Thus the available capital will be allocated to the

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expenditure. Thus, the available capital will be allocated to the projects that will benefit the company and its shareholders the most HARD CAPITAL RATIONING: capital market unwilling to provide funds, not common SOFT CAPITAL RATIONING: management limits amount because: poor performance, not prepared to accept lender’s conditions, managers want to limit equity issues & adverse market conditions IX. PROFITABILITY INDEX Shows relative profitability of project or present value benefits per dollar of cost PI = ( NPV + initial cost ) initialcost DECISION RULE: ACCEPT PI ≥ 1, REJECT PI < 1 7. LECTURE 7 – Capital Budgeting 2 I. CASH FLOW TIMING 1. Cash flows at the start Occurs at beginning of project’s life Include purchase of plant and equipment, establishment expenses, proceeds from sale of old machine, investment in working capital (inventory), market value of assets owned that are to be used in project (opportunity cost) ALWAYS include TAX ON SALES = (WDV – salvage value) x company tax rate 2. Cash flows over the life 8 | P a g e
Occurs over the life span of project Find total cash flow before tax, find tax (CF x company tax rate), then depreciation tax saving (depreciation x company tax rate) 3. Cash flows at the end One-off group of cash flows occur at end of project’s life Include recovered working capital (inventory), salvage value of assets + tax saving, sale of new machines 8. LECTURE 8 – Risk & Return I. HISTORICAL RETURN AN investment is the purchase of an asset with the expectation of making positive future returns Investment should compensate investor for time, inflation and risk Risk is uncertainty of future returns PERCENTAGE RETURNS: Measures return taking into account the amount invested CAPITAL GAINS YIELD: R t = Ending Price Starting Price Starting Price = P t P t 1 P t 1 Measures value of investment ONLY! The average return on an investment is: ´ R = r i n Where r i = return for period I & n = number of observations II. HISTORICAL RISK Risk is variability of returns i.e. standard deviation The larger the standard deviation, the greater the spread of returns = HIGHER RISK The smaller the standard deviation, the narrower the spread of returns = LOWER RISK If asset has PERFECT CERTAINTY, standard deviation = 0 s = ( R 1 ´ R ) 2 +( R 2 ´ R ) 2 + +( R n ´ R ) 2 n 1 III. CAPITAL MARKET EFFICIENCY Prices of securities change due to new information arriving and change quickly as there are many investors & competition Competition among investors is an important driver of informational efficiency If markets are efficient, investors and financial managers can believe securities are priced at or near true value Overall efficiency of a capital market depends on its operational and informational efficiency In an efficient market, market prices adjust quickly to new information about a security as it becomes available Market efficiency can be explained at 3 form levels: 1. Strong, 2. Semi-strong and 3. Weak ROLE OF SECURITIES MARKETS – Efficient Market Hypothesis (EMH) 9 | P a g e
IV. EXPECTED RETURN Assigning probabilities to different outcomes allows a measure of the return that can be expected in the long-run E ( R ) = P i ×R i Where P i = Probability of outcome I & R i = Return of outcome i V.

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