Chapter-20 Financial Management - Bharat Sanchar Nigam Limitedtraining.bsnl.co.in/digital_library_source... · Capital expenditure Decisions in BSNL or any telecom ... of priority

E2-E3 Core Rev. Date: 31-03-2016

©BSNL, India For Internal Circulation Only

1

Chapter-20

Financial Management



2

Financial Management

Investment Analysis

Telecom Industry is highly capital intensive. After the telecom

services in India were thrown open to private players,

investment in telecom projects has increased multifold. In line

with this industry trend, BSNL and the other public sector

enterprise, MTNL, have been investing very heavily in capital

assets to stay ahead of the competition. The National Telecom

Policy‟99 and related government legislations have imposed

clear direction and targets for the telecom companies. Some of

the objectives in NTP‟99 are:

Create a modern & efficient Telecom Infrastructure taking

into account convergence of Information Technology,

Media, telecom & consumer electronic.

Strengthen R&D for world class Manufacturing

capabilities

Enable Indian Telecom Players to become truly Global

Players

These objectives and the related telecom policy, legislative and

licensing initiatives of the government have spurred capital

investment in telecom Industry, by BSNL and the other telecom



3

sector players. A clear need also has emerged as a consequence,

to ensure that the Capital expenditure (Or CAPEX) decisions

taken at various levels of BSNL are in tune with the best

practices in the industry and the return on investment conforms

to, or exceeds, the industry norms.

Nature of capital expenditure decisions:

Capital expenditure Decisions in BSNL or any telecom

company are very critical for its survival and growth because-

CAPEX decisions involve huge investment, in rupee terms

and in foreign currency terms also in many cases

The decisions are either irreversible in Nature or reversible

at a huge cost

Their Consequences extend over a long period into the

future

CAPEX decisions are among the most difficult decisions

to make, in industry segments like Telecom, due to the fast

changing Technologies, fast changing customer

preferences, severe competition and supply-demand

dynamics.

Future costs and benefits of a CAPEX decision are very

uncertain.



4

At present, some the important telecom services on which

capital investments are being made by telecom companies are as

below:

Access provision – Fixed, Cellular Mobile, Wireless in

Local loop, Cable Service Provision

Radio paging

Public Mobile Radio Trunk Services

NLD & ILD services

Global Mobile Personal communication by satellite

V-Sat based services

Other Services (IN, WEB, digital Network etc)

These telecom projects have different components – like

switching, transmission, and value added services, apart from

usual components of Land, buildings, vehicles etc. Gestation

periods and Payback periods differ from segment to segment

and technology to technology. While wired line services saw

phenomenal investments and growth in earlier decades, the 21st

century has started with wireless revolution – with GSM and

CDMA technologies competing for the wireless telecom space.

BSNL has presence in both GSM and CDMA technologies and

is using both for purposes for which they are found suitable in

different segments of the network from time to time.



5

Steps in CAPEX decisions

Every CAPEX decision involves the following fundamental

steps:

Identification of Potential Investment opportunities:

Potential investment opportunities are to be identified by

carefully screening the following : New/emerging telecom

Technologies; New Uses for existing

technologies/infrastructure; customer needs perceived

through Market surveys and customer feed back; Need to

spread to New locations; new opportunities indicated by

the growth path of competitors, and the regulatory

framework and policies of government.

Preliminary screening of Opportunities: This involves

assembling a set of investment opportunities as above and

narrowing the list to preferred alternatives. At this stage,

the criteria typically applied are : compatibility with the

company‟s existing technology, Existing & potential skill

sets, organizational environment; easy availability of

technology, equipment and their potential sources; lead

time; reasonableness of costs; associated Risks (like

obsolescence), competition in the segment etc. After

considering these factors, the set of preferred alternatives



6

can be assembled for conducting a more detailed

feasibility study of each.

Feasibility study: Feasibility study involves preparation of

a detailed Project report (approximating to a Project

estimate in BSNL) examining the Marketing, Technical,

Financial and Economic feasibility aspects of a project.

The report contains fairly specific estimates of Costs &

benefits, means of raising funds, schedules of

implementation, profitability estimates, social benefits of

the project etc. Then, all the projects are listed in the order

of priority based on (i) cost-benefit analysis (ii) company

policy and (iii) funds availability. The approval of

competent authority is to be accorded now, in the order of

priority within the available funds. With the disappearance

of waiting lists of customers and emergence of on-demand

provision of services and fierce competition in most parts

of the country and in every business segment, the newer

methods described herein can be used for Investment

Analysis

Implementation: After approval of specific projects,

implementation needs to be planned with the Preparation

of Blue prints, designs, plant engineering, Equipment

selection and procurement, construction, Training, trial

run, commissioning and equipment maintenance planning.



7

The project report must take into account these factors for

successful implementation of the project.

Dealing with implementation Delays : This involves

locating potential causes for implementation delays and

taking care of them through various means like PERT

(project evaluation research techniques), CPM(Critical

path method) and assigning specific time-bound

responsibilities to the nominated project managers for

different implementation stages in clear terms. PERT is

mainly for R&D projects though some techniques can be

used in a few others. Critical path method involves

splitting of a project into its component operations and

ensuring simultaneous completion of various unlinked

operations so that the project can be implemented in the

minimum possible time. A simple example of a project

consisting 4 operations, namely, buying land and

machinery, constructing building and installing machinery

can be illustrated. Here, buying land and buying machinery

can be done simultaneously as independent operations.

Constructing building depends only on buying land but not

on buying machinery and hence can be planned

accordingly. But, installing machinery requires that all the

preceding three operations are completed, namely buying

land and machinery and constructing building. Standard



8

notations and techniques are used in more formal CPM

drawings.

A Simple CPM Diagram

Performance review: After implementation, the project

performance must be reviewed to see whether it matches

the revenue and performance projections made in the

project report and the reasons for variations. Appropriate

remedial action is to be taken based on performance

review.

The detailed project report also must contain Market appraisal,

Technical appraisal, financial appraisal and Economic appraisal

of the project.

Market appraisal deals with size of market in the area and

expected share of the project in the market. It takes into account

past trends, expected future trends, results of market surveys and

the assessment of specific customer requirements in the project

STEP.1.B : BUY MACHINERY STEP.3:INSTAL MACHINERY

STEP.1.A.BUY

LAND STEP.2 CONSTRUCT

BLDG



9

area. In the scenario of “on-demand-provision” of services,

market appraisal assumes great significance in the justification

of each project.

Technical appraisal examines technical feasibility, required

scale of operations, existing infrastructure of power, land,

buildings etc and required technology to support anticipated

customer requirements. This flows from market appraisal and

planned techno commercial choices.

Economic appraisal deals with social cost-benefit analysis

especially in respect of government supported projects and

government specified targets, and indicates the impact of the

project on the society it serves in terms of government-specified

targets. For Complying with Universal service obligations and

any other government targets, it is appropriate for telecom

companies to keep such details and justification in respect of

VPTs. The financial appraisal looks at risk- return, cash inflows

and outflows and their impact on the viability of the project.

Financial Appraisal:

Before making capital investments on any project, the

investment analysis must estimate the cash outflows (on

Investments and working capital outflows) and the cash inflows



10

(Revenues) and apply standard decision rules to determine

whether the investment satisfies the requisite decision criteria.

This is popularly known as Financial Appraisal of a project. The

general principles adopted by Corporate finance managers in a

standard financial appraisal are:

All costs (cash outflows) and benefits (cash Inflows) must

be measured.

Net cash flows must be taken – after deducting the

applicable rate of corporate tax. This means that net cash

returns must be measured and not the accounting profit on

the project.

Cash flows must be determined in incremental terms. In

other words, the actual additional outflows and inflows

resulting from the implementation of the project in

question must be taken into account and not the average of

all earlier investments plus current investment.

Sunk costs like cost of land already purchased for many

other purposes but is now additionally used for the current

project under appraisal must be ignored .

Opportunity costs associated with the resources of the firm

must be considered even though such utilization does not

entail explicit cash outflows:

Existing overhead costs need not be shared by the new

project in projecting the cash outflows



11

In BSNL, the profitability is presently determined with reference

to “Annual Recurring Expenditure (ARE)” and “Anticipated

Receipts &Savings (ARS)” of the project. The other methods of

project evaluation (also called investment appraisal) currently in

use in corporate finance are discussed hereunder.

The terms used in these project evaluation / appraisal techniques

are explained briefly hereunder.

Initial Investment = Cost of all new assets procured

Minus sale value of old assets, if any

Cash Flow After Taxes (CFAT) = Profit After Tax +

Depreciations and other amortizations which do not

involve cash outgo

Project Life = Period during which the project generates

positive Cash Flow After Taxes

Time value of Money = We know that a rupee we get in

future after a few years is worth much less than a rupee we

get today. The Present value (PV) of a rupee that we get in

future depends on (a) an agreed discount rate which in

turn, depends on factors like depreciation, interest on

capital, inflation rates etc and(b) the time lag that the

future period involves. The choice of the discount rate

needs to be done by company managements with caution,



12

taking into account the type of capital used, the quality of

assets proposed to be created and other factors. Standard

tables are available now giving the present value of a

rupee, given the discount rate and the future period of

accrual of the rupee. PV can be calculated for outflows of

cash (investments) and inflows (revenues) and the net

present value (NPV) can be found by deducting the PV of

all outflows from the PV of all inflows. Discount factor

can also be computed without use of tables by using the

formula 1/ (1+ k) n where k = cost of capital; n = year in

which the in/outflow takes place. This formula takes into

account only the cost of capital.

Future Value (FV) factor : This is the opposite of the

present value factor. Given the discount rate and the future

period, we can calculate the future worth of today‟s one

rupee by using standard tables.

Pay-back method(Pay out or Pay off period): Under this

method we calculate the period taken by the project to recover

the investment amount from its future earnings.

Formula: - Pay back period = amount invested

Constant annual earnings

For instance, a project costs Rs.12000 and it is estimated to earn

annually Rs.4000net, then we understand that our investment is



13

recovered over a period of 3 years. The earnings after this period

will constitute profits. This method ascertains the period of time

required for annual earnings of the project to equate with the

initial investment. Here the term „earnings‟ refers to the profits

earned by the project (e.g. machine) before charging the

depreciation thereon but after deducting the tax and other

operating expenses. The recovery period is called the pay-back

period. The project which gives the invested capital in the

shortest time is the best.

Illustration

ABC Company considers the mechanization of a particular

process now carried on by labour. Two methods are available.

The following estimates are made by the experts:

Machine X Machine Y

Working life 5 years 5 years

Cost of machine Rs. 25000 25000

Annual incomes:

I year 7500 3000

II year 10000 6000

III year 15000 11000

IV year 6000 15000

V year 4000 10000

Total 42500 45000

Calculate the period of time taken by each project to repay the

investment amount out of its earnings

Working



14

Here the earning of the machine is unevenly spread over the

years. So, the general formula (investment ÷ Constant annual

earnings) cannot be used here. We have to prepare a table as

given below:-

Machine X Machine Y

Investment (cost of the machine) 25000 250000

Earnings:

I year 7500 3000

II year 10000 6000

First six months in the III year 7500 -

III year - 11000

First four months in the IV year - 5000

Total 25000 25000

Pay Back period 2 ½ years 3 ½ years

From the above results, we understand that machine „X‟ is

preferable to machine „Y‟, because the former repays the capital

earlier.

The pay-back method does not consider the earnings of the post

pay-back period.

Decision Rule: - Projects with shorter Payback Period or, those

which meet a management-prescribed Benchmark are to be

preferred.

Advantages of the concept:



15

Simple to understand and Easy to use

Profit or surplus comes only after Payback period.

Used where techno obsolescence is High

Focuses on need for initial higher cash flows

Eliminates / minimizes risk

Comparable to break-even point

Disadvantages of the method are –

• Stresses only capital recovery (Not profit)

• Nothing about cash flows after PBP

• Non-Comparability of Projects with uneven CFAT

• Ignores Time Value of Money

Discounted Pay Back Period (DPBP)

Determine all Cash outflows (Investment)

Determine all cash Inflows after taxes (revenues) for each

year

For each year, the inflows must be netted against outflows.

For the net amount, apply the PV factor from the tables

and Compute “Discounted Cash Flows After Taxes

(DCFAT)” by applying the formula: Net CFAT x PV

factor of the year..



16

Compute the Cumulative DCFAT (CDCFAT)at the end of

each year i.e., DCFAT till last year + DCFAT of current

year

Determine the year in which CDCFAT = INITIAL

INVESTMENT

This is the Discounted Pay Back Period (DPBP)

Decision Rule: Accept the Project: If DPBP < Bench mark

period fixed by the company. Else, reject the project. Fixing a

proper bench mark in terms of number of years/months by

management for recovery of the initial investment is the

essential first step for applying this method.

EX:- For a particular product “A”, Investment is Rs.36 lakhs.

The cash inflows after taxes for 5 years(in lakhs of Rs) are

given. Determine the payback period if the cash flows are

discounted at 12% p.a.

Year 1 2 3 4 5 Total

CFAT(RS) 11.40 11.40 11.40 11.40 11.40 11.40

PV Factor .8929 .7972 .7118 .6355 .5674 3.6048

DCFAT 10.18 9.08 8.11 7.24 6.47 41.08

CUM.DCFAT 10.18 19.26 27.37 34.61 41.08

So, DPBP = 4 YEARS +[Initial Investment – 4TH

YEAR CDFAT] X 100

5TH

YEAR DCFAT



17

= 4 YEARS + [(36 –34.61)/6.47] x 12= 4

yrs 2m

Pay Back Reciprocal (PBR)

Pay back reciprocal (PBR) is computed by the formula: (CFAT

P.A. / INITIAL INVESTMENT) x 100; the formula gives us the

approximate internal rate of return

Ex:

(1) Initial investment = Rs.50 Lakhs;

(2) Life of project = 10 years

(3) CFAT = Rs.10 lakhs P.A

(4) PBR = (10 / 50) x 100 = 20%

PBR is generally used if (1) Life of project is at least twice the

Payback Period and (2) Project generates equal amount of

annual cash flows

Decision Rule: Accept Projects with highest PBR or those

above a Bench mark fixed

Average rate of return method (Accounting rate of return

method): Under this method an attempt is made to calculate the

profits of a particular project earned over its whole working life.



18

Rate of return = Average annual net profit x

100

Investment

Average annual net profit = all earnings after depreciation

Project‟s economic life

Thus the average rate of return method is an accounting method

which represents the ratio of average annual profits after

depreciation and taxes to the investment in project. A rate of

return is fixed keeping in view the cost of capital of the business

for all capital investment projects, and projects which do not

give the desired minimum rate of return are rejected. Accepted

projects are then ranked according to their respective rates of

return.

Illustration

Calculate the average return for projects „X‟ and „Y‟ from the

following data:

Project „X‟ Project „Y‟

Investment Rs. 20000 30000

Expected life 4 years 5 years

Projected Net income (after

depreciation & taxes)

Year 1 2000 3000

Year 2 1500 3000

Year 3 1500 2000

Year 4 1000 1000

Year 5 1000



19

6000 10000

If we required rate of return is 6%, which project should be

undertaken?

Project „X‟ Project „Y‟

Investment

20000 30000

Average annual net profit

X =6000 Y =10000

4 5

1500 2000

Average rate of return

X = 1500 x 100 Y =2000 x

100

20000 30000

7.5% 6.67%

Since the rate of return for both the projects is higher than the

required rate of return of 6%, both the projects will be

undertaken provided that the two projects are not mutually

exclusive, and that enough financial resources are available.

However, if the two projects are mutually exclusive or enough

financial resources are not available, then Project „X‟ will be

preferred, since the rate of return on Project „X‟ is higher than

the rate on Project „Y‟.

Decision Rule: Accept projects with highest ARR or above

Benchmark



20

Advantages:

• Simple to understand

• Easy to compute

• Income throughout Project Life is considered

Disadvantages:

• Does Not consider CFAT which is more crucial

• Takes rough average of profits of future years & ignores

fluctuations in profits year after year

• Ignores time value of money , which is very important in

capital Budgeting

Present value method (Net Present value Method or Net

Gain Method): This method is based upon the concept that a

rupee received today is not the same as a rupee received at the

end of the year, because a rupee received today can be invested

so as to earn more money during the year. Under this method,

we calculate the present values of the future earnings spread

over a number of years either evenly or unevenly(using present

value table). Then the sum total of these discounted earnings

will be compared with the actual investment to find out the

surplus (or otherwise). But, the problem is what should be

discounting rate at which the earnings are brought down to the

present values? This rate is known as he cut-off rate. The rate is

based on the average cost of capital which should be adjusted to



21

allow for the risk element in each investment project. All cash

flows are discounted to present value using the required rate of

return. According to this criterion, the project is accepted if the

present value of cash inflow exceeds the present value of cash

outflows. The net present value method is superior to other

methods above, as it takes into account both the magnitude and

the timing of cash flows over the effective life of the asset.

According to this method, the capital project which is quick

earning and gives the returns during early years is considered

better than the capital project with the same total of returns but

with longer gestation periods.



22

Illustration

Calculate the net present values of Machine „X‟ and machine

„Y‟ from the following data:

Machine „X‟ Machine „Y‟

Initial investment Rs. 20000 30000

Expected life 5 years 5 years

Salvage value Rs. 1000 2000

Cash flows

Year

1 5000 20000

2 10000 10000

3 10000 5000

4 3000 3000

5 2000 2000

6 30000 40000

Required Rate of Return

The management determines 10% as the cut-off rate over the

proposed investment project. Discount factors at this rate are

given below:

Year 1 2 3 4 5

P.V. .909 .826 .751 .683 .621

Solution:

Machin

e „X‟

Machine „Y‟

Value Discount

factor @10%

Pres

ent

valu

e of

Val

ue

Disc

ount

facto

r

Prese

nt

value

of



23

cash

flow

@10

%

cash

flow

Cash

outflow

Initial

investmen

t

20000

1

2000

0

300

00

1

30000

Cash

inflows:

Year

1 5000 .909 4545 200

00

.909 18180

2 10000 .826 8260 100

00

.826 8260

3 10000 .751 7510 500

0

.751 3755

4 3000 .683 2049 300

0

.683 2049

5 2000 .621 1242 200

0

.621 1242

5

(salvage)

1000 .621 621 200

0

.621 1242

Present

value

2422

7

34728

Net

present

values

(cash

inflow-

cash

outflow)

4227

4728



24

The NPV of project „X‟ is Rs.4227 and that of project „Y‟ is

Rs.4728. Since the net cash inflows exceed the net cash

outflows for both the projects, both the projects are acceptable.

When the two projects are mutually exclusive so that only one

project can be undertaken, the NPV fails to establish which is a

better project, since NPV is expressed in absolute rather than in

relative terms. For making a comparison between the two

projects we will have to calculate the profitability index.

Profitability index = Present value of cash inflows

Present value of cash outflows

Machine „X‟ Machine „Y‟

24227 34728

20000 30000

=1211 =1157

Irrespective of the fact that the net present value of machine „Y‟

is greater than that of Machine „X‟, Machine „X‟ is better than

machine „Y‟ since the profitability index of Machine „X‟ is

greater than the profitability index of machine „Y‟.

Decision Rule:-Accept if NPV is Positive



25

Example: - A Firm‟s Investment on a machine = Rs.2 lakhs;

Cash Flow after tax & depreciation = 35,000 p.a. Cost of capital

=10%; Its life = 10 years; salvage value =nil; Calculate Present

value, net present value and also profitability Index:

Annuity factor from the tables for 10 years at 10% = 6.1446

So, Discounted cash flows after taxes = present value of 35,000

p.a. paid for 10 years = 6.1446 x 35,000 = Rs.2,15, 061 (PV)

NPV = DCFAT( - )Initial Investment= Rs.15,061

Formula for Profitability Index (PI) = DCFAT /Initial

Investment = 215061 / 200000

=1.075; (see technique.6 below)

Decision: As NPV >0 and PI > 1 the firm should purchase the

machinery

Merits of NPV/DCF

Considers Time value, a very important factor

All cash Flows are taken (Unlike Pay Back Period)

Focuses on the basic objective of adding to the

Shareholder wealth



26

Different Projects can be evaluated independently but

compared on NPV basis



27

Disadvantages

Involves complex calculations

Forecasting Flows & discount rate is difficult

NPV & Ranking of projects differ at different rates,

leading to inconsistency in decision making

Ignores difference in (a) size of investments & (b) the

benefits of earlier inflows enabling the undertaking of

more projects later

Discounted cash Flow method or Yield method or Internal

rate of return method or Time adjusted rate of return or

Project rate of return: This is used to analyse cash flows

when the approximate cost of capital is not pre-determined, so

we do not know the appropriate discount rate for discounting

cash flows to their present value. The aim of this method is to

find out percentage rate of discount that will reduce all future

cash inflows to the same value as the cash invested in the

project. The higher the percentage rate of discounting that is

used, the lower will be the present value of the cash flows. The

lower the percentage used, the higher will be the sum of the

present values. By a process of trail and error (using present

value table) a percentage rate can be ascertained that will equate

the present value of the future cash flows from the project with

the value of the cash investment. When the rate is found, it will



28

be the rate of return earned on the funds invested in the project.

It allows ranking of investments according to their internal

return.

Illustration

Calculate the internal rates of return for projects A and B from

the following data:-

A B

Initial investment Rs. 15000 15000

Effective life (no salvage

value)

4 years 4 years

Cash inflow:

Year 1 6000

Year 2 6000

Year 3 6000

Year 4 6000 30000

Solution

Project - A

There is an annuity of Rs.6000 per year for Project A. So for

calculating the internal rate of return we will use the annuity

table. The proportion of annuity of Rs.6000 and initial

investment of Rs.15000 is 6000: 15000 or 1:2.5 So in the

annuity table, we will need the discount rate that will reduce an

annuity of Re.1 for 4 years to a present value factor 2.5 A

perusal of the table shows that 2.5 factor lies between the 21%

and 22% discount rates.



29

The approximate internal rate between 21% and 22% shall be

determined by extrapolation as under:

Annuity

(1)

Discount

rate

(2)

Discount factor

(3)

Present value

(4) [1 x 3]

6000 21% 2.5404 15,242

22% 2.4936 14,961

1% 281

Internal rate of return = 2 +{15242 minus 15000}

15242 minus 14961

= 21+ 242 =21.89%

281

Project B

For project „B‟ there is a lump sum of Rs.30000 that will be

received after the end of 4th year. So, for calculating the internal

rate of return, we will use the table that gives the present value

of a rupee due at the end of „n‟ years. The proportion between

the lump sum cash inflow and the initial investment is 30000 :

15000 or 1: .5 So in the table we will read the discount rate that

will reduce a rupee receivable after the end of 4th year to a

present value factor of .5 A perusal of the Table shows that .5

factor lies between 18% and 19% discount rates.

The approximate internal rate between 18% and 19% shall be

determined by extrapolation as under:-



30

Ump sum

(1)

Discount

rate

(2)

Discount factor

(3)

Present value

(4) [1 x 3]

30000 18% .5157 15,471

19% .4286 14,958

1% 513

Internal rate of return = 2 +{15471 minus 15000}

15471 minus 14958

= 18+ 471 =18.92%

513

Establishing capital priorities

It is essential to establish a system of priorities when the

available capital is limited, so that best use is made of it. The

following is a list of such priorities.

1. Projects already in hand: They refer to the projects which

are incomplete but requires additional expenditure for

completion They will receive normally top priority since

they are in mid stream.

2. Projects necessitated by law: They refer to the projects

which are necessary to comply with certain legal

requirements. Expenditure is necessary, since it cannot be

avoided.

3. Projects to maintain capacity: are meant to keep the

productive capacity of the business intact (e.g.)

expenditure on the replacement of a machine.



31

4. Projects to increase earnings: These are undertaken to

reduce costs or to increase sales of the existing products

and are, therefore, naturally looked upon with favour.

5. Projects to develop New Projects: They refer to the

schemes which are required to improve the profitability

of business.

Cost of Financing a Project

In making investment decisions, it is appropriate to have in view

the cost of financing project. This is known as the cost of

capital. Common sense tell us that it would be uneconomical for

an individual to borrow money for investment purposes, if he

could not invest these funds at a higher rate. Thus in selecting

from among potential investments, a company should accept

only those proposals whose accepted return would at least

exceed the cost of capital to the firm.

Capital expenditure control will have the following features:

1. Constant search: There must be a complete awareness on

the part of all management personnel that long-term

expenditure constitutes the basis of profits over long

periods. This creates constant search for new methods,

processes and products.



32

2. Comprehensive planning: Budget of an organization

incorporates all the ideas for the future expansion

programme. The capital expenditure budget should be so

planned as to ensure balanced development of each part

of the business as well as of the company as a whole.

3. Justification: Having framed the capital budget, it is vital

to see that each project is justified by its forecast

profitability. This can be done by using one or more of

the systematic rational methods of ranking investment

proposals such as Pay Back Method, Average Rate of

Return Method discounted Cash Flow Method etc.

4. Authorization: There has to be some routine at every

stage request, authorization, progress and audit. Requests

for capital allocation should be made periodically and

they should be reviewed as they pass upward through

managerial level until they reach a committee which

shifts these projects and submits its recommendations to

the Board of Directors for final recommendation.

5. Authentication: As a project is carried out, all

expenditure should be authenticated as being within the

previously authorized budget for the project of the

company.

6. Progress: Major capital expenditure projects cannot be

accomplished overnight. They require the preparation of

detailed plans and instructions. The next step consists of



33

issuance of reports during the period in which project is

performed. These reports are aimed at observing that

overall programme remains within limits set by the

policy of the company. Moreover, many unexpected

delays may have to be faced. Therefore control of

progress is essential.

7. Post completion audits: This is important phase of the

capital expenditure control. Post-completion audits of

projects determine whether their actual value is in

accordance with the one determined at the time of

authorization. It is also possible to detect those areas

where action can be taken to improve future results

which may be very valuable n the consideration of future

projects.

Decision Rule:

If IRR off rate (generally, Cost of capital), ACCEPT

If IRR < Cost of Capital, REJECT

If IRR = Cost of > cut- capital, INDIFFERENT

Ex.: - Calculate IRR of an investment of Rs.2.5 lakhs if CFATs

= Rs.45,000 p.a. for 10 years

Annual CFAT for 10 years = 45,000 p.a.



34

PV interest Annuity Factor DCFAT

10% 6.1446 2,76,507

14% 5.2161 2,34,725

For 4%, difference = 41,782

So, IRR = 10% + [(2,76,507 - 2,50,000) / 41,782] x 4% =

12.54%

Decision Rule: If 12.54% is above cost of capital, Accept; Else

Reject;

IRR Advantages:

Takes time Value into account

Takes into account all cash outflows and inflows & time

periods

Immediate decision by comparing IRR with cost of capital

Helps to maximize shareholder wealth

Projects with heavy initial years CFAT will have higher

IRR. But NPV takes the timing difference at a suitable

discount rate



35

Disadvantages:

Tedious to compute for multiple outflows and inflows in

each year.

Multiple IRRs leads to difficult interpretation

Conflict with NPV, if in/outflows patterns are different for

different proposals

Presumes that all cash inflows are reinvested immediately

at the IRR – which is not practically possible.

Working Capital Management

To create a commercial entity and carrying out commercial

activity an investment called capital is required. This investment

may be in the form of cash or other assets. These assets

are used by the company for generating benefits to the company.

These assets are two types: Fixed and Current.

Fixed assets are those assets which are permanent in nature and

facilitate business activity. Examples of fixed assets are land,

buildings, machinery, furniture, and long-term investments.

They are not converted as revenue in short term but facilitate

generation of revenue.



36

Current assets on the other hand are those assets of the entity

which are either held in the form of cash or can be easily

converted into cash within a short period, say usually within a

year or an accounting period. Examples of current assets are

cash, short-term investments, sundry debtors or accounts

receivable, stock, loans and advances etc.

Liabilities are economic obligations of the company to pay cash

or provide goods or services to outsiders including shareholders.

Liabilities may be long-term or current. Long-term liabilities

are those which are repayable over a period greater than the

accounting period like share capital, debentures, long-term loans

etc. Current liabilities on the other hand have to be paid within

the accounting period like sundry debtors or accounts payable,

bills payable, outstanding expenses, short-term loans etc.

Working Capital Management means management of current

asset and current liabilities. Traditionally the term working

capital is defined in two ways, Gross Working Capital and Net

Working Capital. Gross Working Capital is equal to the total of

all current assts. Net Working Capital is defined as the

difference between Gross Working Capital and Current

liabilities. The basic objective of working capital is to provide

adequate support for the smooth functioning of normal business

operations of a company. The total amount of financial



37

resources at the disposal of a company is limited. These

resources can be put to alternative uses, the larger the amount of

investment in current assets, the smaller will be the amount

available for investment in other profitable avenues available to

a company.

Working capital traditionally comprises of cash and bank

balances, goods or inventories, cash equivalents like bills

receivables and sundry debtors, etc. As the business is generally

run on credit basis there is a time gap between the transaction

and actual realization of revenue. Similarly there is a lead-time

from procurement to consumption of materials. Hence the

balances of sundry debtors and inventories invariably remain in

the books of a business entity. Similarly a business enterprise

takes some time to meet its obligations of payments for services

or purchases. But at a given point of time the business concern

must be able to meet its liabilities when called upon, by

converting its current assets into cash. So the working capital

management is basically an issue of liquidity. Thus some part

of investment of the owners is always blocked in holding these

current assets and at times the concern is forced to bring in

additional funds from by way of borrowings. The business

concerns have different methods of meeting this working capital

requirement; some of the important methods of raising working

capital are discussed below.



38

Working Capital Management

The problems of Working Capital Management are either not

able to assess the actual requirements of working capital and

thereby holding excess current assets like cash and inventories,

or not able to realize the sundry debtors or bill receivable thus

resulting in blocking of funds in working capital. While holding

a reasonable level of working capital is advisable in liquidity

point of view and for maintaining optimum levels of production,

sale of goods or services, holding excess working capital in

anyway results in losses to the concern. Let us discuss how the

various components of working capital have an impact on

profitability of the business concern.

The main components of working capital management include

1. Cash management,

2. Receivable management

3. Inventory management.

Cash Management

There is a general tendency to confuse profits with cash. But

there is a difference between profits and cash. Profits can be



39

said to be the excess of income over the expenditure of the

business entity, for a particular accounting period. It includes

both cash incomes (cash sales, interest on investment, etc.) and

non-cash incomes (credit sales, discounts received etc. Similarly

both expenses in cash/check (payment of salaries, wages,

interest on term loans, etc.) and non-cash expenses

(depreciation, preliminary expenses incurred during in

corporation which are write-off every year, outstanding

expenses like unpaid salaries or rent or insurance) where there is

no actual outflow of cash at the time of accounting are included.

„Cash‟ refers to the cash as well as the bank balances of the

company at the end of the accounting period, as reflected in the

Balance Sheet of the company. While profits reflect the earning

capacity of a company, cash reflects its liquidity position.

Why Companies hold cash?

The need for holding cash arises from a variety of reasons which

are briefly summarized below.

Transaction Motive

A company is always entering into transactions with other

entities. While some of these transactions may not result in an

immediate inflow/outflow of cash (eg: credit purchases and



40

sales) other transactions cause immediate cash inflows and

outflows. So firms always keep a certain amount as cash to deal

with routine transactions where immediate cash payments are

required.

Precautions Motive

Contingencies have a habit of cropping up when least expected.

A sudden fire may break out, accidents may happen, employees

may go on strike, creditors may present bills earlier than

expected or debtors may make payments later than warranted.

The company has to be prepared to meet these contingencies to

minimize its losses. For this purpose companies generally

maintain some amount in the form of cash.

Speculative Motive

Firms also maintain cash balances in order to take advantage of

opportunities that do not take place in the course of routine

business activities. For example, there may be a sudden

decrease in the price of raw materials which is not expected to

last long or the firm may want to invest in securities of other

companies when the price is just right. These transactions are of

a purely speculative nature for which the firms need cash.



41

Objectives of Cash Management

The objective of cash management can be regarded as one of

making short-term forecasts of cash position, finding avenues

for financing during periods when cash deficits are anticipated

and arranging for repayment/investment during periods when

cash surpluses are anticipated with a view to minimizing idle

cash as far as possible. Towards this end short-term forecasts of

cash receipts and payments are made in the structured form of

cash budgets, information is monitored at appropriate intervals

for the purpose of control and taking suitable measures as

warranted by the situation.

Cash Forecasting and Budget

The principal tool of cash management is cash budgeting or

short-term cash forecasting. Usually, the time chosen for

making short-term forecast for preparing cash budgets is taken

to one year. For the purpose of better monitoring and control,

however, the year is divided into quarters, quarters into months

and months into weeks. Under critical conditions a week is

further divided into days. The efficiency of cash management

can be enhanced considerably by keeping a close watch and

controlling a few important factors mentioned below:

Prompt Billing and Mailing



42

A time lag occurs from the date of dispatching goods or

providing services to the date of preparing invoice or bill and

mailing the same to the customer. If this time gap can be

minimized, early collections can be expected, otherwise

collections get delayed.

Collection of Cheques and Remittances of Cash

Delay in the receipt of cheques and depositing the same in the

bank will inevitably result in delayed cash realization. This

delay can be reduced by taking measures for hastening the

process of collection and depositing cheques/cash from

customers.

Receivables Management

Introduction

Business firms generally sell goods on credit, to facilitate sales

especially from those customers who cannot borrow from other

sources, or find it very expensive or difficult to do so. Goods or

services sold on credit get converted (from the point of view of

the selling firm) into receivables (book debts) which when

realized, generate cash. The average balance in the receivables



43

account would approximately be: average daily credit sales

multiplied by average collection period. For example, if the

average daily credit sales of a firm are Rs. 3,00,000 and the

average collection period is 40 days, the average balance in the

receivables account would be Rs. 1,20, 00,000. Since

receivables often account for a significant proportion of the total

assets, management of receivables take up a lot of the Finance

Manager‟s time.

Purpose of Receivables Management

The object of receivables management is to promote sales and

profits until that point is reached where the returns that the

company get from funding of receivables is less than the cost

that the company has to incur in order to fund these receivables.

Hence, the purpose of receivables is directly connected with the

company‟s objectives of making credit sales which are:

Increasing total sales as if a company sells goods on

credit, it will be in a position to sell more goods than if it

insists on immediate cash payment.

Increasing profits as a result of increase in sales not only

in volume, but also because companies charge a higher

margin of profit on credit sales as compared to cash sales.



44

In order to meet the increasing competition, the company

may have to grant better credit facilities than those

offered by its competitors.

Cost of Maintaining Receivables

Additional fund requirement for the company

When a firm maintains receivables, some of the firm‟s

resources remain blocked in them because there is a time

lag between the credit sale to customer and receipt of

cash from them as repayment. To the extent that the

firm‟s resources are blocked in its receivables, it has to

arrange additional finance to meet its own obligations

towards its creditors and employee, like payments for

purchases, salaries and other production and

administrative expenses. Whether this additional finance

is met from its own resources or from outside, it involves

a cost to the firm in terms of interest (if financed from

outside) or opportunity costs (if internal resources which

could have been put to some other use are taken).

Administrative costs

When a company maintains receivables, it has to incur

additional administrative expenses in the form of salaries



45

to clerks who maintain records of debtors, expenses on

investigating the creditworthiness of debtors etc.

Collection costs

These are costs which the firm, has to incur for collection

of the amounts at the appropriate time from the

customers.

Defaulting costs

When customers make default in payments, not only is the

collection effort to be increased but the firm may also have to

incur losses from bad debts.

Questions in “Financial Management”

1. What is the significance of Investment Analysis in

Financial Management ?

2. Discuss about the various steps involved in CAPEX

Decisions ?

3. What is meant by Critical Path Method ?

4. Discuss about the various project appraisal techniques ?

5. What is meant by Financial appraisal of a Project ? How it

is carried out ?

6. What are the advantages and disadvantages of payback

period Method ?



46

7. What are the merits and demerits of Discounted Cash Flow

Methods ?

8. Brief about the working Capital management ?

9. What are the main components of working capital ?

10. What are the motives of holding the cash under cash

management system ?

Documents

Chapter-20 Financial Management - Bharat Sanchar Nigam Limitedtraining.bsnl.co.in/digital_library_source... · Capital expenditure Decisions in BSNL or any telecom ... of priority