Tag: Strategic Financial Management BMS Notes

The Capital budgeting is based on Cash flows. These cash flows are estimated cash flows. The estimation on future returns, cash flows, is done on the basis of various assumptions. The actual returns in terms of cash inflows depend on a variety of factors such as price, sales volume, effectiveness of advertising campaign, competition, cost of raw material, manufacturing cost and so on. Each of these, in term, depends on other variables like the state economy, the rate of inflation, govt policy and so on. Risk in the variability in the actual returns in relation to estimated return as forecast at the time of initial capital budgeting decisions.

It was assumed that those investment proposals did not involve any kind of risk, i.e., whatever the proposal is undertaken, there would not be any change in the business risk which are apprehended by the suppliers of capital. Practically, in real world situation, this seldom happens.

We know that decisions are taken on the basis of forecast which again depends on future events whose happenings cannot be anticipated/predicted with absolute cer­tainly due to some factors, e.g., economic, social, political etc. That is why question of risk and uncertainty appear before the business world although it varies from one investment proposal to another.

For example, some proposal may not even involve any risk, e.g., investment in Government bonds and securities where there is a fixed rate of return exists, some may be less risky, e.g., expansion of the existing business, others may be more risky, e.g., setting up a new operation.

That is, different investment proposals have different degrees of risk. It should be remembered that if there is any change in business risk complexion, there remains also a change in the apprehension of the creditors and the investors about the firm as well In short, if the acceptance of any proposal proves the firm more rising, creditors and investors will not be interested or will not consider it with favour which, in other words, adversely affect the total valuation of the firm.

Therefore, while evaluating investment proposals care should be taken about the effect that their acceptance may have on the firm’s business risk as apprehended by the creditors and/or investors. As such, the firm should always prefer a less risky investment proposal than a more risky one.

The riskiness of an investment proposal may be defined as the variability of its possible terms, i.e., the variability which may likely be occurred in the future returns from the project. For example, if a person invests Rs 25,000 to short-term Govern­ment securities, carrying 12% interest, he may accurately estimate his future return year after year since it is absolutely risk-free.

On the contrary, instead of investing Rs 25,000 m short-term Government security, if he wants to purchase the shares of a company, then it is not at all possible for him to estimate the future returns accurately, since the dividend rates of a company may widely vary, viz., from 0% to a very high figure.

Therefore, as there is a high degree of variability relating to future returns, it is relatively risky as compared to his investment in Government securities. Thus, the risk may be defined as the variability which may likely to accrue in future between the estimated/expected returns and actual returns. The greater is the variability between the two, the risker the project and vice-versa.

Risk:

It involves situations in which the probabilities of a particular event which occurs are known, i.e., chance of future loss can be foreseen.

Uncertainty:

The difference between risk and uncertainty, therefore, lies in the fact that variability is less in risk than in uncertainty. The risk situation is one in which the probability of occurrence of a particular event is known. These probabilities are not Known under uncertainty situation.

Risk refers to a set of unique outcomes for a given event which can be assigned probability, while uncertainty refers to the outcomes to a given event which are too unsure to be assigned probabilities. However, in practical terms, risk and uncertainty are used interchangeably.

In brief, risk with reference to capital Budgeting, results from the variation between the estimated and actual return. The greater the variability between the two, the riskier is the project.

Various evaluation methods are used for risk and uncertainty in capital budgeting are as follows:

(i) Risk-adjusted cut off rate (or method of varying discount rate)

(ii) Certainly equivalent method.

(iii) Sensitivity technique.

(iv) Probability technique

(v) Standard deviation method.

(vi) Co-efficient of variation method.

(vii) Decision tree analysis.

The immediate earlier approach, viz., the Probability Assignment Approach, through the calculation of expected monetary value, does not supply a precise value about the variability of cash flow to the decision-maker.

Two Projects have the same cash outflow and their net values are also the same, standard durations of the expected cash inflows of the two Projects may be calculated to measure the comparative and risk of the Projects. The project having   a higher standard deviation in said to be riskier as compared to the other.

Example

From the following information, ascertain which project should be selected on the basis of standard deviation.

Solution

Project X

n= 1 , ∑fd² = 38,30,500

Standard Deviation (6)

= √(∑fd²/n)

= √(3830500/1)

= 1957.2

Capital Rationing is a strategy used by companies or investors to limit the number of projects they take on at a time. If there is a pool of available investments that are all expected to be profitable, capital rationing helps the investor or business owner choose the most profitable ones to pursue.

Companies that employ a capital rationing strategy typically produce a relatively higher return on investment (ROI). This is simply because the company invests its resources where it identifies the highest profit potential.

Types of Capital Rationing

Soft capital rationing

In contrast, soft capital rationing refers to a situation where a company has freely chosen to impose some restrictions on its capital expenditures, even though it may have the ability to make much higher capital investments than it chooses to. The company may choose from any of a number of methods for imposing investment restrictions on itself. For example, it may temporarily require that a project offer a higher rate of return than is usually required in order for the company to consider pursuing it. Or the company may simply impose a limit on the number of new projects that it will take on during the next 12 months.

Hard capital rationing

Hard capital rationing represents rationing that is being imposed on a company by circumstances beyond its control. For example, a company may be restricted from borrowing money to finance new projects because it has suffered a downgrade in its credit rating. Thus, it may be difficult or effectively impossible for the company to secure financing, or it may only be able to do so at exorbitant interest rates.

Advantages:

More Stability

As the company is not investing in every project, the finances are not over-extended. This helps in having adequate finances for tough times and ensures more stability and an increase in the stock price of the company.

Fewer Projects

Capital rationing ensures that less number of projects are selected by imposing capital restrictions. This helps in keeping the number of active projects to a minimum and thus manage them well.

Budget

The first and important advantage is that capital rationing introduces a sense of strict budgeting of the corporate resources of a company. Whenever there is an injunction of capital in the form of more borrowings or stock issuance capital, the resources are properly handled and invested in profitable projects.

Higher Returns

Through capital rationing, companies invest only in projects where the expected return is high, thus eliminating projects with lower returns on capital.

No Wastage

Capital rationing prevents wastage of resources by not investing in each new project available for investment.

Disadvantages

Intermediate Cash Flows

Capital rationing does not add intermediate cash flows from a project while evaluating the projects. It bases its decision only on the final returns from the project. Intermediate cash flows should be considered in keeping the time value of money in mind.

Un-Maximizing Value

Capital rationing does not allow for maximizing the maximum value creation as all profitable projects are not accepted and thus, the NPV is not maximized.

Efficient Capital Markets

Under efficient capital markets theory, all the projects that add to company’s value and increase shareholders’ wealth should be invested in. However, by following capital rationing and investing in only certain projects, this theory is violated.

Small Projects

Capital rationing may lead to the selection of small projects rather than larger-scale investments.

Cost of Capital

In addition to limits on budget, capital rationing also places selective criteria on the cost of capital of shortlisted projects. However, to follow this restriction, a firm has to be very accurate in calculating the cost of capital. Any miscalculation could result in selecting a less profitable project.

XBRL (eXtensible Business Reporting Language) is a freely available and global framework for exchanging business information. XBRL allows the expression of semantic meaning commonly required in business reporting. The language is XML-based and uses the XML syntax and related XML technologies such as XML Schema, XLink, XPath, and Namespaces. One use of XBRL is to define and exchange financial information, such as a financial statement. The XBRL Specification is developed and published by XBRL International, Inc. (XII).

XBRL is a standards-based way to communicate and exchange business information between business systems. These communications are defined by metadata set out in taxonomies, which capture the definition of individual reporting concepts as well as the relationships between concepts and other semantic meaning. Information being communicated or exchanged is provided within an XBRL instance.

Advantages:

XBRL offers major benefits at all stages of business reporting and analysis. The benefits are seen in automation, cost saving, faster, more reliable and more accurate handling of data, improved analysis and in better quality of information and decision-making. All types of organisations can use XBRL to save costs and improve efficiency in handling business and financial information. Because XBRL is extensible and flexible, it can be adapted to a wide variety of different requirements. All participants in the financial information supply chain can benefit, whether they are preparers, transmitters or users of business data.

XBRL enables producers and consumers of financial data to switch resources away from costly manual processes, typically involving time-consuming comparison, assembly and re-entry of data. They are able to concentrate effort on analysis, aided by software which can validate and manipulate XBRL information.

Data Collection and Reporting

By using XBRL, companies and other producers of financial data and business reports can automate the processes of data collection. For example, data from different company divisions with different accounting systems can be assembled quickly, cheaply and efficiently if the sources of information have been upgraded to using XBRL. Once data is gathered in XBRL, different types of reports using varying subsets of the data can be produced with minimum effort. A company finance division, for example, could quickly and reliably generate internal management reports, financial statements for publication, tax and other regulatory filings, as well as credit reports for lenders. Not only can data handling be automated, removing time-consuming, error-prone processes, but the data can be checked by software for accuracy.

Data Consumption and Analysis

Users of data which is received electronically in XBRL can automate its handling, cutting out time-consuming and costly collation and re-entry of information. Software can also immediately validate the data, highlighting errors and gaps which can immediately be addressed. It can also help in analysing, selecting, and processing the data for re-use. Human effort can switch to higher, more value-added aspects of analysis, review, reporting and decision-making. In this way, investment analysts can save effort, greatly simplify the selection and comparison of data, and deepen their company analysis. Lenders can save costs and speed up their dealings with borrowers. Regulators and government departments can assemble, validate and review data much more efficiently and usefully than they have hitherto been able to do.

Disadvantages

Cost

The largest disadvantage remains cost. According to Malin, Bergquist and Company, LLP, “Although some experts say, over time, XBRL could lead to up to a twenty five percent decrease in reporting costs, some companies may find it difficult to justify the initial costs. ” Unless a company has an automated tagging process, tagging XBRL data consumes hours of labour, increasing the cost associated with using the language.

Company transparency

A big push for the use of XBRL involves financial transparency. XBRL takes away a company’s ability to “hide” financial tricks in the books. Despite the fact that XBRL’s design makes filing financial information easier, cheaper and faster, investors could find themselves digging deeper to determine the exact data reported.

Inexperienced users

Not all accountants have familiarity with XBRL; in fact, some have only heard of the language. XBRL’s complexity combined with letting inexperienced users create data for transmission increases the opportunity for errors. These errors lead to a lack of confidence in the system and by investors. Because of this reason, many companies outsource the implementation of XBRL instead of letting in-house management information systems resources (MIS) manage the implementation. This outsourcing leads to increased cost and defeats the cost-cutting benefits associated with implementing XBRL.

Security

Because XBRL data remains available at all times, it requires more security to maintain its integrity. These stricter security requirements not only affect security breaches initiated outside of the company’s database, but security breaches from within the company as well. More accurate data makes XBRL a great tool, but it also means the data must remain secure. If a data breach occurs and investors gain access to the breached data (because of its constant availability) then inaccurate investment decisions could stem from the breach.

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