scheme of revival and rehabilitation of the company in such manner as may be prescribed. Where the sick company has no draft scheme of revival and rehabilitation to offer, it shall file a declaration to that effect along with the application.

The companies Act 156 provisions does not contain a section requiring the company/BOD/Creditors to submit again an application for revival after determination of sickness. Thus the path for revival of sick company under existing Companies Act 1956 from the view point of the company requires only a reference by directors. Its the tribunal which will move forward with inquiry, order and revival/winding up.

Emphasis on ‘Debts’
The companies Act 1956 uses terms like net worth and debts; but the companies bill 2011 uses the term ‘debts’ payable by the subject company. As per Sec 253 (8) and Sec 253 (9) of companies bill 2011, where the Tribunal is satisfied that a company has become a sick company, the Tribunal shall, after considering all the relevant facts and circumstances of the case, decide, as soon as may be, by an order in writing, whether it is practicable for the company to make the repayment of its debts referred to in sub-section (1) within a reasonable time. If the Tribunal deems fit under sub-section (8) that it is practicable for a sick company to pay its debts referred to in that sub-section within a reasonable time, the Tribunals hall, by order in writing and subject to such restrictions or conditions as may be specified in the order, give such time to the company as it may deem fit to make repayment of the debt.

Thus the previous condition in the companies act 1956  related  to ‘net worth’ has been dispensed by the companies bill 2011.

Operating Agency and special director

The Companies Act 1956 provides that the tribunal may appoint any operating agency to enquire into the scheme for revival and submit report to the tribunal. However, the companies bill does not expressly provide that the service of ‘operating agency’ be availed by the tribunal in the inquiry/revival process.

Interim administrator
The companies Act 1956 contained provision (section 424 B(4)) as to power of tribunal to appoint special directors for the purpose of conducting inquiry into the company under question. The special director to submit report within 60 days of his appointment. But, companies bill does not contain such a provision. Instead it introduces a person called ‘interim administrator’ under section 256. As per section 256, the Tribunal shall, not later than 7 days from such receipt of receipt of application for revival,—

(a)  fix a date for hearing not later than 90 days from date of its receipt;
(b)  appoint an interim administrator to convene a meeting of creditors of the company in accordance with the provisions of section 257 to be held not later than 45 days from receipt of the order of the Tribunal appointing him to consider whether on the basis of the particulars and documents furnished with the application made under section 254, the draft scheme, if any, filed along with such application or otherwise and any other material available, it is possible to revive and rehabilitate the sick company and such other matters, which the interim administrator may consider necessary for the purpose and to submit his report to the Tribunal within 60 days from the date of the order.

Where no draft scheme is filed by the company and a declaration has been made to that effect by the Board of Directors, the Tribunal may direct the interim administrator to take over the management of the company; and issue such other directions to the interim administrator as the Tribunal may consider necessary to protect and preserve the assets of the sick company and for its proper management.
The directors and the management of the company shall extend all possible assistance and cooperation to the interim administrator to manage the affairs of the company.

Committee of creditors
The interim administrator under the companies bill shall appoint a committee of creditors with such number of members as he may  determine, but not exceeding seven, and as far as possible a representative each of every class of creditors should be  represented in that committee. The holding of the meeting of the committee of creditors and the procedure to be followed at such meetings, including the appointment of its chairperson, shall be decided by the interim administrator.  The interim administrator may direct any promoter, director or any key managerial personnel to attend any meeting of the committee of creditors and to furnish such information as may be considered necessary by the interim administrator.

The companies Act 1956 does not require holding of meeting of creditors for their assent for moving to the tribunal for winding up/revival as per the resolution passed by creditors representing 3/4th of  the outstanding amount.

Revival or winding up based on interim administrators report and creditors resolution

The tribunal makes its order for revival/ winding up based on the interim administrators report and resolution passed with consent of creditors representing 3/4ths in value of outstanding amount. The Companies Act 1956 also provides that no scheme for revival of sick company shall be submitted by secured creditors unless such scheme has been approved by atleast three-fourth in value of creditors of the sick industrial company.

As per section 258, on the date of hearing fixed by the Tribunal and on consideration of the report of the interim administrator filed under sub-section (1) of section 256, if the Tribunal is satisfied that the creditors representing three-fourths in value of the amount outstanding against the sick company present and voting have resolved that—
(a) it is not possible to revive and rehabilitate such company, the Tribunal shall record such opinion and order that the proceedings for the winding up of the company be initiated; or
(b) by adopting certain measures the sick company may be revived and rehabilitated, the Tribunal shall appoint a company administrator for the company and cause such administrator to prepare a scheme of revival and rehabilitation of the sick company.

 ‘Administrator’ into the revival or restructuring process
Under companies bill the tribunal may on ordering revival of sick company appoint a person as ‘company administrator’ The Tribunal may also, appoint an interim administrator as the company administrator. However, the interim administrator or the company administrator, as the case may be, shall be appointed by the Tribunal from a databank maintained by the Central Government or any institute or agency authorised by the Central Government in a manner as may be prescribed consisting of the names of company secretaries, chartered accountants, cost accountants and such other professionals as may, by notification, be specified by the Central Government. The terms and conditions of the appointment of interim and company administrators shall be such as may be ordered by the Tribunal.

The company administrator shall perform such functions as the Tribunal may direct. The company administrator may, with the approval of the Tribunal, engage the services of suitable expert or experts. The company administrator may cause to be prepared with respect to the company—
(a) a complete inventory of—
       (i) all assets and liabilities of whatever nature;
      (ii) all books of account, registers, maps, plans, records, documents of title and
           all other documents of whatever nature;
(b) a list of shareholders and a list of creditors showing separately in the list of 
     creditors, the secured creditors and unsecured creditors;
 (c) a valuation report in respect of the shares and assets in order to arrive at the        reserve price for the sale of any industrial undertaking of the company or for the    fixation of the lease rent or share exchange ratio;
(d) an estimate of the reserve price, lease rent or share exchange ratio;
(e) proforma accounts of the company, where no up-to-date audited accounts are
     available; and
(f) a list of workmen of the company and their dues referred to in sub-section (3) of
     section 325.

As per Section 261 of the Companies Bill 2011 provides that, the company administrator shall prepare or cause to prepare a scheme of revival and rehabilitation of the sick company after considering the draft scheme filed along with the application under section 254.

In the companies Act 1956, it was the operating agency who was entrusted with the job of preparing scheme for revival. There is no person called ‘administrator’ (relating to revival of sick companies) in the existing companies act 1956 provisions.

Sanction of scheme
The scheme prepared by the company administrator shall be placed before the meeting of creditors for their approval within 60 days (extendable by tribunal upto 120 days) of his appointment. The company administrator shall convene separate meetings of secured and unsecured creditors of the sick company and if the scheme is approved by the unsecured creditors representing one-fourth in value of the amount owed by the company to such creditors and the secured creditors, representing three-fourths in value of the amount outstanding against financial assistance disbursed by such creditors to the sick company,  the company administrator shall submit the scheme before the Tribunal for sanctioning the scheme. Where the scheme relates to amalgamation of the sick company with any other company, such scheme shall, in addition to the approval of the creditors of the sick company under this sub-section, be laid before the general meeting of both the companies for approval by their respective shareholders and no such scheme shall be proceeded with unless it has been approved, with or without modification, by a special resolution passed by the shareholders of that company.

But, under companies act 1956 the provisions are different. The scheme is to be prepared by the operating agency expeditiously within 60 days (extendable to 90 days by tribunal) from date of order of tribunal. Where the scheme relates to amalgamation, the same shall be approved at Annual general Meeting of the company by the shareholders through special resolution. The scheme may thereafter be sanctioned within 60 days by the tribunal and may be given force from date decided by the tribunal.
Winding up of sick company

The companies Act 1956 provides for winding up where the Tribunal, after making inquiry under section 424B and after consideration of all the relevant facts and circumstances and after giving an opportunity of being heard to all concerned parties, is of the opinion that the sick industrial company is not likely to make its net worth exceed the accumulated losses within a reasonable time while meeting all its financial obligations and that the company as a result thereof is not likely to become viable in future and that it is just and equitable that the company should be wound up, it may record its findings and order winding up of the company.

The companies bill 2011 provides for winding up proceedings-

a)     Where the creditors passes a special resolution for applying to the tribunal for its winding up order.
b)      Where the scheme is not approved by creditors in the manner in (a), and the tribunal receives report of company administrator to the effect.

Rehabilitation and Insolvency Fund

The companies act 1956 already provided for establishment of ‘Rehabilitation and Revival Fund’ under sections 441 A to 441 G for the purposes of rehabilitation, revival and liquidation of the sick companies. However, the companies bill 2011 has given a new name to such a fund for similar purpose ie. ‘Rehabilitation and Insolvency Fund’. The Central Government shall appoint an administrator to manage the fund and the following items shall be credited to the fund.

(a) the grants made by the Central Government for the purposes of the Fund;
(b) the amount deposited by the companies as contribution to the Fund;
(c) the amount given to the Fund from any other source; and
(d) the income from investment of the amount in the Fund.
                                     

Prepared by Victor J. Uruvath , CS Professional Programme, Kerala
Source: Bare Act, ICSI study material, Internet.

Wednesday, 18 April 2012

CAPITAL BUDGETING

CAPITAL BUDGETING
Capital budgeting - meaning

‘‘Capital budgeting is long term planning for making and financing proposed capital outlays’’– Charles T Horngreen

-          Capital budgeting decisions are strategic investment decisions that have an impact on future profitability and survival of business.
-          Capital budgeting involves planning and control of capital expenditure
-          Capital budgeting involves choice among several alternatives of capital expenditure
-          Capital budgeting involves exchange of current funds for future benefits

Relevance of CB decisions
1.       Capital budgeting involves investment of substantial amount of funds. Where the decision goes wrong, it would affect future profitability of the firm.
2.        C.B decisions have its effect over a long time span. Every firm would try to achieve maximum growth through incurring high capital cost. Capital budgeting decisions has an impact on future growth and survival of business. No one can accurately predict future. Longer the time period, greater the risk & uncertainty. The factor of risk cannot be eliminated fully. Wrong decisions would affect long term survival.
3.       Capital budgeting decisions once taken are irreversible in nature. After purchasing a capital asset the firm may not be in a capacity to reverse the decision. It would be difficult to reverse the decisions as the same would be expensive.
4.       Capital budgeting decisions are complex, as it involves estimation of costs and benefits that would arise in future. The factors which compel capital investment include rising demand for products, obsolescence of technology/equipment, need for improvement in product, wear and tear of equipments, diversification needs etc. These factors are directly related to profitability and survival of the firm.
5.       Capital budgeting or planning of capital expenditure is not a single transaction of acquisition/improvement of assets, but a process performed over a period of time (say each year) to ensure alteration/improvement/acquisition of assets in time.

Capital expenditure & Time value of money

As mentioned earlier, capital budgeting refers to process of making investment decisions in capital expenditure. Capital expenditure is the expenditure incurred for acquiring or improving the fixed assets, the benefits of which are expected be received over a number of years in future. E.g. for capital expenditure- expenditure incurred on acquisition of land and building, R & D project cost, expansion in fixed assets etc. A fixed asset here means an asset the benefits of which are expected to be received over period of time exceeding one year.

Capital budgeting decisions involving heavy investments considers time value of money. Why? The value of money is not stable every time. The firm pays money today the benefits of which arise in future. A rupee received today is better than a rupee received tomorrow. You can buy an item for Rs.5 today but the same quantity of same article may not available for Rs.5/- after 5 or 6 yrs. The value of Re.1 may be near 0.91 paisa next year. Capital budgeting involves exchange of current funds for future benefits. Hence, the firms resort to the discounting cash inflows while deciding upon investing in assets.

Types of decisions
1.       Mutually exclusive decisions:  There would be competing proposals and acceptance of one proposal automatically excludes acceptance of the other. For e.g. ABC ltd has two options- either it can purchase the machine using bank loan or it can take it on lease. ABC ltd (after evaluation) selects to lease the machine which automatically results in rejection of proposal for purchase.
2.       Accept reject decisions: Decisions on independent proposals on the basis of minimum rate of return. For e.g.: ABC ltd fixes a minimum rate of return on return @ 22%. It rejects proposal X on the reason that the return is only 19.5 %.
3.       Capital rationing decisions: When a firm fixes a limit on the maximum amount that can be invested during a given period of time, then it could be said that the firm is resorting to ‘capital rationing’. Where the firm decides to invest in a project, it has to select the most profitable proposal from the available ones. The firm should accept proposals with positive NPV. But there may arise situations where the firm will not be able to invest in all the profitable proposals due to constraints in the availability of funds. The constraints on procurement of necessary funds may be internal (self imposed) or external (external factors). Sometimes the top management may have fixed capital budget. E.g. there are profitable projects worth Rs. 1oo lac, but the management has limited the maximum amount of investment to Rs. 95 lacs. In such a case the firm has to compare between projects and select profitable projects of aggregate investment not exceeding Rs. 95 lacs. In simple words, capital rationing is the process whereby projects are ranked on the basis of rate of return and a combination of profitable projects are selected in order to utilize the available funds in an efficient manner.
The standard NPV decision rule – ‘’accept all positive NPV projects” will not apply here because of shortage of capital. The firm allocates limited funds to the projects in a manner so as to maximize the long run returns. Capital rationing also means that the firm forgoes the next most profitable investment falling after the budget ceiling even though it is estimated to yield a rate of return much higher than the required rate of return, thus, capital rationing does not lead to optimum results.
Capital budgeting process
Identification  à economic & non-economic criteria  à Screening à Evaluation à Capital expenditure budget à implementation and Control  à Performance review report
The first step in the process is identification of investment proposals. The firm should have a planning body and it should invite proposals from departments/ lower levels/top management. The management shall issue well defined guidelines for searching investment proposals to ensure that useful ideas reach the planning body. The depts shall submit the proposals to the planning body. The firm should have an economic (e.g. ROI) and non-economic (e.g. legal requirements, risk etc) criteria for selection for proposals which should be reviewed from time-to-time. Proposals which fail to comply with criteria should be rejected. It’s better to communicate the criteria to all depts in the beginning itself. In third step i.e. screening, conflicting/ duplicate proposals are to be eliminated/rejected and useful proposals are considered.  In the fourth step the profitability of the proposal is evaluated in detail (see ‘types of decisions’ above). The firm may use NPV method, ARR, payback period method, IRR etc for evaluation of proposals. In the fifth step, a capital budget which contains the amount of estimated expenditure (large outlay) to be incurred in the project during the budget period is prepared. However, projects involving small outlays may be decided at lower levels for expeditious action.  The sixth step is implementation of proposal within allowed time frame and costs. The management should have formulated a procedure to exercise control over projects while in process. PERT and CPM are effective techniques to control and monitor implementation of projects. The last step is review of performance of the project through post completion audit. Here, actual expenditure is compared with budgeted expenditure; actual return is compared with expected returns in order to find out variances and to take corrective action for the same.

                    
Capital Budgeting Techniques (Evaluation methods)

A). Traditional methods
1.                                     Payback/ pay off/ payout period method

It’s the simplest method of evaluating investment proposals. Payback period means the number of years required to recover the original investment. Shortest the payback period, then more preferable and less risky.

Rule: Accept the proposal with low payback period.

Post payback profitability index = [cash inflows after recovery of original invt / original investment] * 100.

Some firms may select projects with highest post-payback period/ profitability index.
Payback period= Original cost / annual cash inflow.

[Author’s notes:
1. Where the cash flows are not uniform, then payback period = normal payback period + (Remaining cash to be recovered / next year cash inflow) * (12)}.
2. Cash inflow means profit after tax but before depreciation.
3. Salvage value to be treated as inflow and be discounted at that year’s rate]
2.                                     Average Rate of Return method



Rule:  Accept if ARR > cut off rate (min rate)
i. ARR on original invt = [Profits after dep & tax / net investment*no of years of profit]   * 100.

ii. ARR on avg invt = [Avg annual profits / avg invt] * 100
[Author’s note:
1.  Cash inflow  = PATD
2. Net invt = total invt less scrap
3.Avg invt = net invt/ 2
B) Discounted cash flow methods

1.                         Net present value method (NPV)

Rule: accept, if NPV > zero or greater than other projects (positive value)

An improvement over NPV method called Terminal value method or modified IRR method, assumes that the future cash inflows are immediately reinvested in another project at an interest rate or rate of return. The project to be accepted if total value of compounded reinvested CF is more( than PV of outlays/ pv of other project)
Steps
1.                        Calculate sum of Cash inflow * discount rate of corresponding year to obtain PV of cash inflows
2.                        NPV = Initial investment less total PV of inflows.
2. Internal Rate of Return method (IRR)

Here the rate of discount is to be determined by trial and error. IRR is the rate which equates pv of cash inflow and pv of cash outflows. It’s the rate at which NPV is zero. This method is also called time adjusted rate of return or discounted rate of return or yield method or trial & error yield method.


See the example given below this table.#


3.                        Profitability index method

Rule: Accept if PI  > or  = 1
P.I = PV of Cash inflows/ PV of cash outflows

IRR determination #

E.g.  Original investment of a project = Rs. 30,000.

Year
Cash inflows
1
4000
2
10000
3
20000
4
11000
Discount factor = 12 %

IRR =?


First, multiply cash flows by different discount factor values till you receive a cash flow marginally greater than outflows and cash flow just below the outflow. Note both discount factors in mind.
Yr
CF
DF@ 12 %
PV of CF
DF@14 %
PV of CF
DF@16 %
PV of CF
1
4000
0.8929
3572
0.8772
3509
0.8621
3448
2
10000
0.7972
7972
0.7695
7695
0.7432
7432
3
20000
0.7118
14236
0.6750
13500
0.6407
12814
4
11000
0.6355
6991
0.5921
6513
0.5523
6075

Rs. 32771

Rs. 31217

Rs. 29769


Now use following technique to find IRR i.e. true rate of return which equates PV of inflows with PV of outflows

[NB: Equation given below is a personally modified version (using interpolation concept) for convenience and not a standard equation. Refer study material for original equation].

IRR (true rate of return)   = R +  { (CIFR -  COF) / ( CIFR – CIF L ) } * (L - R)

Where,
R = D.F rate which gives cash inflows marginally greater than outflow (sometimes R will be given in the question. If not given, you have try DF rates on cash flows to get R), 
L = D.F rate which gives cash inflows just below the outflow.
CIFR = Cash inflows at R
COF = cash outflow
CIF L = cash inflow just below the COF
Thus, here

IRR = 12 % + {(32771 – 30000)/ (32771 -29769)} * (16-12) = 15.69 %.    
                                                OR
IRR= 12% + { (32771 – 30000)/ (32771-31217)} * (14-12) = 15.6%

Risk measurement and Sensitivity analysis

Risk and uncertainity are quite inherent in capital budgeting decisions. Future is uncertain and involves risk. Seasonal fluctuations, political environment, tax rates, market acceptability of the product, business cycles etc may influence implementation of the investment decision.  So, chance for variation of future returns from that of estimated ones cannot be eliminated. Greater the variability, greater would be the risk. Risk refers to probability that some unfavourable event is likely to happen. Hence risk could be measured by following methods -

1.       Risk adjusted NPV method: greater the uncertainty, greater the risk is said to be and larger would be the premium required from such projects. Risky project can be accepted if they can generate additional returns over and above what risk-less project could earn. The cash flows are discounted using discount factor calculated by adding risk premium rate to risk free rate.

NPV = Cash flows (discounted at free rate +premium rate) - original investment

2.       Certainty equivalent method: here, the expected cash inflows are reduced by multiplying them by certainity coefficients. The resulting cash flows are then discounted using risk free rate (DF)

3.       Standard Deviation: Standard deviation is a measure of average variance or deviation of possible cash flows from the expected cash flows. Lower SD indicates lower risk and vice versa.

SD =   /n  

Where, d= CF – mean, f= frequency or probability, n= total frequency & mean = total cash flows/ no. of CF

Wherever returns are expressed in revenue terms the coefficient of variation gives better measurement for risk evaluation. SD can also be used when two projects have same cost and same NPV to find which project is better.

Coefficient of variation = [SD / Mean] *100 

Both SD and CV require to be adjusted with the discount rate with which the project investments are evaluated. It is used when the projects under consideration have same cost but different NPV.

4.       Decision tree: Decision tree is a tree-form pictorial representation that takes into account, results of all expected outcomes. It is used when the decisions are sequential. It represents the relationship between a present decision and future events, future decisions and consequences.

5.       Sensitivity technique: under this approach, the cash flows are divided into three sections ‘optimistic’, ‘most likely’, and ‘pessimistic’. The NPV under these three situations are to be found out and where the NPVs differ widely, it means ‘great risk’. The company may reject or accept the project based on risk bearing ability.

6.       Simulation: Simulation is representation of reality in some physical form or in some form of mathematical equations. Simulation does not produce optimum results and it is used to obtain expected return for a risky investment involving heavy expenditure. It has been described as ‘what to do when all else fails’. This method involves use of computers to determine the distribution of rate of return and is expensive. The steps are given below –

i. Define the problem to determine the objectives and constraints.
ii. Randomly select a value of each variable from its distribution.
iii. take these values and other given information and calculate the projects IRR or NPV
iv. Repeat steps i and ii many times and
v. prepare IRR or NPV distribution which is the result of the above.

7.       Linear programming model: Linear programming is the most widely used Operation research technique which is concerned with developing optimal solutions to problems of business world. Oil refineries, steel industry, airlines, railways, textiles, defence establishments etc are users of LP.  LP problems are concerned with either minimizing the cost or maximizing the profit. They are used in planning of product mix, blending, diet, transportation, routing and assignment problems. It helps in optimum utilization of resources and be applied in investment decisions also.

Cost of capital

The cost of capital of company is the minimum required rate of earning or the cut-off rate for capital expenditure. Usually in discounted cash flow techniques cost of capital is used to discount the future cash flows. Companies use the concept of cost of capital for comparing proposals. The project which has a rate of earnings below cost of capital would be rejected. Generally, the sources of capital include –

i.         Equity Capital
ii.       Preference share capital
iii.      Debt
iv.     Retained earnings
v.       Depreciation  (But, not a source for assessment of cost of capital)
Cost of equity capital i.e.   Ke  = [D1/Po] + g
Where D1 = Dividend on equity paid in period 1, Po = market value and g = growth rate of dividend.
Cost of Preference capital i.e. Kp = D/R where D = fixed dividend on pref share capital and R= Net proceeds on sale of pref shares.
Cost of debt i.e. Kd= (1-T) R, where T = marginal tax rate, R= contracted rate of interest
Cost of retained earnings i.e.  KR =  D(1-T) , where D= dividend rate & T = tax rate.
If tax liability is presupposed / & capital gains tax is to be paid, then KR = D(1-T) / P(1-Tc) where  D= Dividend rate, T= Tax rate & Tc = Capital gains tax.

If no tax liability of the equity holder then KR = [Dividend /market price] * 100.

E.g. 1.  Suppose, XYZ & co has paid a dividend of Rs. 5 last year. The market price of share is Rs. 50 and dividend is expected to grow next year by  4%. . Cost of retained earnings = ?
Here D, Po and G are given. So, cost of retained earnings = [D (1+G) / Po] + G = [5 (1+.04) / 50] + .04 = 14.4 %

Eg.2. Where dividend= Rs. 1.50,  stock exchange price of shares = Rs. 14 and tax rate = 50% and capital gains tax @ 20 %,  then cost of retained earnings (KR) = 1.50 (1-0.50) / 14 (1-0.2)  = 6.7 %

[Authors note: where rate of return on security, rate of return on mkt portfolio and Beta coefficient is given then cost of retained earnings can also be calculated using CAPM method]

Composite cost of capital is calculated as combined weighted average of the cost of all different sources of capital (i.e. sum of weight * K….).

Source: ICSI study material, UNOM
Dedicated to CS professional programme students

Prepared by Victor J. Uruvath , CS Professional Programme,
Thrissur- Kerala
Published by: Santhosh Thomas Thaikkadan, CS Professional Student, Thrissur-Kerala
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Disclaimer: The article may contain additional information/equations different from those available in the study material. The students are recommended to read the study material for more clarifications on the subject.  The author &/publisher could not be held liable for any loss/damage on account of any omissions/errors in the article.