captial budgeting advanced
TRANSCRIPT
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CAPITAL BUDGETINGCAPITAL BUDGETING
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Meaning of Capital BudgetingMeaning of Capital Budgeting
SignificanceSignificance
Capital Budgeting processCapital Budgeting process
Project classification and Investment CriteriaProject classification and Investment Criteria --
Payback methodPayback method
ARR MethodARR Method
Net Present ValueNet Present Value
IRR MethodIRR Method
Profitability Index.Profitability Index.
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Introduction:Introduction:OneOne ofof thethe aspectaspect ofof financialfinancial managementmanagement isis investmentinvestment..
InvestmentInvestment meansmeans expenditureexpenditure inin cashcash oror itsits equivalentequivalent duringduring oneone oror moremore timetime
periodsperiods inin anticipationanticipation ofof enjoyingenjoying aa netnet inflowinflow ofof cashcash oror itsits equivalentequivalent inin somesome futurefuture
timetime periodsperiods..
AppraisalAppraisal ofof InvestmentInvestment isis essentialessential toto knowknow thatthat thethe investmentsinvestments willwill bringbring benefitsbenefits orornotnot..
InvestmentInvestment DecisionDecision:: InvestmentInvestment ProposalProposal
thesethese areare thethe termsterms associatedassociated withwith longlong termterm resourcesresources oror assetsassets
ProposalsProposals involvinginvolving investmentinvestment ofof fundsfunds forfor aa periodperiod ofof tenten oror moremore willwill fallfall inin thethe
categorycategory ofof investmentinvestment.. (( nono hardhard andand fastfast rules)rules)..
LongLong termterm decisionsdecisions regardingregarding planningplanning andand developmentdevelopment ofof availableavailable financialfinancial
resourcesresources forfor wealthwealth maximizationmaximization
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Why Investments are necessary ?Why Investments are necessary ?
Expansion of the business.Expansion of the business.
Diversification of the businessDiversification of the business
Replacement of the Assets/ TechnologyReplacement of the Assets/ Technology Research and DevelopmentResearch and Development
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Capital ExpenditureCapital Expenditure: Expenditure for: Expenditure for
longer period of time involving high risk.longer period of time involving high risk.
the benefit of these expenditure is spreadthe benefit of these expenditure is spreadover number of years.over number of years.
Right of PreRight of Pre--emptive: The right of theemptive: The right of theequity share holders to receive the newequity share holders to receive the new
issue on proissue on pro--rata basisrata basis
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Capital BudgetingCapital Budgeting:: the process ofthe process of
planning for purchases of longplanning for purchases of long--
term assets.term assets.
exampleexample::
Suppose our firm must decide whether toSuppose our firm must decide whether topurchase a new plastic molding machinepurchase a new plastic molding machine
for Rs 2,500,000. How do we decide?for Rs 2,500,000. How do we decide?
Will the machine be profitable?Will the machine be profitable?
Will our firm earn a high rate of returnWill our firm earn a high rate of return
on the investment?on the investment?
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DecisionDecision--making Criteria inmaking Criteria in
Capital BudgetingCapital Budgeting
How do we decide if a capitalHow do we decide if a capital
investment project should beinvestment project should be
accepted or rejected?accepted or rejected?
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The Ideal Evaluation Method should:The Ideal Evaluation Method should:
a) includea) include all cash flowsall cash flows that occurthat occur
during the life of the project,during the life of the project,
b) consider theb) consider the time value of moneytime value of money,,c) incorporate thec) incorporate the required rate ofrequired rate of
returnreturn on the project.on the project.
DecisionDecision--making Criteria inmaking Criteria in
Capital BudgetingCapital Budgeting
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Capital budgeting consists in planningCapital budgeting consists in planning
development of available capital for the purpose ofdevelopment of available capital for the purpose ofmaximizing the long term profitability of themaximizing the long term profitability of the
concernconcern LynchLynch
The main features of capital budgeting areThe main features of capital budgeting area. potentially large anticipated benefitsa. potentially large anticipated benefits
b. a relatively high degree of riskb. a relatively high degree of risk
c. relatively long time period between the initialc. relatively long time period between the initialoutlay and the anticipated return.outlay and the anticipated return.
-- OsterOster YoungYoung
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Meaning of Capital Budgeting:Meaning of Capital Budgeting: Planning for capital assetsPlanning for capital assets
Capital budgeting decisionCapital budgeting decision means deciding whether or not the investment ismeans deciding whether or not the investment isto be made.to be made.
Capital budgeting is the processCapital budgeting is the process of allocating funds for longof allocating funds for long--term investmentterm investmentprojects or proposals,projects or proposals,
Importance of Capital Budgeting:Importance of Capital Budgeting:
Includes huge amount therefore necessary to consider to generate profits.Includes huge amount therefore necessary to consider to generate profits.
Relating to future period therefore affects the growthRelating to future period therefore affects the growth
Once taken difficult to reverseOnce taken difficult to reverse
Complex decisionsComplex decisions Helps for long term financial planningHelps for long term financial planning
Helps of proper replacement and researchHelps of proper replacement and research
Helps to control capital expendituresHelps to control capital expenditures
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ON THE BASIS OFON THE BASIS OF
FIRMSS EXISTENCEFIRMSS EXISTENCE
Replacement andReplacement and
Modernization Decision.Modernization Decision.
(aim is to improve operating(aim is to improve operating
efficiency)efficiency)
Expansion DecisionExpansion Decision
( existing successful firms)( existing successful firms)
Diversification DecisionDiversification Decision
DECISION SITUATIONDECISION SITUATION
Mutually ExclusiveMutually Exclusive
Decision(one taken otherDecision(one taken other
will be excluded).will be excluded).
Accept or Reject Decision.(Accept or Reject Decision.(
when proposals arewhen proposals areindependent and do notindependent and do not
compete with each other).compete with each other).
Contingent DecisionContingent Decision
(depending upon other)(depending upon other)If want start a factory u have toIf want start a factory u have to
build infra ( in remote area)build infra ( in remote area)
TYPES OF CAPITAL INVESTMENT DECISIONSTYPES OF CAPITAL INVESTMENT DECISIONS
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Capital Budgeting ProcessCapital Budgeting Process Examine the various steeps involved inExamine the various steeps involved in
Capital BudgetingCapital Budgeting
Project Generation ( investment generationProject Generation ( investment generation
for the project)for the project) Project Evaluation( evaluation ofProject Evaluation( evaluation of
alternatives).alternatives).
Project Selection (Best)Project Selection (Best) Project Execution ( implementation)Project Execution ( implementation)
FollowFollow--up of the Project( assessment ofup of the Project( assessment of
subsequent results)subsequent results)
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Capital budgeting process involves the followingCapital budgeting process involves the following
11.. ProjectProject generationgeneration:: GeneratingGenerating thethe proposalsproposals forfor investmentinvestment
isis thethe firstfirst stepstep..TheThe investmentinvestment proposalproposal maymay fallfall intointo oneone of of thethe followingfollowing
categoriescategories::
ProposalsProposals toto addadd newnew productproduct toto thethe productproduct line,line,
proposalsproposals toto expandexpand productionproduction capacitycapacity inin existingexisting lineslines
proposalsproposals toto reducereduce thethe costscosts ofof thethe outputoutput ofof thethe existingexisting
productsproducts withoutwithout alteringaltering thethe scalescale ofof operationoperation..
SalesSales campaining,campaining, tradetrade fairsfairs peoplepeople inin thethe industry,industry, RR andand DD
institutes,institutes, conferencesconferences andand seminarsseminars willwill offeroffer widewide varietyvariety ofof
innovationsinnovations onon capitalcapital assetsassets forfor investmentinvestment..
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2.2. Project EvaluationProject Evaluation: it involves two steps: it involves two steps
Estimation of benefits and costs: the benefits and costsEstimation of benefits and costs: the benefits and costs
are measured in terms of cash flows. The estimation ofare measured in terms of cash flows. The estimation ofthe cash inflows and cash outflows mainly depends onthe cash inflows and cash outflows mainly depends on
future uncertainities. The risk associated with eachfuture uncertainities. The risk associated with each
project must be carefully analysed and sufficeintproject must be carefully analysed and sufficeint
provision must be made for covering the differentprovision must be made for covering the differenttypes of risks.types of risks.
Selection of an appropriate criteria to judge theSelection of an appropriate criteria to judge the
desirability of the project: It must be consistent withdesirability of the project: It must be consistent with
the firms objective of maximising its market value.the firms objective of maximising its market value.
The technique of time value of money may come as aThe technique of time value of money may come as a
handy tool in evaluation such proposals.handy tool in evaluation such proposals.
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3.3. ProjectProject SelectionSelection:: NoNo standardstandard administrativeadministrativeprocedureprocedure cancan bebe laidlaid downdown for for approvingapproving thetheinvestmentinvestment proposalproposal.. TheThe screeningscreening andand selectionselectionproceduresprocedures areare differentdifferent fromfrom firmfirm toto firmfirm..
4.4. ProjectProject EvaluationEvaluation:: OnceOnce thethe proposalproposal forfor capitalcapitalexpenditureexpenditure isis finalised,finalised, itit isis thethe dutyduty ofof thethe financefinancemanagermanager toto exploreexplore thethe differentdifferent alternativesalternatives availableavailableforfor acquiringacquiring thethe fundsfunds.. HeHe hashas toto prepareprepare capitalcapitalbudgetbudget.. SufficientSufficient carecare mustmust bebe takentaken toto reducereduce thetheaverageaverage costcost ofof fundsfunds.. HeHe hashas toto prepareprepare periodicalperiodicalreportsreports andand mustmust seekseek priorprior permissionpermission fromfrom thethe toptop
managementmanagement.. SystematicSystematic procedureprocedure shouldshould bebedevelopeddeveloped toto reviewreview thethe performanceperformance ofof projectsprojects duringduringtheirtheir lifetimelifetime andand afterafter completioncompletion..
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TheThe followfollow up,up, comparisoncomparison ofof actualactual performanceperformance withwith
originaloriginal estimatesestimates notnot onlyonly ensuresensures betterbetter forecastingforecasting
butbut alsoalso helpshelps inin sharpeningsharpening thethe techniquestechniques forforimprovingimproving futurefuture forecastsforecasts..
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MMention the factors influencing theention the factors influencing the
capital budgetingcapital budgeting
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Availability of Funds:Availability of Funds:
Company has 3 projects which require 3Company has 3 projects which require 3
Rs 50,000, 1,00,000 and 25,000Rs 50,000, 1,00,000 and 25,000
The company has Rs 75,000 to invest.The company has Rs 75,000 to invest. Working Capital Requirements:Working Capital Requirements: Starting of new project may requireStarting of new project may require
modification in working capital requirements.modification in working capital requirements.
Immediate need of the projectImmediate need of the project : Even if the projects may not earn: Even if the projects may not earn
immediately some of them need to be implemented urgently.immediately some of them need to be implemented urgently.
CuttCutt-- Off Rate:Off Rate: if estimated Return is < Cutt off Rateif estimated Return is < Cutt off Rate-------- Reject theReject theprojectproject
Capital returnCapital return : How much time it takes to return the investments: How much time it takes to return the investments
Taxation policyTaxation policy : Liberal: Liberal helps for easy recovery of investmenthelps for easy recovery of investment Structure of capitalStructure of capital : Leveraged helps to earn more however risk is more: Leveraged helps to earn more however risk is more
Lending policies of financial institutions:Lending policies of financial institutions: Lending rate, surety etc playLending rate, surety etc playrolerole
Government policyGovernment policy: Economic policy: Economic policy------ Direct impact on investmentDirect impact on investmentdecisions.decisions.
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Capital Investment ProposalsCapital Investment Proposals
Independent Proposals: do not compete withIndependent Proposals: do not compete with
another in a way of acceptance . Straightanother in a way of acceptance . Straight
way accepted or rejected directly by theway accepted or rejected directly by the
firm.firm.
Dependent or Contingent: acceptanceDependent or Contingent: acceptance
dependence on another proposal.dependence on another proposal.
Mutually Exclusive Proposals.Mutually Exclusive Proposals.
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Techniques of Evaluating Investment ProposalsTechniques of Evaluating Investment Proposals
Capital Budgeting Appraisal TechniquesCapital Budgeting Appraisal Techniques
What are the techniques of evaluation ofWhat are the techniques of evaluation ofinvestment? Discussinvestment? Discuss
Number of ProposalsNumber of Proposals
Which is to be selectedWhich is to be selected
Number of factorsNumber of factors------ returnsreturns timetime----
benefitsbenefits------ safetysafety------ riskrisk
Finance Manger is responsible to take theFinance Manger is responsible to take the
decision of selectiondecision of selection
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Methods of AppraisalMethods of Appraisal
Traditional Methods:Traditional Methods:
Pay Back PeriodPay Back Period
Accounting Rate of Return ( Return onAccounting Rate of Return ( Return on
Investment)Investment)
Discounted Cash Flow MethodsDiscounted Cash Flow Methods
Net Present Value MethodNet Present Value Method
Internal Rate of Return MethodInternal Rate of Return Method
Profitability Index Method.Profitability Index Method.
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Pay back period methodPay back period method
It refers to the period in which the project will generate theIt refers to the period in which the project will generate the
necessary cash to recover the initial investment.necessary cash to recover the initial investment.It does not take the effect of time value of money.It does not take the effect of time value of money.
It emphasizes more on annual cash inflows, economic lifeIt emphasizes more on annual cash inflows, economic life
of the project and original investment.of the project and original investment.
The selection of the project is based on the earning capacityThe selection of the project is based on the earning capacity
of a project.of a project.
It involves simple calculation, selection or rejection of theIt involves simple calculation, selection or rejection of the
project can be made easily, results obtained is moreproject can be made easily, results obtained is morereliable, best method for evaluating high risk projects.reliable, best method for evaluating high risk projects.
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Cons/ DemeritsCons/ Demerits
It is based on principle of rule of thumb,It is based on principle of rule of thumb,
Does not recognize importance of time value ofDoes not recognize importance of time value of
money,money,
Does not consider profitability of the project,Does not consider profitability of the project,
Does not recognize income beyond pay backDoes not recognize income beyond pay back
period.period.
Does not reflect all the relevant dimensions ofDoes not reflect all the relevant dimensions of
profitability.profitability.
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Payback PeriodPayback Period
The number of years needed to recoverThe number of years needed to recover
the initial cash outlay.the initial cash outlay.
How long will it take for the project toHow long will it take for the project to
generate enough cash to pay for itself?generate enough cash to pay for itself?
PB = InitialPB = Initial cashoutlaycashoutlay
Annual Cash InflowsAnnual Cash Inflows
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Payback PeriodPayback Period
How long will it take for the project toHow long will it take for the project to
generate enough cash to pay for itself?generate enough cash to pay for itself?
( CASH INFLOW is UNIFORM)( CASH INFLOW is UNIFORM)
00 11 22 33 44 55 8866 77
(500) 150 150 150 150 150 150 150 150(500) 150 150 150 150 150 150 150 150
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PBP =PBP = Initial cash outlayInitial cash outlay
Annual Cash InflowsAnnual Cash Inflows
= 500/150= 3.33years= 500/150= 3.33years
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Payback PeriodPayback Period
How long will it take for the projectHow long will it take for the project
to generate enough cash to pay forto generate enough cash to pay for
itself?itself?
00 11 22 33 44 55 8866 77
(500) 150 150 150 150 150 150 150 150(500) 150 150 150 150 150 150 150 150
Payback period = 3.33 years.Payback period = 3.33 years.
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Is a 3.33 year payback period good?Is a 3.33 year payback period good?
Is it acceptable?Is it acceptable?Firms that use this method willFirms that use this method will
compare the payback calculation tocompare the payback calculation to
some standard set by the firm.some standard set by the firm. If our senior management had set aIf our senior management had set a
cutcut--off of 5 years for projects likeoff of 5 years for projects like
ours, what would be our decision?ours, what would be our decision?
Accept the projectAccept the project..
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Drawbacks of Payback Period:Drawbacks of Payback Period:
Firm cutoffs areFirm cutoffs are subjectivesubjective..
Does not considerDoes not consider time value of moneytime value of money..
Does not consider anyDoes not consider any required rate ofrequired rate ofreturnreturn..
Does not consider all of the projectsDoes not consider all of the projects
cash flowscash flows..
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Drawbacks of Payback Period:Drawbacks of Payback Period:
Does not consider all of the projectsDoes not consider all of the projects
cash flows.cash flows.
00 11 22 33 44 55 8866 77
(500) 150 150 150 150 150 (300) 0 0(500) 150 150 150 150 150 (300) 0 0
Consider this cash flow stream!
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Drawbacks of Payback Period:Drawbacks of Payback Period:
Does not consider all of the projectsDoes not consider all of the projects
cash flows.cash flows.
00 11 22 33 44 55 8866 77
(500) 150 150 150 150 150 (300) 0 0(500) 150 150 150 150 150 (300) 0 0
This project is clearly unprofitable, but we
would accept it based on a 4-year payback
criterion!
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Discounted PaybackDiscounted Payback
Discounts the cash flows at the firmsDiscounts the cash flows at the firms
required rate of return.required rate of return.
Payback period is calculated usingPayback period is calculated usingthese discounted net cash flows.these discounted net cash flows.
ProblemsProblems::
Cutoffs are still subjective.Cutoffs are still subjective.
Still does not examine all cash flows.Still does not examine all cash flows.
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Discounted PaybackDiscounted Payback
00 11 22 33 44 55
(500) 250 250 250 250 250(500) 250 250 250 250 250
DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 --500500 --500.00500.00
11 250250 219.30219.30
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Discounted PaybackDiscounted Payback
00 11 22 33 44 55
(500) 250 250 250 250 250(500) 250 250 250 250 250
DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 --500500 --500.00500.00
11 250250 219.30219.30 1 year1 year
280.70280.70
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Discounted PaybackDiscounted Payback
00 11 22 33 44 55
(500) 250 250 250 250 250(500) 250 250 250 250 250
DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 --500500 --500.00500.00
11 250250 219.30219.30 1 year1 year
280.70280.7022 250250 192.38192.38
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Discounted PaybackDiscounted Payback
00 11 22 33 44 55
(500) 250 250 250 250 250(500) 250 250 250 250 250
DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 --500500 --500.00500.00
11 250250 219.30219.30 1 year1 year
280.70280.7022 250250 192.38192.38 2 years2 years
88.3288.32
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Discounted PaybackDiscounted Payback
00 11 22 33 44 55
(500) 250 250 250 250 250(500) 250 250 250 250 250
DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 --500500 --500.00500.00
11 250250 219.30219.30 1 year1 year
280.70280.7022 250250 192.38192.38 2 years2 years
88.3288.32
33250250 168.75168.75
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Discounted PaybackDiscounted Payback
00 11 22 33 44 55
(500) 250 250 250 250 250(500) 250 250 250 250 250
DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 --500500 --500.00500.00
11 250250 219.30219.30 1 year1 year
280.70280.7022 250250 192.38192.38 2 years2 years
88.3288.32
33250250 168.75168.75 .52 years.52 years
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Discounted PaybackDiscounted Payback
00 11 22 33 44 55
(500) 250 250 250 250 250(500) 250 250 250 250 250
DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 --500500 --500.00500.00
11 250250 219.30219.30 1 year1 year
280.70280.7022 250250 192.38192.38 2 years2 years
88.3288.32
33250250 168.75168.75 .52 years.52 years
The DiscountedThe Discounted
PaybackPayback
isis 2.522.52 yearsyears
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Discounted PBP=Discounted PBP=
year of Max recovery + Balance to be recoveredyear of Max recovery + Balance to be recovered
Discounted Cash inflow of the year of Last recoveryDiscounted Cash inflow of the year of Last recovery
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Accounting Rate of Return method/ AverageAccounting Rate of Return method/ Average
Rate of Return MethodRate of Return Method
What is accounting rate of return? Briefly explainWhat is accounting rate of return? Briefly explainits limitations :its limitations :
Accounting ROR means the average annual yieldAccounting ROR means the average annual yield
on the project. Profit after tax and depreciation ason the project. Profit after tax and depreciation asa percentage to the total investment is considered.a percentage to the total investment is considered.
.. ConsidersConsiders thethe earningsearnings ofof thethe projectproject ofof thethe economiceconomic lifelife..
BasedBased onon conventionalconventional accountingaccounting conceptsconcepts..
ThisThis methodmethod hashas beenbeen introducedintroduced toto overcomeovercome thethe disadvantagedisadvantage ofof
paypay backback periodperiod....
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This method of ARR is not commonlyThis method of ARR is not commonly
accepted in assessing the profitability ofaccepted in assessing the profitability ofcapital expenditure. Because the methodcapital expenditure. Because the method
does to consider the heavy cash inflowdoes to consider the heavy cash inflow
during the project period as the earningsduring the project period as the earnings
with be averaged.with be averaged.
The cash flow advantage derived byThe cash flow advantage derived by
adopting different kinds of depreciation isadopting different kinds of depreciation is
also not considered in this method.also not considered in this method.
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AcceptAccept oror RejectReject CriterionCriterion:: UnderUnder thethe method,method, allall project,project, havinghaving
AccountingAccounting RateRate of of returnreturn higherhigher thanthan thethe minimumminimum raterate
establishmentestablishment byby managementmanagement willwill bebe consideredconsidered andand thosethose havinghavingARRARR lessless thanthan thethe prepre--determineddetermined raterate.. ThisThis methodmethod ranksranks aa
ProjectProject asas numbernumber one,one, ifif itit hashas highesthighest ARR,ARR, andand lowestlowest rankrank isis
assignedassigned toto thethe projectproject withwith thethe lowestlowest ARRARR..
MeritsMerits
ItIt isis veryvery simplesimple toto understandunderstand andand useuse..
ThisThis methodmethod takestakes intointo accountaccount savingsaving overover thethe entireentire economiceconomic
lifelife of of thethe projectproject.. Therefore,Therefore, itit providesprovides aa better better meansmeans of of
comparisoncomparison ofof projectproject thanthan thethe paypay backback periodperiod..
ThisThis methodmethod throughthrough thethe conceptconcept ofof "net"net earnings"earnings" ensuresensures aacompensationcompensation ofof expectedexpected profitabilityprofitability ofof thethe projectsprojects andand
ItIt cancan readilyreadily bebe calculatedcalculated byby usingusing thethe accountingaccounting datadata..
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DemeritsDemerits
1. It ignores time value of money.1. It ignores time value of money.
2. It does not consider the length of life of the projects.2. It does not consider the length of life of the projects. 3. It is not consistent with the firm's objective of maximizing the3. It is not consistent with the firm's objective of maximizing the
market value of shares.market value of shares.
4. It ignores the fact that the profits earned can be reinvested.4. It ignores the fact that the profits earned can be reinvested. --
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Give the meaning of discounted cash flow method. WhatGive the meaning of discounted cash flow method. What
are its advantages?are its advantages?
Discounted cash flow methodDiscounted cash flow methodTimeTime adjustedadjusted techniquetechnique isis anan improvementimprovement overover paypay backback methodmethod
andand ARRARR..
AnAn investmentinvestment isis essentiallyessentially outout flowflow of of fundsfunds aimingaiming atat fair fair
percentagepercentage ofof returnreturn inin futurefuture.. TheThe presencepresence ofof timetime asas aa factorfactor inin
investmentinvestment isis fundamentalfundamental forfor thethe purposepurpose of of evaluatingevaluating
investmentinvestment.. TimeTime isis aa crucialcrucial factor,factor, because,because, thethe realreal valuevalue ofof
moneymoney fluctuatesfluctuates overover aa periodperiod ofof timetime.. AA rupeerupee receivedreceived todaytoday hashas
moremore valuevalue thanthan aa rupeerupee receivedreceived tomorrowtomorrow..
InIn evaluatingevaluating investmentinvestment projectsprojects itit isis importantimportant toto considerconsider thethetimingtiming ofof returnsreturns onon investmentinvestment.. DiscountedDiscounted cashcash flowflow techniquetechnique
takestakes intointo accountaccount bothboth thethe interestinterest factorfactor andand thethe returnreturn afterafter thethe
paybackpayback 'period'period..
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Discounted Cash Flow TechniqueDiscounted Cash Flow Technique
It is based on time value of money,It is based on time value of money,
income is spread over a few yearsincome is spread over a few years
Rupee today is more important.Rupee today is more important.
Therefore future income is to be discounted.Therefore future income is to be discounted.
1.1. NPVNPV
2.2. 2. IRR2. IRR
( mention the merits of NPV and IRR)( mention the merits of NPV and IRR)
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DiscountedDiscounted cashcash flowflow techniquetechnique involvesinvolves thethe followingfollowing
stepssteps::
CalculationCalculation ofof cashcash inflowinflow andand outout flowsflows overover thethe entireentirelifelife ofof thethe assetasset..
DiscountingDiscounting thethe cashcash flowsflows byby aa discountdiscount factorfactor
AggregatingAggregating thethe discounteddiscounted cashcash inflowsinflows andand comparingcomparing
thethe totaltotal soso obtainedobtained withwith thethe discounteddiscounted outout flowsflows..
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Net present value methodNet present value method ::
Sum of the present values of all the cash inflows less theSum of the present values of all the cash inflows less the
sum of the present values of all the cash outflowssum of the present values of all the cash outflowsassociated with the proposal.associated with the proposal.
It recognizes the impact of time value of money.It recognizes the impact of time value of money.
It is considered as the best methodIt is considered as the best method
It is widely used in practice.It is widely used in practice.
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The cash inflow to be received at differentThe cash inflow to be received at different
period of time will be discounted at aperiod of time will be discounted at a
particular discount rate. The present valuesparticular discount rate. The present values
of the cash inflow are compared with theof the cash inflow are compared with the
original investment. The differenceoriginal investment. The difference
between the two will be used for accept orbetween the two will be used for accept orreject criteria. If the different yields (+)reject criteria. If the different yields (+)
positive value , the proposal is selected forpositive value , the proposal is selected for
investment. If the difference shows (investment. If the difference shows (--))negative values, it will be rejected.negative values, it will be rejected.
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ProsPros::
ItIt recognizesrecognizes thethe timetime valuevalue ofof moneymoney..
ItIt considersconsiders thethe cashcash inflowinflow ofof thethe entireentire projectproject..ItIt estimatesestimates thethe presentpresent valuevalue ofof theirtheir cashcash inflowsinflows byby usingusing
aa discountdiscount raterate equalequal toto thethe costcost ofof capitalcapital..
ItIt isis consistentconsistent withwith thethe objectiveobjective ofof maximizingmaximizing thethe
welfarewelfare ofof ownersowners..ConsCons::
ItIt isis veryvery difficultdifficult toto findfind andand understandunderstand thethe conceptconcept ofofcostcost ofof capitalcapital
ItIt maymay notnot givegive reliablereliable answersanswers whenwhen dealingdealing withwithalternativealternative projectsprojects underunder thethe conditionsconditions ofof unequalunequal liveslivesofof projectproject..
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Net Present ValueNet Present Value
yyNPV = the total PV of the annual netNPV = the total PV of the annual netcash flowscash flows -- the initial outlay.the initial outlay.
NPVNPV == -- IOIOCFCFtt
(1 + k)(1 + k) tt
nn
t=1t=177
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Net Present ValueNet Present Value
yy Decision RuleDecision Rule::
yy If NPV is positive,If NPV is positive, ACCEPTACCEPT..
yy If NPV is negative,If NPV is negative, REJECTREJECT..
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NPV ExampleNPV Example
Suppose we are considering a capitalSuppose we are considering a capitalinvestment that costs Rs 56,000 and providesinvestment that costs Rs 56,000 and provides
annual net cash flows of Rs.4,000, Rs 16,000 ,annual net cash flows of Rs.4,000, Rs 16,000 ,
Rs 18,000, Rs 20,000 and Rs 25,000 in 1Rs 18,000, Rs 20,000 and Rs 25,000 in 1stst , 2, 2ndnd,,
33rdrd, 4, 4thth and 5and 5thth year. The firms cost of capitalyear. The firms cost of capital
is 10%.Determine whether firm should acceptis 10%.Determine whether firm should accept
the proposal or not?the proposal or not?
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NPV CalculationNPV Calculation
YearYear AnnualAnnual
Cash FlowCash Flow
PV FactorPV Factor PV of CashPV of Cash
FlowsFlows
11 4,0004,000 0.9090.909 3,6363,636
22 16,00016,000 0.8260.826 1321613216
33 18,00018,000 0.7510.751 1351813518
44 20,00020,000 0.6830.683 1366013660
55 25,00025,000 0.6210.621 1552515525
TotalTotal 83,00083,000 68,64568,645
LessLess Initial InvestmentInitial Investment 56,00056,000
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NPV CALCULATION:NPV CALCULATION:
yyNPV = the total PV of the annual netNPV = the total PV of the annual netcash flowscash flows -- the initial outlay.the initial outlay.
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Internal Rate of ReturnInternal Rate of Return
It is that rate at which the sum of discounted cashIt is that rate at which the sum of discounted cash
inflows equals the sum of discounted cashinflows equals the sum of discounted cash
outflows for the proposal. It is the rate at whichoutflows for the proposal. It is the rate at which
the net present value of the investment is zero.the net present value of the investment is zero.
It is the rate of discount which reduces the NPV ofIt is the rate of discount which reduces the NPV ofan investment to zero. It is called internal ratean investment to zero. It is called internal rate
because it depends mainly on the outlay andbecause it depends mainly on the outlay and
proceeds associated with the project and not onproceeds associated with the project and not onany rate determined outside the investment.any rate determined outside the investment.
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MeritsMerits ofof IRRIRR methodmethod
ItIt considerconsider thethe timetime valuevalue ofof moneymoney
CalculationCalculation ofof casotcasot of of capitalcapital isis notnot aaprerequisiteprerequisite forfor adoptingadopting IRRIRR
IRRIRR attemptsattempts toto findfind thethe maximummaximum raterate ofof interestinterestatat whichwhich fundsfunds investedinvested inin thethe projectproject couldcould beberepaidrepaid outout of of thethe cashcash inflowsinflows arisingarising fromfrom thetheprojectproject..
ItIt isis notnot inin conflictconflict withwith thethe conceptconcept of of
maximisingmaximising thethe welfarewelfare of of thethe equityequityshareholdersshareholders..
ItIt considersconsiders cashcash inflowsinflows throughoutthroughout thethe lifelife ofofthethe projectproject..
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ConsCons
Computation of IRR is tedious and difficult toComputation of IRR is tedious and difficult to
understandunderstand
Both NPV and IRR assume that the cash inflowsBoth NPV and IRR assume that the cash inflows
can be reinvested at the discounting rate in thecan be reinvested at the discounting rate in the
new projects. However, reinvestment of funds atnew projects. However, reinvestment of funds atthe cut off rate is more appropriate than at thethe cut off rate is more appropriate than at the
IRR.IRR.
IT may give results inconsistent with NPVIT may give results inconsistent with NPVmethod. This is especially true in case ofmethod. This is especially true in case of
mutually exclusive project.mutually exclusive project.
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Step 1:Calculation of cash outflowStep 1:Calculation of cash outflow
Cost of project/assetCost of project/asset xxxxxxxx
Transportation/installation chargesTransportation/installation charges xxxxxxxx
Working capitalWorking capital xxxxxxxxCash outflowCash outflow xxxxxxxx
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Step 2: Calculation of cash inflowStep 2: Calculation of cash inflow
SalesSales xxxxxxxx
Less: Cash expensesLess: Cash expenses xxxxxxxx
PBDTPBDT xxxxxxxx
Less: DepreciationLess: Depreciation xxxxxxxx
PBTPBT xxxxxxxx
less: Taxless: Tax xxxxxxxx
PATPAT xxxxxxxx
Add: DepreciationAdd: Depreciation xxxxxxxx
Cash inflow p.aCash inflow p.a xxxxxxxx
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Note:Note:
Depreciation = St.Line methodDepreciation = St.Line method
PBDTPBDT Tax is Cash inflow ( if the tax amount isTax is Cash inflow ( if the tax amount is
given)given)
PATBD = Cash inflowPATBD = Cash inflow
Cash inflowCash inflow-- Scrap and working capital must beScrap and working capital must be
added.added.
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Step 3: Apply the different techniquesStep 3: Apply the different techniques
Pay back period= No. of years + Amt to recover/ totalPay back period= No. of years + Amt to recover/ total
cash of next years.cash of next years. ARR = Average Profits after tax/ Net investment x 100ARR = Average Profits after tax/ Net investment x 100
NPV= PV of cash inflowsNPV= PV of cash inflows PV of cash outflowsPV of cash outflows
Profitability index = PV of cash inflows/ PV of cashProfitability index = PV of cash inflows/ PV of cash
outflowsoutflows IRR :IRR :
Pay back factor: Cash outflow/ Avg cash inflow p.a.Pay back factor: Cash outflow/ Avg cash inflow p.a.
Find IRR rangeFind IRR range
PV of Cash inflows for IRR range and then calculate IRRPV of Cash inflows for IRR range and then calculate IRR
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)
IRRIRR: the return on the firms: the return on the firms
invested capital. IRR is simplyinvested capital. IRR is simply
the rate of return that the firmthe rate of return that the firm
earns on its capital budgetingearns on its capital budgeting
projects.projects.
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)
NPVNPV == -- IOIOACFACFtt
(1 + k)(1 + k) tt
nn
t=1t=1
77
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)
n
t=177
IRR: = IOACFt
(1 + IRR) t
NPVNPV == -- IOIOACFACFtt
(1 + k)(1 + k) tt
nn
t=1t=1
77
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)
IRR is the rate of return that makes theIRR is the rate of return that makes the
PV of the cash flowsPV of the cash flows equalequal to the initialto the initial
outlay.outlay.
This looks very similar to our Yield toThis looks very similar to our Yield to
Maturity formula for bonds. In fact, YTMMaturity formula for bonds. In fact, YTM
isis the IRR of a bond.the IRR of a bond.
n
t=1
77IRR: = IO
ACFt
(1 + IRR) t
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Calculating IRRCalculating IRR
Looking again at our problem:Looking again at our problem:The IRR is the discount rate thatThe IRR is the discount rate that
makes the PV of the projected cashmakes the PV of the projected cash
flowsflows equalequal to the initial outlay.to the initial outlay.
0 1 2 3 4 5
(276,400)
83,000 83,000 83,000 83,000 116,000
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This is what we are actually doing:This is what we are actually doing:
83,000 (PVIFA83,000 (PVIFA 4, IRR4, IRR) + 116,000 (PVIF) + 116,000 (PVIF 5, IRR5, IRR))
= 276,400= 276,400
00 11 22 33 44 55
(276,400)(276,400)83,000 83,000 83,000 83,000 116,00083,000 83,000 83,000 83,000 116,000
83 000 83 000 83 000 83 000 116 00083 000 83 000 83 000 83 000 116 000
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This is what we are actually doing:This is what we are actually doing:
83,000 (PVIFA83,000 (PVIFA 4, IRR4, IRR) + 116,000 (PVIF) + 116,000 (PVIF 5, IRR5, IRR))
= 276,400= 276,400
This way, we have to solve for IRR by trialThis way, we have to solve for IRR by trial
and error.and error.
00 11 22 33 44 55
(276,400)(276,400)83,000 83,000 83,000 83,000 116,00083,000 83,000 83,000 83,000 116,000
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IRR with your CalculatorIRR with your Calculator
IRR is easy to find with yourIRR is easy to find with your
financial calculator.financial calculator.
Just enter the cash flows as you didJust enter the cash flows as you did
with the NPV problem and solve forwith the NPV problem and solve for
IRR.IRR.
You should getYou should get IRR = 17.63%!IRR = 17.63%!
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IRRIRR
yy Decision RuleDecision Rule::
yy If IRR is greater than or equalIf IRR is greater than or equalto the required rate of return,to the required rate of return,ACCEPTACCEPT..
yy If IRR is less than the requiredIf IRR is less than the requiredrate of return,rate of return, REJECTREJECT..
IRR is a good decisionIRR is a good decision makingmaking
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IRR is a good decisionIRR is a good decision--makingmaking
tool as long as cash flows aretool as long as cash flows are
conventionalconventional.. ((-- + + + + +)+ + + + +)
Problem: If there are multipleProblem: If there are multiple
sign changes in the cash flowsign changes in the cash flow
stream, we could get multiplestream, we could get multiple
IRRs.IRRs. ((-- + ++ + -- + +)+ +)
IRR is a good decisionIRR is a good decision makingmaking
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IRR is a good decisionIRR is a good decision--makingmaking
tool as long as cash flows aretool as long as cash flows are
conventionalconventional.. ((-- + + + + +)+ + + + +)
Problem: If there are multipleProblem: If there are multiple
sign changes in the cash flowsign changes in the cash flow
stream, we could get multiplestream, we could get multiple
IRRs.IRRs. ((-- + ++ + -- + +)+ +)
0 1 2 3 4 5
(500) 200 100 (200) 400 300
IRR is a good decisionIRR is a good decision makingmaking
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IRR is a good decisionIRR is a good decision--makingmaking
tool as long as cash flows aretool as long as cash flows are
conventionalconventional.. ((-- + + + + +)+ + + + +)
Problem: If there are multipleProblem: If there are multiple
sign changes in the cash flowsign changes in the cash flow
stream, we could get multiplestream, we could get multiple
IRRs.IRRs. ((-- + ++ + -- + +)+ +)
0 1 2 3 4 5
(500) 200 100 (200) 400 300
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Problem: If there are multipleProblem: If there are multiple
sign changes in the cash flowsign changes in the cash flow
stream, we could get multiplestream, we could get multiple
IRRs.IRRs. ((-- + ++ + -- + +)+ +)
We could find 3 different IRRs!We could find 3 different IRRs!
0 1 2 3 4 5
(500) 200 100 (200) 400 300
1 2 31 2 3
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Summary Problem:Summary Problem:
Enter the cash flows only once.Enter the cash flows only once.
Find theFind the IRRIRR..
Using a discount rate of 15%, findUsing a discount rate of 15%, find NPVNPV..Add back IO and divide by IO to getAdd back IO and divide by IO to get PIPI..
0 1 2 3 4 5
(900) 300 400 400 500 600
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Summary Problem:Summary Problem:
IRR =IRR = 34.37%.34.37%.
Using a discount rate of 15%,Using a discount rate of 15%,
NPV =NPV = $510.52.$510.52.PI =PI = 1.57.1.57.
0 1 2 3 4 5
(900) 300 400 400 500 600
P fi bili I dP fi bili I d
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Profitability IndexProfitability Index
NPVNPV == -- IOIOACFACFtt
(1 + k)(1 + k) tt
nn
t=1t=1
77
P fit bilit I dP fit bilit I d
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Profitability IndexProfitability Index
t
NPVNPV == -- IOIOACFACFtt
(1 + k)(1 + k) tt
nn
t=1t=1
77
PI = IOACFt(1 + k)
n
t=177
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Profitability IndexProfitability Index
yy Decision RuleDecision Rule::
yy If PI is greater than or equalIf PI is greater than or equal
to 1,to 1, ACCEPTACCEPT..
yy If PI is less than 1,If PI is less than 1, REJECTREJECT..
P fit bilit I d M th d/ B fit C tP fit bilit I d M th d/ B fit C t
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Profitability Index Method/ Benefit CostProfitability Index Method/ Benefit Cost
Ratio Method/ Desirability FactorRatio Method/ Desirability Factor
Method for comparing the proposals eachMethod for comparing the proposals each
involving different amount of cash inflows.involving different amount of cash inflows.
PI is worked out , if index value = 1 projectPI is worked out , if index value = 1 project
is accepted otherwise rejected.is accepted otherwise rejected.
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Merits:Merits:
Uses the concept of time value.Uses the concept of time value.
Better than NPVBetter than NPV
Demerits:Demerits: Fails to as a guide in resolving capitalFails to as a guide in resolving capital
rationing.rationing.
Project with a lower profitability index mayProject with a lower profitability index maybe selected which may generate cash flowbe selected which may generate cash flow
which can be used for another project.which can be used for another project.
C i l R i i A i i h fiC i l R i i A i i h fi
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Capital Rationing: A situation where a firmCapital Rationing: A situation where a firm
has more investment proposals than it canhas more investment proposals than it can
finance. It may be defined as a situationfinance. It may be defined as a situationwhere a constraint is placed on the total sixewhere a constraint is placed on the total sixe
of capital investment during a particularof capital investment during a particular
period.period. firm to select combination of investmentsfirm to select combination of investments
proposals that provide the highest NPVproposals that provide the highest NPV
subject to the budget constraint for thesubject to the budget constraint for the
period.period.
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CutCut ofof Rate: Minimum rate which theRate: Minimum rate which the
management wishes to have from anymanagement wishes to have from any
project. It is usually based on cost ofproject. It is usually based on cost of
capital.capital.
Factoring:Factoring:
a factor is a financial institution whicha factor is a financial institution which
provides the management and financialprovides the management and financial
services like financing of debt arising out ofservices like financing of debt arising out of
credit sales.credit sales.They maintain required records and renderThey maintain required records and render
advisory service to the clients.advisory service to the clients.
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Thank YouThank You