ASSIGNMENT

Course Code : MS-42

Course Title : Capital Investment and Financing Decisions
Assignment No. : MS-42/TMA /SEM-I/2019

Q1.What do you understand by cost of capital? Explain in detail how the cost of capital for
various components of capital is computed?
Ans:
Cost of capital is the required return necessary to make a capital budgeting project, such as building
a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity, and is
used by companies internally to judge whether a capital project is worth the expenditure of
resources, and by investors who use it to determine whether an investment is worth the risk
compared to the return. Cost of capital depends on the mode of financing used — it refers to the
cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed
solely through debt. Many companies use a combination of debt and equity to finance their
businesses and, for such companies, the overall cost of capital is derived from a weighted average of
all capital sources, widely known as the weighted average cost of capital (WACC). Since the cost of
capital represents a hurdle rate that a company must overcome before it can generate value, it is
extensively used in the capital budgeting process to determine whether the company should
proceed with a project.
Cost of capital is widely used in economics and accounting. Another way to describe cost of capital
is the opportunity cost of making an investment in a business. Wise company management will only
invest in initiatives and projects that will provide returns that exceed the cost of capital.
Cost of capital, from the perspective on an investor, is the return expected by whomever is
providing the capital for a business. In order words, it is an assessment of the risk of a company's
equity. In doing this an investor may look at the volatility (beta) of a company to determine
whether a certain stock is too risky or a good investment.
The cost of capital for various components of capital is computed
1. Cost of Debt
Debt may be issued at par, at premium or discount. It may be perpetual or redeemable. The
technique of computation of cost in each case has been explained later.
(a) Debt issued at par: The computation of cost of debt issued at par is comparatively an easy task.
It is the explicit interest rate adjusted further for the tax liability of the company. It may be
computed according to the following formula:
Kd = (l-T)R
Where,
Kd = Cost of debt;

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 T = Marginal tax rate;
R = Debenture interest rate.
The tax is deducted out of the interest payable, because interest is treated as an expense while
computing the firm’s income for tax purposes. However, the tax adjusted rate of interest should be
used only in those cases where the “earning of the firm before interest and tax” (EBIT) is equal to or
exceed the interest. In case, EBIT is in negative, the cost of debt should be calculated before
adjusting the interest rate for tax.
(b) Debt issued at premium or discount: In case the debentures are issued at premium or discount,
the cost of debt should be calculated on the basis of net proceeds realized on account of issue of
such debentures or bonds. Such cost may further be adjusted keeping in view the tax applicable to
the company. Cost of debt can be calculated according to the following formula:
Kd= I(1-T)/NP
Where,
Kd = Cost of debt after tax.
I = Annual interest payment.
NP = Net proceeds of loans or debentures.
T = Tax rate.
2. Cost of Preference Capital
The computation of the cost of preference capital however poses some conceptual problems. In
case of borrowings, there is legal obligation on the firm to pay interest at fixed rates while in case of
preference shares, there is no such legal obligation. Hence, some people argue that dividends
payable on preference share capital do not constitute cost. However, this is not true. This is
because, though it is not legally binding on the company to pay dividends on preference shares, it is
generally paid whenever the company makes sufficient profits. The failure to pay dividend may be
better of serious concern from the point of view of equity shareholders. They may even lose control
of the company because of the preference shareholders getting the legal right to participate in the
general meetings of the company with equity shareholders under certain conditions in the event of
failure of the company to pay them their dividends. Moreover, the accumulation of arrears of
preference dividends may adversely affect the right of equity shareholders to receive dividends.
This is because no dividend can be paid to them unless the arrears of preference dividend are
cleared. On account of these reasons the cost of preference capital is also computed on the same
basis as that of debentures. The method of its computation can be put in the form of the following
equation:
Kp=Dp/Np
Where,
Kp = Cost of preference share capital
Dp = Fixed preference dividend

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 Np = Net proceeds of preference shares.
In case of redeemable preference shares, the cost of capital is the discount rate that equals the net
proceeds of sale of preference shares with the present value of future dividends and principal
repayments.
3. Cost of Equity Capital
The computation of the cost of equity capital is a difficult task. Some people argue, as observed in
case of preference shares, that the equity capital does not involve any cost. The argument put
forward by them is that it is not legally binding on the company to pay dividends to the equity
shareholders. This does not seem to be a correct approach because the equity shareholders invest
money in shares with the expectation of getting dividend from the company. The company also
does not issue equity shares without having any intention to pay them dividends. The market price
of the equity shares, therefore, depends upon the return expected by the shareholders.
Conceptually cost of equity share capital may be defined as the minimum rate of return that a firm
must earn on the equity financed portion of an investment in a project in order to leave unchanged
the market price of such shares.
From the preceding discussion, it is implied that in order to find out the cost of equity capital, one
must be in a position to determine what the shareholders as a class expect from their investment in
equity shares. This is a difficult proposition because shareholders as a class are difficult to predict
or quantify. Different authorities have conveyed different explanations and approaches.

In order to determine the cost of equity capital, it may be divided into new equity and existing
equity. The following are some of the appropriate according to which the cost of equity capital can
be worked out:
(a) Dividend price (D/P) approach
According to this approach, the investor arrives at the market price of an equity shares by
capitalizing the set of expected dividend payments. Cost of equity capital has therefore been defined
as “the discount rate that equates the present value of all expected future dividends per share with
the net proceeds of the sale (or the current market price) of a share”.
In other words, the cost of equity capital will be that rate of expected dividends which will maintain
the present market price of equity shares.
This approach rightly emphasizes the importance of dividends, but it ignores the fact that the
retained earnings have also an impact on the market price of the equity shares. The approach
therefore does not seem to be very logical.
The cost of new equity can be determined according to the following formula:
Ke =D/NP
Where,
Ke= Cost of equity capital;

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 D= Dividend per equity share;
NP = Net proceeds of an equity share.
In case of existing equity shares, it will be appropriate to calculate the cost of equity on the basis of
market price of the company’s shares. In the present case, it can be calculated according to the
following formula:
Ke = D/MP
Where,
Ke= Cost of equity capital;
D= Dividend per equity share;
MP = Market price of an equity share.
(b) Dividend price plus growth (D/P + g) approach
According to this approach, the cost of equity capital is determined on the basis on the expected
dividend rate plus the rate of growth in dividend. The rate of growth in dividend is determined on
the basis of the amount of dividends paid by the company for the last few years. The computation of
cost of capital according to this approach can be done by using the following formula:
Ke = (D/NP) + g
Where,
Ke = Cost of equity capital;
D= Expected dividend per share;
NP = Net proceeds of per share;
g= Growth in expected dividend.
It may be noted that in case of existing equity shares, the cost of equity capital can also be
determined by using the above formula. However, the market price (MP) should be used in place of
net proceeds (NP) of the shares as given above.
(c) Earning price (E/P) approach
According to this approach, it is the earning per share which determines the market price of the
shares. This is based on the assumption that the shareholders capitalize a stream of future earnings
(as distinguished from dividends) in order to evaluate their share holdings. Hence, the cost of
capital should be related to that earnings percentage which could keep the market price of the
equity shares constant. This approach, therefore, takes into account both dividends as well as
retained earnings. However, the advocates of this approach differ regarding the use of both
earnings and the market price figures. Some simply use of current earning rate and the current
market price of the share of the company for determining the cost of capital. While others
recommend average rate of earnings (based on the earnings of the past few years) and the average
market price (calculated on the basis of market price for the last few years) of equity shares.

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The formula for calculating the cost of capital according to the approach is as follows:
Ke =E/NP
Where
Ke= Cost of equity capital;
D= Earnings per share;
NP = Net proceeds of an equity share.
However, in case of existing equity shares, it will be appropriate to use market price (MP) instead of
net proceeds (NP) for determining the cost of capital.
(d) Realized Yield Approach
According to this approach, the cost of equity capital should be determined on the basis of the
returns actually realized by the investors in a company on their equity shares. Thus, according to
this approach the past records in a given period regarding dividends and the actual capital
appreciation in the value of the equity shares held by the shareholders should be taken to compute
the cost of equity capital.
This approach gives fairly good results in case of companies with stable dividends and growth
records. In case of such companies, it can be assumed with reasonable degree of certainty that the
past behavior will be repeated in the future also.
Q2.What do you understand by project planning? Explain the various aspects on which
Economic Appraisal of a project is done.
Ans:
Project planning is part of project management, which relates to the use of schedules such as Gantt
charts to plan and subsequently report progress within the project environment.
Initially, the project scope is defined and the appropriate methods for completing the project are
determined. Following this step, the durations for the various tasks necessary to complete the work
are listed and grouped into a work breakdown structure. Project planning is often used to organize
different areas of a project, including project plans, work loads and the management of teams and
individuals. The logical dependencies between tasks are defined using an activity network diagram
that enables identification of the critical path. Project planning is inherently uncertain as it must be
done before the project is actually started. Therefore the duration of the tasks is often estimated
through a weighted average of optimistic, normal, and pessimistic cases. The critical chain method
adds "buffers" in the planning to anticipate potential delays in project execution.Float or slack time
in the schedule can be calculated using project management software.Then the necessary resources
can be estimated and costs for each activity can be allocated to each resource, giving the total
project cost. At this stage, the project schedule may be optimized to achieve the appropriate balance
between resource usage and project duration to comply with the project objectives. Once
established and agreed, the project schedule becomes what is known as the baseline schedule.
Progress will be measured against the baseline schedule throughout the life of the project.
Analyzing progress compared to the baseline schedule is known as earned value management.

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The various aspects on which Economic Appraisal of a project is done
Project appraisal is the structured process of assessing the viability of a project or proposal. It
involves calculating the feasibility of the project before committing resources to it. It is a tool that
company’s use for choosing the best project that would help them to attain their goal. Project
appraisal often involves making comparison between various options and this done by making use
of any decision technique or economic appraisal technique.
Project appraisal is a tool which is also used by companies to review the projects completed by it.
This is done to know the effect of each project on the company. This means that the project
appraisal is done to know, how much the company has invested on the project and in return how
much it is gaining from it.
Process of project appraisal
The process of project appraisal consists of five steps and they are – initial assessment, defining
problem and long-list, consulting and short-list, developing options, and comparing and selecting
project. The process of appraisal generally starts from the initial phase of the project. If the
appraisal process starts from an early stage, then the company will be in a better position to decide
how capital should be spend in the project and also it will help them to make the decision of not
spending too much or stopping a project that is not economically viable.
Types of project appraisal
Appraisal of projects can be done by many ways, but the most common of them are financial and
economic appraisal. In case of financial project appraisal, the company reviews the cost of the
project and the expected revenues that will be generated by the project. This type of appraisal helps
the company to prevent overspending on a project. It also helps in finding certain areas where
alterations can be done for generating higher revenues. Under economic appraisal, the company
mainly focuses on the total benefit of the project and less on the costs spent on the project. Other
than these two types of appraisal, there are also other types of project appraisal which include
technical appraisal, management or organizational appraisal and marketing and commercial
appraisal.

Q3.What is project risk? Explain the various techniques used for measurement of project
risk.
Ans:
Project risk is an uncertain event or condition that, if it occurs, has an effect on at least one project
objective.Risk management focuses on identifying and assessing the risks to the project and
managing those risks to minimize the impact on the project. There are no risk-free projects because
there are an infinite number of events that can have a negative effect on the project. Risk
management is not about eliminating risk but about identifying, assessing, and managing risk.
The various techniques used for measurement of project risk
1. Brainstorming

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Is used extensively in formative project planning and can also be used to advantage to identify and
postulate risk scenarios for a particular project. It is a simple but effective attempt to help people
think creatively in a group setting without feeling inhibited or being criticized by others.
The rules are that each member must try to build on the ideas offered by preceding comments. No
criticism or disapproving verbal or nonverbal behaviors are allowed. The intent is to encourage as
many ideas as possible, which may in turn, trigger the ideas of others.
2. Sensitivity Analysis
Sensitivity analysis seeks to place a value on the effect of change of a single variable within a project
by analyzing that effect on the project plan. It is the simplest form of risk analysis. Uncertainty and
risk are reflected by defining a likely range of variation for each component of the original base case
estimate. In practice such an analysis is only done for those variables which have a high impact on
cost, time or economic return, and to which the project is most sensitive.
Some of the advantages of sensitivity analysis include impressing management that there is a range
of possible outcomes, decision making is more realistic, though perhaps more complex. And the
relative importance of each variable examined is readily apparent. Some weaknesses are that
variables are treated individually, limiting the extent to which combinations of variables can be
assessed, and a sensitivity diagram gives no indication of anticipated probability of occurrence.
3. Probability Analysis
Probability analysis overcomes the limitations of sensitivity analysis by specifying a probability
distribution for each variable, and then considering situations where any or all of these variables
can be changed at the same time. Defining the probability of occurrence of any specific variable may
be quite difficult, particularly as political or commercial environments can change quite rapidly.
As with sensitivity analysis, the range of variation is subjective, but ranges for many time and cost
elements of a project estimate should be skewed toward overrun, due to the natural optimism or
omission of the estimator.
4.Delphi Method
The basic concept is to derive a consensus using a panel of experts to arrive at a convergent
solution to a specific problem. This is particularly useful in arriving at probability assessments
relating to future events where the risk impacts are large and critical. The first and vital step is to
select a panel of individuals who have experience in the area at issue. For best results, the panel
members should not know each other identity and the process should be conducted with each at
separate locations.
The responses, together with opinions and justifications, are evaluated and statistical feedback is
furnished to each panel member in the next iteration. The process is continued until group
responses converge to s specific solution.
5. Monte Carlo
The Monte Carlo method, simulation by means of random numbers, provides a powerful yet simple
method of incorporating probabilistic data. Basic steps are:

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a. Assess the range of the variables being considered and determine the probability distribution
most suited to each.
b.For each variable within its specific range, select a value randomly chosen, taking account of the
probability distribution for the occurrence of the variable.
c. Run a deterministic analysis using the combination of values selected for each one of the
variables.
d.Repeat steps 2 and 3 a number of times to obtain the probability distribution of the result.
Typically between 100 and 1000 iterations are required depending on the number of variables and
the degree of confidence required.
6. Decision Tree Analysis
A feature of project work is that a number of options are typically available in the course of
reaching the final results. An advantage of decision tree analysis is that it forces consideration of
the probability of each outcome. Thus, the likelihood of failure is quantified and some value is place
on each decision. This form of risk analysis is usually applied to cost and time considerations, both
in choosing between different early investment decisions, and later in considering major changes
with uncertain outcomes during project implementation.
7. Utility Theory
Utility theory endeavors to formalize management’s attitude towards risk, an approach that is
appropriate to decision tree analysis for the calculation of expected values, and also for the
assessment of results from sensitivity and probability analyses. However, in practical project work
Utility Theory tends to be viewed as rather theoretical.
8. Decision Theory
Is a technique for assisting in reaching decisions under uncertainty and risk. All decisions are based
to some extent on uncertain forecasts. Given the criteria selected by the decision-maker, Decision
Theory points to the best possible course whether or not the forecasts are accurate.

Q4.Explain in detail the various non traditional financial arrangements through which long
term financing can be procured.
Ans:
The various non traditional financial arrangements through which long term financing can be
procured
The funds which are not paid back within a period of less than a year are referred to as long term
finance. Certain long term finance options directly form a part of the permanent capital of the firm.
In such cases, the repayment obligation does not even arise. A 20 year mortgage or 10 year treasury
bills are examples of long term finance. The primary purpose of obtaining long-term funds is to
finance capital projects and carrying out operations on an expansionary scale. Such funds are
normally invested into avenues from which greater economic benefits are expected to arise in
future.

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Sources of Long Term Finance

The nature of such finance can be ownership as well as borrowing or a hybrid of the two. Some of
the main sources of long term finance are listed below
Equity
Equity is the foremost requirement at the time of floatation of any company. They represent the
ownership funds of the company and are permanent to the capital structure of the firm. The equity
can be private or public. Private equity is raised from institutional or high net worth individuals.
Public equity is raised by issuing shares to the public at large which are subscribed to by retail
investors, mutual funds, banks and a pool of other investors. On the flipside, equity is an expensive
variant of long term finance. The investors expect a high return due to the extent of risk involved.

 Pro: No repayment obligation arises during the lifetime of the company.

 Con: Issue of shares via an IPO in the primary market is a costly affair and entails several
legal and banking expenses.
Bonds
Bonds are debt instruments involving two parties- the borrower and the lender. The borrower can
be the government, a local body or a corporation. They provide fixed interest payments at periodic
intervals and are redeemable at a predetermined date in future. Bonds are normally issued against
collateral and are therefore a highly secured form of long term finance. Bonds may prove to be a
very cost effective source of funds in a bullish market.

 Pro: Easier to raise funds via bonds, especially federal bonds since they enjoy complete
investor confidence.
 Con: Subject to interest rate risk. Therefore the price of bonds will fall with an increase in
prevailing interest rates.
Term Loans
Term loans are borrowings made from banks and financial institutions. Such term loans may be for
the medium to long term with repayment period ranging from 1 to 30 years. Such long term
finance is generally procured to fund specific projects (expansion, diversification, capital
expenditure etc) and is, therefore, also known as project finance. Term loans can be sourced by
both small as well as established businesses. Also, the interest rates are relatively low and are
negotiated depending upon the duration of the loan, nature of security furnished, the risk involved
etc.

 Pro: Term loans can be sanctioned immediately within a matter of days depending upon the
financial health of the firm.
 Con: Heavy collaterals are required to be furnished to obtain a term loan. Even then, the
amount of loan disbursed remains a fraction of the asset value.
Internal Accruals

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Internal accruals are nothing but the reserve of profits or retention of earnings that the firm has
created over the years. They represent one of the most essential sources of long term finance since
they are not injected into the business from external sources. Rather it is self-generated and
highlights the sustainability and profitability of the entity Also internal accruals are owner’s funds
and therefore create no charge on the assets of the company.

 Pro: The firm incurs absolutely no cost in raising such funds.

 Con: It may be a source of conflict since the shareholders may prefer payout of dividends
rather than a plough back.
Venture Capital
This form of financing has emerged with the growing popularity of start-up culture worldwide. VC
firms invest into companies at their inception or seed stage. They are constantly on a watch out for
firms demonstrating high growth potential. Their investment takes the form of ownership funds
and forms a part of the permanent capital of the firm. Venture capitalists also have a predetermined
exit strategy before they invest. This results in the target company being listed or a secondary sale
to another VC firm.
For example, direct procurement systems involve the integration of purchasing into a company's
supply-chain management system, delivering the right supplies at the right time. This procurement
method is classified in manufacturing systems as "just-in-time," which minimizes inventory holding
costs and ensures the smooth delivery of supplies needed in the manufacturing process.
Primarily, a procurement process ensures that the company's purchasing is competitive, fair, and
provides the best possible prices available in the market. Because of the efficiencies gained
through a formal procurement process, procurement is an important systems component in a
company's overall management structure. Some problems on a company's cash flow and balance
sheet can be traced to problems with procurement, including holding supplies and inventory too
long and having the terms of payables for supplies not matched to their respective receivables.

Q5.What is financial engineering? Discuss the factors that have contributed to the evolution
of financial engineering?
Ans:
Financial engineering is a multidisciplinary field involving financial theory, methods of engineering,
tools of mathematics and the practice of programming.It has also been defined as the application of
technical methods, especially from mathematical finance and computational finance, in the practice
of finance.Despite its name, financial engineering does not belong to any of the fields in traditional
professional engineering even though many financial engineers have studied engineering
beforehand and many universities offering a postgraduate degree in this field require applicants to
have a background in engineering as well.In the United States, the Accreditation Board for
Engineering and Technology (ABET) does not accredit financial engineering degrees.In the United
States, financial engineering programs are accredited by the International Association of
Quantitative Finance.

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Financial engineering draws on tools from applied mathematics, computer science, statistics and
economic theory.In the broadest sense, anyone who uses technical tools in finance could be called a
financial engineer, for example any computer programmer in a bank or any statistician in a
government economic bureau.However, most practitioners restrict the term to someone educated
in the full range of tools of modern finance and whose work is informed by financial theory.It is
sometimes restricted even further, to cover only those originating new financial products and
strategies.Financial engineering plays a key role in the customer-driven derivatives businesswhich
encompasses quantitative modelling and programming, trading and risk managing derivative
products in compliance with the regulations and Basel capital/liquidity requirements.
The factors that have contributed to the evolution of financial engineering
Computational finance and mathematical finance are both subfields of financial engineering.
Computational finance is a field in computer science and deals with the data and algorithms that
arise in financial modeling. Mathematical finance is the application of mathematics to finance.
Quantitative analyst ("Quant") is a broad term that covers any person who uses math for practical
purposes, including financial engineers. Quant is often taken to mean “financial quant,” in which
case it is similar to financial engineer.The difference is that it is possible to be a theoretical quant, or
a quant in only one specialized niche in finance, while “financial engineer” usually implies a
practitioner with broad expertise.
“Rocket scientist” (aerospace engineer) is an older term, first coined in the development of rockets
in WWII (Wernher von Braun), and later, the NASA space program; it was adapted by the first
generation of financial quants who arrived on Wall Street in the late 1970s and early 1980s. While
basically synonymous with financial engineer, it implies adventurousness and fondness for
disruptive innovation.Financial "Rocket scientists" were usually trained in applied mathematics,
statistics or finance; and spent their entire careers in risk-taking.They were not hired for their
mathematical talents, they either worked for themselves or applied mathematical techniques to
traditional financial jobs.The later generation of financial engineers were more likely to have PhDs
in mathematics or physics and often started their careers in academics or non-financial fields.
The first degree programs in financial engineering were set up in the early 1990s. The number and
size of programs has grown rapidly, so now some people use the term “financial engineer” to mean
someone who has a degree in the field.
An older use of the term "financial engineering" that is less common today is aggressive
restructuring of corporate balance sheets. It is generally (but not always) a disparaging term,
implying that someone is profiting from paper games at the expense of employees and investors.

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