The Basics of Financing a Business

BUSINESS FINANCE

CHARATERISTICS OF PROJECT EVALUATION
 Single project assessment or assessment of
mutually exclusive projects.
 Huge funds involved (Berman, Knight and
Case, 2013) .
 Irreversible decisions (Bierman Jr, and Smidt,
2012) .
 Resources involved: Technology, Manpower,
Time ansd Efforts.

PROJECT CHOICES
 Choice 1: Introduction of a new product for
the low-end market.
 Choice 2: Expansion of market for the
existing product.
 Above projects are mutually exclusive
projects.
 Selection of one option would lead to the
rejection of the other option.

METHODS OF EVALUATION
 Cash Payback Period
 Net Present Value
 Internal Rate of Return
 Profitability Index
 Accounting Rate of Return
 Discounted Cash Pay Back, and others.

WEIGHTED AVERAGE COST OF CAPITAL
 Total average cost of different sources of
capital in an entity (Brigham and Houston,
2012) .
 Based on either market value weights or book
value weights.
 First Step: Calculate individual source of
finances.
 Second Step: Apply weights to the respective
cost of capital.

COST OF DEBT
 After tax cost of debt forms the part of WACC.
 Cost of debt of entity Chowkidar plc:
Coupon per bond (C)
= 4%
Coupon per bond (C)
= 4.00
Face Value of Bond
(FV) = 100
t = 7
Market Price (PV) = 91.5
Kd =
(4 +
((100-91.50)/7))/((100+91.50)/2)
Kd =
0.05445729
2
Kd = 5.45%
Kd (after tax) = 4.41%

COST OF EQUITY
 Various methods used: CAPM, Gordon’s Growth
Model, Dividend Discount Mode, and others.
 Gordon Growth Model used for computing cost
of equity of Chowkidar Plc.
Ke (Cost of equity )
= (D *(1 + g))/ P + g
Where,
D = Dividend last paid
G = Growth Rate
P = Current market price
G = 4.55%
Ke (Cost of
equity ) =
((0.14*(1 + 4.55%)) /100) +
4.55%
Ke (Cost of
equity ) = 4.6964%
Ke = 4.70%

WEIGHTED AVERAGE COST OF CAPITAL
 The respective weights are multiplied with the
individual cost of capital of different finance
source. Computation of WACC
Ratio of bonds = 0.59
Ratio of mezzanine finance = 0.4
Ratio of equity = 0.1
Cost of Equity = 4.70%
Cost of Debt = 4.41%
Cost of Mezzanine Finance = 8%
WACC = 3.93%

COMPARATIVE EVALUATION OF THE
PROJECTS
 Varied results in varied scenarios.
Description Option 1 Option 2
NPV WACC 5903683.28 39651249.67
NPV
(Mezanninne
Rate)
-4072975.34 31414781.28
IRR 6.22% 33%
PAYBACK (YRS) 5.73 2

SELECTION BASED ON VARIOUS
TECHNIQUES
Description Option 1 Option 2 Selection
NPV WACC 5903683.2
8
39651249.
67
Option 1
NPV
(Mezanninn
e Rate)
-
4072975.3
4
31414781.
28
Option 2
IRR 6.22% 33% Option 2
PAYBACK
(YRS)
5.73 2 Option 2

COMPARATIVE EVALUATION OF THE PROJECTS
 Method used for evaluation: NPV, IRR, PAYBACK.
 Method considered for selection: NPV
 Benefits of NPV:
Considers time value of money (Gὂtze, Northcott and
Schuster, 2015) .
Gives outcome in absolute form.
 Disadvantages of NPV:
Complex to perform (Moran, 2015).
Difficult to determine cost of capital.
Qualitative factors are ignored.

SHORT COMINGS OF VARIED EVALUAITON
TECHNIQUES
 Cash Payback Period: The technique does not
considers the time value of money.
 The method does not considers the cash flow
that arise after the recovery of the initial
costs.
 Does not gives efficient result in case of two
projects with uneven cash flows.

SHORT COMINGS OF VARIED EVALUAITON
TECHNIQUES
 Internal Rate of Return: There could be
multiple rate of returns for a same project.
 The results are not in the absolute terms.

NET PRESENT VALUE METHOD
 NPV Formula:
 NPV = = + + + …. +
where:
k = Rate of discounting
CFi = net cash flow from year 1,
CF0 = Initial amount of the investment in
thr project
n = number of years

RECOMMENDATIONS
 Option 1 shows higher NPV with the
WACC.
 Option 1 is recommended to be selected.
 Qualitative factors to be considered:
Technological changes.
Demand of products.
Political and economic changes.

CONCLUSION
 Investment decisions are key
decisions of an entity.
 Careful evaluation is necessitated.
 Different methods lead to different
results.
 Inputs from departmental heads is
essential.

REFERENCES
 Berman, K., Knight. J., and Case, J. (2013) Financial Intelligence,
Revised Edition: A Manager's Guide to Knowing What the Numbers
Really Mean. Boston: Harvard Business Review Press, p. 212.
 Bierman Jr, H., and Smidt, S. (2012) The capital budgeting decision:
economic analysis of investment projects. 9th ed. Oxon: Routledge.
 Brigham, E. F., and Houston, J. F. (2012) Fundamentals of Financial
Management. Boston MA: Cengage Learning.
 Goyat, S., and Nain, A. (2016) Methods of Evaluating Investment
Proposals. International Journal of Engineering and Management
Research (IJEMR), 6(5), p. 279.
 Gὂtze, U., Northcott, D., and Schuster, P. (2015) Investment
Appraisal: Methods and Models. 2nd ed. London: Springer.
 Moran, A. (2015) Managing Agile. Strategy, Implementation,
Organisation and People. New York: Springer.