PAYBACK PERIOD

The payback period is the length required to recover the initial cash outlay on the project. For example if a project involves a cash outlay of Rs600000 and generates cash inflows of Rs 100000, Rs 150000 Rs 150000 and Rs 200000, in the first, second, third, and fourth years, respectively, its payback period is 4 years because the sum of cash inflows during 4 years is equal to the initial outlay divided by the annual cash inflows. For example a project which has an initial cash outlay of Rs 1000000/300000=3 1/3 years.
According to the payback criterion, the shorter the payback period, the more desirable the project. Firms using this criterion generally specify the maximum acceptable payback period. If this is n years, projects with a payback period of n years or less are deemed worthwhile and projects with a payback period exceeding n years are considered unworthy.

Evaluation

A widely used investment criterion, the payback period seems to offer the following advantages.

1. It is simple, both in concept and application. It does not use involved concepts and tedious calculations and has few hidden assumptions.

2. It is a rough and ready method for dealing with risk. It favours projects which generate substantial cash inflows in earlier years and discriminates against projects which bring substantial cash inflows in later years but not in earlier years. Now if risk tends to increase with futurity in general, this may be true the payback criterion may be helpful in weeding out risky projects.

3. Since it emphasises earlier cash inflows, it may be a sensible criterion when the firm is pressed with problems of liquidity.

PROJECT CLASSIFICATION

Project analysis  entails time and effort. The costs incurred in this exercise must be justified by the benefits from it. Certain projects, given their complexity and magnitude may warrant a detailed analysis other may call for a relatively simple analysis. Hence firms normally classify projects into different categories
 Each category is then analysed somewhat differently.
While the system of classification may vary from one firm to another, the following categories are found in most classifications.

Mandatory investment

These are expenditures required to comply with statutory requirement. Examples of such investment are pollution control equipment, medical dispensary, fire fighting equipment, creche in factory premises, and so on. These are often non revenue producing investments. In analysing such investments, the focus is mainly on finding the most cost effective way of fulfilling a given statutory need.

Replacement projects

Firms routinely invest in equipment meant to replace obsolete and inefficient is to reduce costs, increase yield and improve quality. Replacement projects can be evaluated in a fairly straightforward manner, though at times the analysis may be quite detailed.

Expansion projects

These investments are meant to increase capacity and/or widen the distribution network. Such investments call for an explicit forecast of growth. Since this can be risky and complex, expansion projects normally warrant more careful analysis than replacement projects. Decisions relating to such projects are taken by the top management.

Diversification projects

These investments are aimed at producing new products or services or entering into entirely new geographical areas. Often diversification projects entail substantial risks, involve large outlays, and require considerable managerial effort and attention. Given their strategic importance, such projects call for a very thorough evaluation, both quantitative and qualitative. Further they require a significant involvement of the board of directors.

Research and development projects

Traditionally, R&D projects absorbed a very small proportion of capital budget in most Indian companies. Things however are changing. Companies are now allocating more funds to R&D projects, more so in knowledge intensive industries.R&D projects are characterised by numerous uncertainties and typically involve sequential decision making. Hence the standard DCF analysis is not applicable to them. Such projects are decided on the basis of managerial judgement. Firms which rely more on quantitative methods use decision tree analysis and option analysis to evaluate R&D projects.

Miscellaneous projects

This is a catch all category that includes items like interior decoration, recreational facilities, executive, landscaped gardens, and so on. There is on personal preferences of top management.

DISTINCTION AMONG VALUATION CONCEPTS

The term value is used in different senses. Hence, let us briefly review the differences that exist among the major concepts of value.

Liquidation value versus going concern value

The liquidation value is amount that can realised when an asset or a group of assets representing a part or even the whole of a firm is sold separately from the operating organisation to which it belongs. In contrast the going concern value represents the amount that can be realised if the firm is sold as a continuing operating entity.

In general security valuation models assume a going concern an operating business entity that generates cash flows to its security holders. When the going concern assumption is not appropriate as in the cash of an impending bankruptcy, liquidation value of assets is more relevant in determining the worth of the firm's financial securities.

Book value versus market value

The book value of an asset is the accounting value of the asset, which is simply the historical cost of the asset less accumulated depreciation or amortisation as the case may be. The book value of a firm's equity is equal to the book value of its assets minus the book value of its liabilities. Because the book value reflects a historical accounting value it may diverge significantly from the market value.

The market value of an asset is simply the market price at which the asset trades in the market place. Often the market value is greater than the book value.

Market value versus intrinsic value

As the nomenclature suggests, the market value of a security is the price at which the security trades in the financial market.

The intrinsic value of a security is the present value of the cash flow stream expected from the security, discounted at a rate of return appropriate for the risk associated with the security. Put differently, intrinsic value is economic value. If the market is reasonably efficient, the market price of the security should hover around its intrinsic value. 

SALES FORECAST

The sales forecast is typically point of the financial forecasting exercise. Most of the financial variables are projected in relation to the estimated level of sales. Hence the accuracy of the financial forecast depends critically on the accuracy of the sales forecast.
Although the financial managers may participate in the process of developing the sales forecast, the primary responsibility for if typically vests with the marketing department or planning group.
Sales forecast may be prepared for varying planning horizons to serve different purposes. A sales forecast for a period of 3-5 years. Of for even longer durations, may be developed mainly to aid investment planning. A sales forecast for a period of one year is the primary basis for the financial forecasting exercise discussed in this chapter. Sales forecasts for shorter durations may be prepared for facilitating working capital planning and cash budgeting.
A wide range of sales forecasting techniques and methods are available. They may be divided into three broad categories.

* Qualitative Techniques

These techniques rely essentially on the judgement of experts to translate qualitative information into quantitative estimates.

* Time series projection methods

These methods generate forecasts on the basis of an analysis of the past behaviour of time series.

*  Causal models

These techniques seek to develop forecast based on cause effect relationship expressed in explicit quantitative manner.

WHAT AND WHY OF FINANCIAL PLANNING

A long term financial plan represents a blueprint of what a firm proposes to do in the future. Typically it covers a period of three to ten years most commonly it spans a period of five years. Naturally planning over such an extended time horizon tends to be in fairly aggregative terms. While there is considerable variation in the scope, degree of formality and level of sophistication in financial planning across firms, most corporate financial plans have certain common elements. These are.

1. Economic assumptions

The financial plan is based on certain assumptions about the economic environment.

2. Sales forecast

The sale forecast is typically the starting point of the financial forecasting exercise. Most financial variables are related to the sales figure.

3. Pro forma statements.

The heart of a financial plan are the pro forma profit  and loss account and balance sheet.

4. Asset requirements

Firms need to invest in plant and equipment and working capital. The financial plan spells out the projected capital investment and working capital requirements over time.

5. Financing plan

Suitable sources of financing have to be thought of for supporting the investment in capital expenditure and working capital. The financing plan delineates the proposed means of financing.

6. Cash budget

The cash budget shows the cash inflows and outflows expected in the budget period.

LEVERAGES

Leverage arises from the presence of fixed costs in a firm's cost structure. It is useful to classify leverage as operating and financial leverage.

Operating Leverage

Operating leverage stems from the presence of fixed costs. When a firm has fixed operating costs, a change in 1 percent in sales results in a change of more than 1 percent in PBIT.

Financial leverage

Financial leverage arises from the use of fixed cost financing. When a firm has fixed cost financing a change in 1 percent in PBIT  results in a change of more than 1 percent in earnings per share.

Total leverage

Total leverage refers to the combination of operating leverage and financial leverage. Thanks to the presence of fixed operating costs and fixed financing costs, a given change in sales is translated into a larger relative change in earnings pet share through  a two step magnification process.

BREAK EVEN ANALYSIS

Like ratio analysis, break even analysis also called cost volume profit analysis, is a tool for financial analysis. It is primarily concerned with the following issues.
1. How profit varies with changes in output?
2. How profit varies with changes in costs prices?

Basic Assumptions

A simple tool for profit planning and analysis,break even analysis is based on several assumptions

Cost classification

The break even model assumes that the costs of the firm can be divided into two components.

A. Fixed costs

B. Variable costs.

Fixed costs remain constant irrespective of the changes in output. They include items such as managerial and supervisory salaries, depreciation charges, property tax, rent, interest on term loans, insurance and so on. Variable costs vary proportionately with output. They include items like material cost, power cost, and selling commission.

Constancy of unit selling price

This implies that the total revenue of the firm is a linear functions of the output. For firms which have a strong market for their products, this Assumptions is quote valid. For other firms, however it may not be so. Price reduction might assumption and not unrealistic enough to impair the validity of the cost volume profit model, particularly in the relevant range of output.

Stability of product mix

In the case of a multi product firm, the cost volume profit model assumes that the product mix of the firm remains stable. Without this premise, it is not possible to define the average variable profit ratio when different products have different variable profit ratios. While it is necessary to make this assumption, it must be borne in mind that the actual mix of products may differ from the planned one. Where this discrepancy is likely to be significant, cost volume profit model has limited applicability.

No change in inventory

A final assumption underlying the conventional cost volume profit model is that the volume of sales is equal ti the volume of production during an accounting period. Put differently inventory changes are assumed to be nil. This is required because in cost volume profit analysis, we match total costs and total revenues for a particular period