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Capital rationing is a strategy opted by companies that restrict the company’s investment in only one project at a given point of time. When several investments are available, the business needs to invest in the most profitable one.Companies that rely on capital rationing usually have higher return on investment. This is simply because the company chooses the option where profitability is guaranteed and at its maximum.Benefits of Capital RationingCapital rationing often leads to the most successful projects and hence it often guarantees the highest return on investment. Investors are interested in capital rationing because this gives them the idea of ... Read More
The theory of the net income approach suggests increasing the value of a firm by decreasing the overall cost of capital. The cost of capital in the theory is measured in terms of Weighted Average Cost of Capital (WACC). It can be done by incurring and collecting a higher proportion of debt because it is a cheaper source of finance in comparison to equity finance.WACC is the weighted average costs of equity and debts, and the weights are the units of capital collected from each source.According to the Net Income Approach theory, changes in the financial leverage of a firm ... Read More
Qualitative factors play an important role in capital budgeting decisions. Although capital budgeting relies more on quantitative measures, there are abrupt influences of qualitative factors on capital budgeting decisions. Qualitative factors are not expressed in capital budgeting decisions (unlike quantitative factors), however, in terms of context, qualitative factors are equally important.Qualitative Factors Vary According to DemongraphyQualitative factors usually change according to markets and demography where a project has to be implemented. For example, in India, the three qualitative factors that guide projects are urgency, strategy, and environment. Each of these three factors needs to be considered in the case of ... Read More
The valuation approach of capital structure is one of the ways capital structures are formed with debt and equity. In fact, shareholders have more risk than debt holders because the cost of equity is higher than the cost of debt. In such situations, owning debt is cheaper than owning equity. A firm will therefore be tempted to go for debt instead of equity when both the options are available.Higher debt, however, increases the risk of default. It increases financial distress and agency costs. The tax deductibility, however, decreases the amount of payback amount. So, there is a constant tradeoff between ... Read More
The decision tree analysis process is an extremely useful tool to calculate sequential investments. As we determine the branches of the decision tree, we can work backward, from future to present to cancel the unprofitable alternatives. By doing so, we can keep only the profitable investment options in our hands.Therefore, the decision tree analysis offers a unique approach to get a bigger picture of the original alternatives and thereby lets the investors choose an optimum profitability project.The utility of decision tree analysis can be broadly divided into the following categories −Presents a Clear PictureThe decision tree analysis shows all implicit ... Read More
Due to the importance of qualitative factors, judgment plays a significant role in capital budgeting. Judgment may seem to be a matter of fancy to many, but its roots are strongly planted in the facts. Decision-making is no different; it must rely on judgment most of the time when it decides something for the organization.There have been debates about the efficiency of judgment in making the right choices in an investment evaluation process. However, many renowned economists have accepted the fact that judgment is an unavoidable tool to make the right business decisions in the case of capital budgeting.The role ... Read More
Operating leverage is a component of fixed costs. Companies that have higher operating leverage or the firms with a lower fraction of variable cost and higher portion of fixed costs have higher operating leverage. This means that most of the costs cannot be scaled down in the phases of declining sales. Such an arrangement increases the risk and makes it increasingly hard to forecast the sales.However, operating leverage is not bad in all situations. While it can magnify losses in periods of lower sales, it can do the same to profits when good business conditions prevail.Operating Leverage and SalesWhen sales ... Read More
The arbitrage process is the backbone of the ModiglianiMiller (MM) hypothesis. However, since the hypothesis assumes a perfect market where arbitrage behavior is different from the practical market scenario, some discrepancies may occur at the core level of the process.Arbitrage may fail to work or work erroneously and may give rise to discrepancies between levered and unlevered firms. The arbitrage process may fail to bring an equilibrium in the process due to the following discrepancies −Landing and Borrowing Rate DiscrepancyThe hypothesis states that individuals and firms can lend and borrow at the same interest rate. However, this is not the case ... Read More
Risk and uncertainty are often used interchangeably in financial management literature. However, there are differences between the two and they represent strictly different ideologies. In this brief article, we will highlight the points that differentiate these two terms, risk and uncertainty, when they are used in Finance parlance.The Concept of RiskRisk is the process of potential loss for a firm. The concept of risk is broad in finance. In finance, the risk is associated with a bad outcome occurring or a good outcome not occurring at all. For instance, If the income falls down below a certain mark, it is ... Read More
The concept of block of assets can be considered under the concept of depreciation of assets under the Indian Tax rules. Let’s go through the concept of depreciation under income tax rules to understand the concept of ‘block of assets’ better.Depreciation under Indian Income Tax RulesDepreciation under Indian Income Tax rules is a deduction allowed by the government for the reduction of the value of assets used by a taxpayer. It is a continuous process and is usually calculated over the useful life of the assets.DepreciationDepreciation is the gradual loss of value of an asset. Under Indian Income Tax rules, ... Read More