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PRATHAM KADAM​
12-04-2026
 1. Capital Budgeting
Capital budgeting is the process of evaluating large-scale investments. It
focuses on cash flow implications rather than accounting profits to keep
calculations simple and accurate.
The Core Concept: NPV vs. IRR
●​ Net Present Value (NPV): The actual dollar amount a project adds to the company's
value after accounting for the time value of money. If NPV is positive, you do the project.
●​ Internal Rate of Return (IRR): The percentage return the project earns. It is the
discount rate where NPV equals zero.

Why it gets tricky: The Conflict

Professors love to ask: "If Project A has a 50% IRR and Project B has a 15% IRR, which is
better?"

●​ The Trap: Most students pick the 50% IRR.

●​ The Reality: If Project A is small (earning 50% on ₹1,000) and Project B is huge
(earning 15% on ₹1,000,000), Project B adds more absolute wealth (NPV).
●​ Example: It is better to have 15% of a gold mine than 100% of a sandwich.
Always pick the higher NPV to maximize shareholder wealth.

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METHODS-​
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Payback Period (PB)

This represents the amount of time required to recover the initial cost of an investment;
essentially, it is the project's "breakeven point".

Pros Cons

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Simple: Easy to calculate and understand Ignores TVM: It does not account for
using basic arithmetic. inflation or the reduced value of future
money.

Liquidity Management: Helps companies Short-Sighted: It ignores all cash flows

see how quickly they can get their cash back. that occur after the payback period is
reached.

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Accounting Rate of Return (ARR)

Also known as the "Average Rate of Return," this estimates profitability by dividing the
average annual profit by the initial investment.

Pros Cons

Easy to Understand: Uses familiar Ignores TVM: Like the Payback method, it fails
accounting terms like "profit". to discount future money.

Full Life View: Unlike Payback, it Accounting Bias: Highly dependent on the
considers the entire life of the project. specific accounting methods used by the firm.

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Internal Rate of Return (IRR)
The IRR is the annualized interest rate at which the NPV of a project becomes zero.

Pros Cons

Comparable: Allows for easy No Dollar Value: It tells you the percentage
comparison between projects and other return but not the actual dollar value added.
investment options.

Time Value: Fully incorporates the time Reinvestment Trap: Assumes all
value of money. intermediate cash flows are reinvested at the
same IRR rate.

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Net Present Value (NPV)
NPV is the difference between the Present Value (PV) of cash inflows and the Present Value of
cash outflows over time

Pros Cons

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Wealth Maximization: Projects with a Sensitivity: Heavily relies on long-term
positive NPV directly increase shareholder projections and estimated inputs.
wealth.

Includes TVM: Properly discounts future Scale Blindness: It doesn't consider the
cash flows using the cost of capital. project's size or Return on Investment
(ROI).

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Profitability Index (PI)​
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Also called the "Benefit-Cost Ratio," it calculates the benefit earned per rupee of investment.
●​ Formula: $\frac{PV\ of\ Cash\ Inflow}{PV\ of\ Cash\ Outflow}$
●​ Decision Rule: If $PI > 1$, accept the project; if $PI < 1$, reject it.
●​ Best Use: This is ideal when you have a fixed budget and need to rank projects by
efficiency.

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2. Capital Structure
Capital structure is your mix of debt and equity.

The Core Concept: The Tax Shield

Debt is generally "cheaper" than equity because interest payments are tax-deductible. This is
known as a Tax Benefit.

●​ WACC (Weighted Average Cost of Capital): This is the overall cost of all your funding
combined.
●​ Objective: You want to find the "Optimal Capital Structure" that results in the lowest
WACC.

Why it gets tricky: The Life Cycle

●​ The Trap: A question might ask why a tech startup should use debt since it’s "cheaper."
●​ The Reality: Debt requires fixed interest payments regardless of profit. Startups have
unstable earnings and high risk.
●​ Pecking Order Theory: Companies prefer using their own cash first, then debt, and
equity only as a last resort because equity dilutes ownership and is the most expensive.

THEORIES

1. Modigliani and Miller (M&M) Hypothesis

This theory is considered a "seminal" work in finance and has two distinct stages based
on the presence of taxes.

A. Case 1: The Irrelevance Theory (No Taxes)

●​ The Concept: In a perfect world without corporate taxes, transaction costs, or
bankruptcy risks, it doesn't matter how you slice the "financial pie". The total
value of the firm remains the same regardless of its debt level.
●​ The Logic: If you increase cheap debt, the risk for equity holders increases.
They will demand a higher return to compensate for this risk, which perfectly
offsets the benefit of the lower-cost debt.
●​ The Formula: $V_L = V_U$ (Value of Levered firm = Value of Unlevered firm).

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 Example: Imagine a pizza (the firm’s total value). Whether you cut it into 4 large
slices (all equity) or 8 smaller slices (debt and equity), the total size of the pizza
remains the same.

B. Case 2: The Relevance Theory (With Taxes)

●​ The Concept: When corporate taxes exist, debt becomes highly beneficial
because interest payments are tax-deductible.
●​ The Logic: This creates a Tax Shield, which reduces the firm's tax bill and
increases its total value.
●​ The Formula: $V_L = V_U + tD$ (Value of Levered firm = Value of Unlevered
firm + Tax rate × Amount of Debt).

2. Net Income (NI) Approach

●​ The Concept: Proposed by Durand, this theory suggests that the capital
structure is relevant to the firm's valuation.
●​ The Logic: Since debt is a cheaper source of finance than equity, increasing the
proportion of debt will lower the firm's overall Weighted Average Cost of Capital
(WACC).
●​ The Goal: A lower WACC directly leads to a higher firm value and a higher share
price.

Example: If a company needs ₹100 and borrowing money (debt) costs 8%

while issuing shares (equity) costs 15%, using more 8% debt will naturally
pull the "average" cost down toward 8%, making the business more
profitable for the owners.

3. Pecking Order Theory

●​ The Concept: Firms do not have a fixed "target" debt-equity ratio. Instead, they
follow a hierarchy based on the ease of access and cost.
●​ The Hierarchy:
1.​ Internal Financing: Use Retained Earnings first to avoid transaction costs
and external interference.
2.​ Debt: If internal cash is insufficient, issue debt to avoid giving up control.
3.​ Equity: Issue new shares only as a last resort because it dilutes
ownership and sends a "bad signal" to the market.

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 Example: If a highly profitable company like Apple has billions in cash, it will
use that first to fund a new factory. It won't ask a bank (debt) or sell new
shares (equity) because it doesn't need to pay interest or answer to new
shareholders.

4. Agency Theory of Capital Structure

●​ The Concept: This theory deals with the conflict of interest between
Shareholders (Principals) and Managers (Agents).
●​ The Problem: Managers might act in their own self-interest (e.g., spending
on luxury offices) rather than maximizing shareholder wealth.
●​ The Solution: Using debt financing forces managers to be disciplined
because they must pay the interest and principal to the bank. This reduces
"free cash" they could waste, though it increases bankruptcy risk.

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 [Link] Policy: The "r vs. k" Logic
When a company makes a profit, it must decide: Pay it out as dividends or keep it (Retained
Earnings)?

The Core Concept: Walter’s Model

Dividend policy depends on two variables:

1.​ r: What the company can earn by reinvesting that money (Internal Rate of Return).
2.​ k: What the shareholders expect to earn elsewhere (Cost of Capital).

Why it gets tricky: The "Growth" Decision

●​ Growth Firm ($r > k$): The company is a "money machine." Shareholders want the
company to keep every penny because the company earns more than they could on
their own. Optimal Dividend = 0%.
●​ Declining Firm ($r < k$): The company is "wasting" money. Shareholders want their
cash back to invest it better elsewhere. Optimal Dividend = 100%.

Tricky Question Idea: "Company Alpha has great growth but pays a huge
dividend. What happens to its share price?"

Answer: According to Walter, the share price will fall because the company is
giving away cash it could have used to generate high returns.

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 ​

4. Working Capital: The "Efficiency" Battle

Working capital is the difference between Current Assets (Cash, Inventory) and Current
Liabilities (Payables).

The Core Concept: The Operating Cycle

This is the time it takes to turn raw materials back into cash.

●​ Formula Logic: (Days to hold inventory) + (Days customers take to pay) - (Days you
take to pay your suppliers).

Why it gets tricky: Liquidity vs. Profitability

●​ Conservative Policy: You keep lots of cash and stock. You are safe (low risk), but your
money is "lazy" and not earning a return (low profitability).
●​ Aggressive Policy: You keep barely any cash. High profitability, but one late payment
from a customer could make you bankrupt (high risk).

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​

QUESTIONS
The "Hidden" Cash Flow: Depreciation and the Tax Shield
The Concept: Depreciation is often called a "non-cash expense" because you don't
actually write a check to pay for it. However, in finance, it is a hero because it hides your
profit from the tax collector.

●​ The Logic: If your company makes ₹100 in profit and the tax rate is 30%, you
usually pay ₹30 in tax. But if you claim ₹20 in depreciation, your "taxable profit"
drops to ₹80. Now, you only pay ₹24 in tax. You just saved ₹6 in real cash
because of an accounting entry.​
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Exam Question (5 Marks)

[Link] a non-cash expense like depreciation affect the Net

Present Value (NPV) of a project? If so, why does a manager
add it back to the profits to find the true cash flow?"

●​ Yes, depreciation significantly impacts NPV, even though it

is a non-cash item.
●​ The Tax Shield Effect: Depreciation is a tax-deductible
expense. It reduces the company's taxable income, which
leads to lower cash outflows for tax payments. This "tax
saving" is a real cash inflow.
●​ The Add-Back Logic: To calculate NPV, we need Cash
Flow After Tax (CFAT). Accountants subtract depreciation
to find the profit, but since no actual cash left the bank,
managers add it back to the Profit After Tax (PAT).
●​ Conclusion: Higher depreciation leads to higher CFAT,
which in turn increases the NPV of the project

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The "Scale" Conflict: NPV vs. IRR
The Concept: Professors love to trap students into picking the highest percentage. IRR
(Internal Rate of Return) is a percentage, but NPV (Net Present Value) is actual wealth
in rupees.

●​ The Logic: Would you rather have a 100% return on ₹10 (gain ₹10) or a 10%
return on ₹1,000,000 (gain ₹100,000)? IRR says the first is better (100% >
10%), but NPV says the second is better because you end up much richer.

Exam Question (5 Marks)

2. A project with a smaller investment shows a much higher IRR

than a large-scale project. Why might a company still prefer the
large-scale project despite its lower percentage return?"

●​ The Problem of Scale: IRR is a relative measure (percentage), while

NPV is an absolute measure (rupee value). A small project can have a
massive IRR but add very little total value to the firm.
●​ Wealth Maximization Objective: The core goal of financial
management is to maximize absolute shareholder wealth, not just
percentage efficiency.
●​ Reinvestment Assumption: NPV assumes cash flows are reinvested at
the Cost of Capital (WACC), which is more realistic. IRR assumes they
are reinvested at the IRR itself, which is often impossible to achieve
consistently.
●​ Conclusion: For a large corporation, a 15% return on a massive
investment adds more "absolute value" (NPV) than a 50% return on a
tiny one. Therefore, NPV is the superior decision tool.

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The "Pecking Order" and Agency Costs

The Concept: This explains how a manager chooses where to get money.
It's not random; there is a hierarchy.

●​ The Logic: Managers hate strangers interfering in their business. First,

they use their own "pocket money" (Retained Earnings). If that runs
out, they go to a bank for a loan (Debt). Only when they are desperate
do they sell parts of the company (Equity).

[Link] to the Pecking Order Theory, why is issuing new equity

considered a 'last resort' for a company, and how does debt help in
reducing 'Agency Costs'?"

●​ The Equity Problem: Issuing new equity is seen as a last resort

because it dilutes the ownership and control of existing shareholders.
It also sends a signal to the market that the firm's stock might be
overvalued.
●​ The Hierarchy: Firms prefer internal financing first (Retained
Earnings) to avoid transaction costs. Debt is the second choice
because it allows for financing without giving up control.
●​ Agency Costs: These are costs from conflicts between managers and
shareholders. Managers might waste cash on "perks" or bad projects.
●​ The Debt Discipline: Debt reduces agency costs by imposing a fixed
repayment schedule. Managers are forced to be efficient and
disciplined with cash because they must pay interest and principal to
the bank

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Working Capital: The "Free Money" Strategy
The Concept: Managing the "Operating Cycle" is about how long your cash is trapped.

●​ The Logic: You want to collect money from customers instantly, but pay your
suppliers as slowly as possible. If you negotiate with a supplier to pay them after
60 days instead of 30, you are effectively using the supplier's money to run your
business for free for an extra 30 days.

4.A company successfully increases its 'Trade Payable Days' while

keeping its 'Inventory' and 'Receivable Days' constant. How does this
impact the company’s liquidity and its need for bank borrowing?"

●​ Impact on the Cycle: Increasing Trade Payable Days decreases the

total Working Capital Cycle in days.
●​ Liquidity Improvement: By delaying payments to suppliers, the
company retains its cash for a longer period. This effectively
provides "interest-free" financing from the suppliers.
●​ Reduced Borrowing: Because the company is using its suppliers'
funds to finance its daily operations, its dependency on external
short-term debt (like bank overdrafts) decreases.
●​ The Risk: However, the manager must ensure that delaying payments
does not damage vendor relationships or result in higher purchase
prices.
●​ Conclusion: Negotiating better credit terms with suppliers is a
powerful strategy to shorten the cash-to-cash cycle and improve the
firm's overall liquidity position.

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Concept The Question The "Conceptual" Key

might ask...

Depreciation How does a It increases cash flow because it

non-cash lowers taxable income, so you pay
expense affect less in cash taxes.
cash flow?

WACC What happens if The Cost of Debt goes DOWN,

the Corporate Tax which usually lowers your WACC
rate goes UP? (making debt even more attractive).

NPV Why is NPV better Payback ignores the Time Value of

than the Money and any cash earned after
"Payback the initial cost is recovered.
Period"?

Financial Where do you go The Money Market (for short-term

Markets for a 6-month needs under 1 year).
loan?

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