Module 4

Capital Building
Contents
• Meaning and Importance of Capital Budgeting
• Inputs for Capital Budgeting Decisions , Investment Appraisal
Criterion—Accounting Rate of Return , Payback Period Discounted,
Payback Period , Net Present Value(NPV) Profitability Index, Internal
Rate of Return (IRR) and Modified Internal Rate of Return, (MIRR)
• Working Capital Management: Concepts of Meaning Working Capital ,
• Importance of Working Capital Management Factors,
• Affecting an Entity‘s Working Capital Needs
• Estimation of Working Capital
• Requirements, Management of Inventories, Management of Receivables ,
Management of Cash and Marketable Securities
Meaning and Importance of Capital
Budgeting
• Nic Barnhart of Pareto Labs defines capital as simply, “Money that is
used to make more money.”
• This definition can apply to individuals in the greater economy and to
companies.
• In the world of business, the term capital means anything a business
owns that contributes to building wealth.
Sources of capital include:
• Financial assets that can be liquidated like cash, cash equivalents,
and marketable securities.
• Tangible assets such as the machines and facilities used to make a
product.
• Human capital; i.e. the people that work to produce goods and
services.
• Brand capital; i.e. the perceived value of a brand recognition.
What is the difference between capital
and money?
• The terms “capital” and “money” are certainly related, but they are
not interchangeable.
• As a business owner, it’s important to know the difference.
• Money is cash that you spend and capital is cash (or other asset)
that you put to work.
• The money in your wallet isn’t a form of capital unless you put it to
work earning you more money.
• People in finance often describe capital as having “greater durability”
than money because it can be continuously re-invested to earn more
value.
How is capital used?
“Think of the capital as the gas tank that powers the whole business.”
– Nic Barnhart, cofounder of Pareto Labs
• Capital is absolutely essential to a company getting off the
ground—it’s like the first fill on the gas tank that will hopefully come
to run a business that is profitable in the long term.
• Capital can be infused into the business at any time, to refuel the tank
if it gets low.
• For a business, capital is made up of two sources:
• Liabilities: Money that a business owes and that has to be paid back.
• Shareholders’ equity: Money that investors put into the company in
exchange for ownership and that never has to be paid back.
Top 4 types of capital for business
• 1. Working capital
• 2. Debt capital
• 3. Equity capital
• 4. Trading capital
1. Working capital
• Working capital—the difference between a company’s assets and
liabilities—measures a company’s ability to produce cash to pay for its
short term financial obligations, also known as liquidity.

Working capital = Current assets – Current liabilities

• Positive working capital means the value of a company’s current assets is

more than its current liabilities Negative working capital, on the other
hand, means that current liabilities outweigh current assets.
• For the company, this could lead to financial issues with creditors, growth,
or production.
2. Debt capital
• Debt capital is acquired by borrowing from financial institutions,
banks, friends and family, credit cards, federal loan programs, and
venture capital, or by issuing bonds.
• Just like an individual needs established credit history to borrow, so
do businesses.
• Debt capital has to be paid off on a regular basis (with interest) but
unlike an individual’s debt, it is seen as more of an essential part of
building a business instead of a financial burden.
3. Equity capital
• Equity capital is any capital raised through selling shares with a key
difference being whether those shares are sold privately or publicly:
• Private: Shares of stock in a company within a private group of
investors.
• Public: Shares of stock in a company that are listed on the stock
exchange (think: IPO).
• The money an investor pays for shares of stock in a company
becomes equity capital for the business.
4. Trading capital
• Trading capital applies exclusively to the financial industry where
brokerage companies need enough capital to support their investment
strategies.
• Trading capital supports the many daily trades that brokerage
companies need to make to generate a profit and the large-scale
trades made by the biggest brokerage firms.
• Sometimes it is granted to individual traders and sometimes to the
firm as a whole.
Capital Budgeting
Capital budgeting

Capital budgeting is the process of making investment decision in

long-term assets or courses of action. Capital expenditure incurred
today is expected to bring its benefits over a period of time. These
expenditures are related to the acquisition & improvement of fixes
assets.
What Is Capital Budgeting?
• Capital budgeting involves choosing projects that add value to a company.
• The capital budgeting process can involve almost anything including acquiring
land or purchasing fixed assets like a new truck or machinery.
• Capital budgeting is the process by which investors determine the value of a
potential investment project.
• The three most common approaches to project selection are payback period
(PB), internal rate of return (IRR), and net present value (NPV).
• The payback period determines how long it would take a company to see
enough in cash flows to recover the original investment.
• The internal rate of return is the expected return on a project—if the rate is
higher than the cost of capital, it's a good project.
• The net present value shows how profitable a project will be versus
alternatives and is perhaps the most effective of the three methods.
Capital Budgeting
• Capital budgeting is the planning of expenditure and the benefit, which
spread over a number of years.
• It is the process of deciding whether or not to invest in a particular
project, as the investment possibilities may not be rewarding.
• The manager has to choose a project, which gives a rate of return,
which is more than the cost of financing the project.
• For this the manager has to evaluate the worth of the projects in-terms
of cost and benefits.
• The benefits are the expected cash inflows from the project, which are
discounted against a standard, generally the cost of capital.
Capital budgeting Techniques
• The capital budgeting appraisal methods are techniques of evaluation
of investment proposal will help the company to decide upon the
desirability of an investment proposal depending upon their; relative
income generating capacity and rank them in order of their
desirability.
• These methods provide the company a set of norms on the basis of
which either it has to accept or reject the investment proposal.
• The most widely accepted techniques used in estimating the
cost-returns of investment projects can be grouped under two
categories.
• 1. Traditional methods
• 2. Discounted Cash flow methods
Payback Period Method:
• Refers to the period in which the proposal will generate cash to
recover the initial investment made.
• It purely emphasizes on the cash inflows, economic life of the project
and the investment made in the project, with no consideration to time
value of money.
• However, as the method is based on thumb rule, it does not consider
the importance of time value of money and so the relevant dimensions
of profitability
Payback period = Cash outlay (investment) / Annual cash inflow
 Merits/Demerits
• Merits:
• 1. It is one of the earliest methods of evaluating the investment projects.
• 2. It is simple to understand and to compute.
• 1. It dose not involve any cost for computation of the payback period
• 2. It is one of the widely used methods in small scale industry sector
• 3. It can be computed on the basis of accounting information available from the books.
• Demerits
• 1. This method fails to take into account the cash flows received by the company after
the pay back period.
• 2. It doesn’t take into account the interest factor involved in an investment outlay.
• 3. It is not consistent with the objective of maximizing the market value of the
company’s share.
• 4. It fails to consider the pattern of cash inflows i. e., the magnitude and timing of
cash in flows.
Accounting rate of return method
(ARR):
• This method helps to overcome the disadvantages of the payback period method.
• Accounting Rate of Return (ARR) is the average net income an asset is expected to
generate divided by its average capital cost, expressed as an annual percentage.
• The ARR is a formula used to make capital budgeting decisions.
• These typically include situations where companies are deciding on whether or not to
proceed with a specific investment (a project, an acquisition, etc.) based on the future
net earnings expected compared to the capital cost.
• However, this method also ignores time value of money and doesn’t consider the
length of life of the projects.
• Also it is not consistent with the firm’s objective of maximizing the market value of
shares.

Average income
ARR=
Average Investment
Merits/Demerits
• Merits
• 1. It is very simple to understand and calculate.
• 2. It can be readily computed with the help of the available accounting data.
• 3. It uses the entire stream of earning to calculate the ARR.
• Demerits:
• 1. It is not based on cash flows generated by a project.
• 2. This method does not consider the objective of wealth maximization
• 3. It ignores the length of the projects useful life.
• 4. It does not take into account the fact that the profits can be re-invested.
Discounted cash flow method:
• The discounted cash flow technique calculates the cash inflow and
outflow through the life of an asset.
• These are then discounted through a discounting factor.
• The discounted cash inflows and outflows are then compared.
• This technique takes into account the interest factor and the return
after the payback period.
Net present Value (NPV) Method:
• This is one of the widely used methods for evaluating capital
investment proposals.
• In this technique the cash inflow that is expected at different periods
of time is discounted at a particular rate.
• The present values of the cash inflow are compared to the original
investment.
• If the difference between them is positive (+) then it is accepted or
otherwise rejected.
Net Present Value (NPV) Method:
Merits/Demerits
• Merits:
• 1. It recognizes the time value of money.
• 2. It is based on the entire cash flows generated during the useful life of the asset
• 3. It is consistent with the objective of maximization of wealth of the owners.
• 4. The ranking of projects is independent of the discount rate used for determining
the present value.
• Demerits:
• 1. It is different to understand and use.
• 2. The NPV is calculated by using the cost of capital as a discount rate. But the
concept of cost of capital. If self is difficult to understood and determine.
• 3. It does not give solutions when the comparable projects are involved in different
amounts of investment.
• 4. It does not give correct answer to a question whether alternative projects or
limited funds are available with unequal lines
Internal Rate of Return (IRR):
• This is defined as the rate at which the net present value of the investment
is zero.
• The discounted cash inflow is equal to the discounted cash outflow. This
method also considers time value of money.
• It tries to arrive to a rate of interest at which funds invested in the project
could be repaid out of the cash inflows. However, computation of IRR is a
tedious task.
• If IRR > WACC(Weighted average cost of capital) then the project is
profitable.
• If IRR > k = accept
• If IR < k = reject
Merits/Demerits
• Merits:
• 1. It consider the time value of money
• 2. It takes into account the cash flows over the entire useful life of the asset.
• 3. It has a psychological appear to the user because when the highest rate of
return projects are selected, it satisfies the investors in terms of the rate of
return an capital
• 4. It always suggests accepting to projects with maximum rate of return.
• 5. It is inconformity with the firm’s objective of maximum owner’s welfare.
• Demerits:
• 1. It is very difficult to understand and use.
• 2. It involves a very complicated computational work.
• 3. It may not give unique answer in all situations.
Profitability Index (PI):
• It is the ratio of the present value of future cash benefits, at the
required rate of return to the initial cash outflow of the investment.
• It may be gross or net, net being simply gross minus one.
• The formula to calculate profitability index (PI) or benefit cost (BC)
ratio is as follows.
• Merits:
• 1. It requires less computational work then IRR method
• 2. It helps to accept / reject investment proposal on the basis of value of the index.
• 3. It is useful to rank the proposals on the basis of the highest/lowest value of the
index.
• 4. It is useful to tank the proposals on the basis of the highest/lowest value of the
index.
• 5. It takes into consideration the entire stream of cash flows generated during the
useful life of the asset.
• Demerits:
• 1. It is some what difficult to understand
• 2. Some people may feel no limitation for index number due to several limitation
involved in their competitions
• 3. It is very difficult to understand the analytical part of the decision on the basis of
probability index.
Significance of capital budgeting
• Capital budgeting is an essential tool in financial management
• Capital budgeting provides a wide scope for financial managers to
evaluate different projects in terms of their viability to be taken up for
investments
• It helps in exposing the risk and uncertainty of different projects
• It helps in keeping a check on over or under investments
• The management is provided with an effective control on cost of
capital expenditure projects
• Ultimately the fate of a business is decided on how optimally the
available resources are used
Working Capital Management
Working Capital Management
• Working capital management is a business strategy designed to ensure that a
company operates efficiently by monitoring and using its current assets and
liabilities to their most effective use.
• The primary purpose of working capital management is to enable the company to
maintain sufficient cash flow to meet its short-term operating costs and
short-term debt obligations.
• A company's working capital is made up of its current assets minus its current
liabilities.
• Current assets include anything that can be easily converted into cash within 12
months. These are the company's highly liquid assets. Some current assets include
cash, accounts receivable, inventory, and short-term investments.
• Current liabilities are any obligations due within the following 12 months. These
include accruals for operating expenses and current portions of long-term debt
payments.
Why Manage Working Capital?
• Working capital management helps maintain the smooth operation of the net
operating cycle, also known as the cash conversion cycle (CCC)—the minimum
amount of time required to convert net current assets and liabilities into cash.
• Working capital management can improve a company's cash flow management
and earnings quality through the efficient use of its resources.
• Management of working capital includes inventory management as well as
management of accounts receivable and accounts payable.
• Working capital management also involves the timing of accounts payable (i.e.,
paying suppliers).
• A company can conserve cash by choosing to stretch the payment of suppliers
and to make the most of available credit or may spend cash by purchasing
using cash—these choices also affect working capital management.
Working Capital Management Ratios
• Current Ratio (Working Capital Ratio): The working capital ratio
or current ratio is calculated as current assets divided by current
liabilities. It is a key indicator of a company's financial health as it
demonstrates its ability to meet its short-term financial obligations.
• Collection Ratio (Days Sales Outstanding):The collection ratio, also known
as days sales outstanding (DSO), is a measure of how efficiently a company
manages its accounts receivable. The collection ratio is calculated as the
product of the number of days in an accounting period multiplied by
the average amount of outstanding accounts receivable divided by the
total amount of net credit sales during the accounting period.
• Inventory Turnover Ratio: The inventory turnover ratio, calculated as cost
of goods sold divided by average balance sheet inventory, reveals how
rapidly a company's inventory is being used in sales and replaced.
Importance of Working Capital
Management
• Working capital is a daily necessity for businesses, as they require a
regular amount of cash to make routine payments, cover unexpected
costs, and purchase basic materials used in the production of goods.
• Efficient working capital management helps maintain smooth operations
and can also help to improve the company's earnings and
profitability.
• Management of working capital includes inventory management and
management of accounts receivables and accounts payables.
• The main objectives of working capital management include
maintaining the working capital operating cycle and ensuring its
ordered operation, minimizing the cost of capital spent on the
working capital, and maximizing the return on current asset
investments.
Importance of Working Capital
Management
• Working capital is an easily understandable concept, as it is linked to an
individual’s cost of living and, therefore can be understood in a more personal
way.
• Individuals need to collect the money that they are owed and maintain a certain
amount on a daily basis to cover day-to-day expenses, bills, and other regular
expenditures.
• Working capital is a prevalent metric for the efficiency, liquidity and overall health
of a company.
• It is a reflection of the results of various company activities, including revenue
collection, debt management, inventory management and payments to suppliers.
• This is because it includes inventory, accounts payable and receivable, cash,
portions of debt due within the period of a year and other short-term accounts.
 Importance of Working Capital
Management
• The needs for working capital vary from industry to industry, and they can even vary
among similar companies.
• This is due to several factors, including differences in collection and payment policies,
the timing of asset purchases, the likelihood of a company writing off some of its
past-due accounts receivable, and in some instances, capital-raising efforts a company is
undertaking.
• Working capital management is essentially an accounting strategy with a focus on the
maintenance of a sufficient balance between a company’s current assets and liabilities.
• An effective working capital management system helps businesses not only cover their
financial obligations but also boost their earnings.
• Managing working capital means managing inventories, cash, accounts payable and
accounts receivable.
• An efficient working capital management system often uses key performance ratios, such as
the working capital ratio, the inventory turnover ratio and the collection ratio, to help
identify areas that require focus in order to maintain liquidity and profitability.
The Importance of Working Capital
Management: Summary
• The goal of working capital management is to maximize
operational efficiency.
• Efficient working capital management helps maintain smooth
operations and can also help to improve the company's earnings
and profitability.
• Management of working capital includes inventory management
and management of accounts receivables and accounts payables.
 Factors affecting the working capital
1. Length of Operating Cycle:
• The amount of working capital directly depends upon the length of
operating cycle.
• Operating cycle refers to the time period involved in production.
• It starts right from acquisition of raw material and ends till payment is
received after sale.
• The working capital is very important for the smooth flow of operating
cycle.
• If operating cycle is long then more working capital is required whereas for
companies having short operating cycle, the working capital requirement is
less.
 Factors affecting the working capital
2. Nature of Business:
• The type of business, firm is involved in, is the next consideration while
deciding the working capital.
• In case of trading concern or retail shop the requirement of working capital
is less because length of operating cycle is small.
• The wholesalers as compared to retail shop require more working capital
as they have to maintain large stock and generally sell goods on credit
which increases the length of operating cycle.
• The manufacturing company requires huge amount of working capital
because they have to convert raw material into finished goods, sell on
credit, maintain the inventory of raw material as well as finished goods.
Factors affecting the working capital
3. Scale of Operation:
• The firms operating at large scale need to maintain more inventory,
debtors, etc. So they generally require large working capital whereas
firms operating at small scale require less working capital.
4. Business Cycle Fluctuation:
• During boom period the market is flourishing so more demand, more
production, more stock, and more debtors which mean more amount
of working capital is required.
• Whereas during depression period low demand less inventories to be
maintained, less debtors, so less working capital will be required.
Estimation of Working Capital
• Estimating working capital means calculating future working capital.
• It should be as accurate as possible because the working capital
planning would be based on these estimates, and banks and other
financial institutes finance the working capital needs to be based only
on such estimates.
• Methods:
• Percentage of revenue or sales,
• Regression analysis
• Operating cycle method
Percentage of Sales Method
• Percentage of Sales Method is the easiest of the methods for calculating the
working capital requirement of a company.
• This method is based on the principle of ‘history repeats itself.’ For estimating,
a relationship of sales and working capital is worked out for, say last 5 years.
• If it is constantly coming near, say 40%, i.e., working capital level is 40% of
sales, the following year’s estimation is done based on this estimate.
• If the expected sales are 500 million dollars, 200 million dollars would be
required as working capital.
• The advantage of this method is that it is very simple to understand and
calculate also.
• The disadvantage includes its assumption, which is difficult to be true for many
organizations.
• So, this method is not useful where there is no linear relationship between the
revenue and working capital. In new startup projects, this method is not
applicable because there is no past.
Regression Analysis Method
• Regression Analysis Method is a statistical estimation tool utilized by mass
for various types of estimation.
• It tries to establish a trend relationship.
• We will use it for working capital estimation.
• This method expresses the relationship between revenue & working capital
in the form of an equation
Working Capital = Intercept + Slope * Revenue
• The slope is the rate of change of working capital with one unit change in
revenue.
• Intercept is the point where regression line and working capital axis meet
Example
• At the end of the statistical exercise with past revenue and working capital
data, we will get an equation like the below:

Working Capital = -6.34 + 0.46 * Revenue

• To calculate working capital, just put the targeted revenue figure in the above
equation, say 200 million dollars.

Working Capital = -6.34 + 0.46 * 200 = -6.34 + 92 = 85.66 ~ 86 Million

Dollar.

• Therefore, we need 86 million dollars of working capital to achieve a revenue

of 200 million dollars.
 Operating Cycle Method
• The operating cycle method is probably the best of the methods because it
considers the actual business or industry situation while giving an estimate of
working capital.
• A general rule can be stated in this method.
• The longer the working capital operating cycle, the higher the requirement for
working capital and vice versa.
• We would agree on the point also.
• The following formula can be used to estimate or calculate the working capital
Working Capital = Cost of Goods Sold (Estimated) * (No. of Days of Operating
Cycle / 365 Days) + Bank and Cash Balance.

• If the cost of goods sold (estimated) is $35 million and the operating cycle is 75
days, the bank balance required is 1.25 million. Therefore, Working Capital =
35 * 75/365 + 1.25 = $8.44 Million.
Important questions
• What is the difference between the Net Present Value (NPV) method
and the Internal Rate of Return (IRR) method?
• What is ‘Internal Rate of Return’?
• Which method of comparing a number of investment proposals is
most suited if each proposal involves different amount of cash
inflows?
• What are the steps while using the equivalent annualized criterion?