JAIIB AFM Module-C Unit 7 : Capital Investment Decisions/Term Loans

12/09/2023

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JAIIB Paper 3 AFM Module C Unit 7 : Capital Investment Decisions/Term Loans (New Syllabus)

IIBF has released the New Syllabus Exam Pattern for JAIIB Exam 2023. Following the format of the current exam, JAIIB 2023 will have now four papers. The JAIIB Paper 3 (Accounting and Financial Management for Bankers) includes an important topic called “Capital Investment Decisions/Term Loans”. Every candidate who are appearing for the JAIIB Certification Examination 2023 must understand each unit included in the syllabus. In this article, we are going to cover all the necessary details of JAIIB Paper 3 (AFM) Module C (FINANCIAL MANAGEMENT ) Unit 7 : Capital Investment Decisions/Term Loans Aspirants must go through this article to better understand the topic, Capital Investment Decisions/Term Loans, and practice using our Online Mock Test Series to strengthen their knowledge of Capital Investment Decisions/Term Loans. Unit 7 : Capital Investment Decisions/Term Loans

Discounted cash flow Techniques for Investment Appraisal

This chapter sets out two main discounting techniques of investment appraisal namely the net present value (NPV) method and the internal rate of return (IRR) methods. Two main assumptions that are made in discussing the two techniques, are as follows:

That the sums of moneys, resulting from an investment, that accrue in future, are know with certainty.
That there is no inflation.

Net present value

NPV method involves comparing the present value of the future cash flows of an investment opportunity with the cash outlay that is required to finance the opportunity. In this ways, we determine whether the investment opportunity provides a surplus, when the cash flows are measured in present value terms.

The stages involved in using the NPV method are as follows:

Estimate all future net cash flows (revenue minus cost) associated with an investment opportunity.
Convert these net cash flow figures to their present value equivalents by discounting at the appropriate discount rate;
Add all the present value figures of future cash flows;
Subtract from this value, the initial cost of investment

Net Present Value(NPV) is a formula used to determine the present value of an investment by the discounted sum of all cash flows received from the project. The formula for the discounted sum of all cash flows can be rewritten as

Positive NPV: In this situation, the present value of cash inflows is greater than the present value of cash outflows. This is an ideal situation for investment
Negative NPV:In this situation, the present value of cash inflows is less than the present value of cash outflows. This is not an ideal situation and any project with this NPV should not be accepted.
Zero NPV: In this situation, the present value of cash inflows equals the present value of cash outflows. You may or may not accept the project.

Question: An Investor invested Rs. 8 lac in a project that gives profit of Rs.2 lakh in the 1^st year , Rs. 2.60 lac in 2^nd year & Rs. 4 lac in the 3^rd year. At 10% discount rate, what is NPV?

Year	Cash Outflow Total = 8 lakh	Cash Inflow	Discount rate	PV
1		2 lakh	0.909	181000
2		2.60 lakh	0.826	214760
3		4 lakh	0.751	300400
Total				696960

Question: ABC Co Ltd. Is considering a new piece of machinery costing Rs. 8000 and it will produce a cash flow of Rs.1200 each year for next 12 years. What is NPV if discount rate is 10%

PV = A/r [1 – 1/ (1+r)^n]

= 1200/.1 [ 1- 1/ (1.1)^12

= 8176

NPV = 8176- 8000

= 176

Internal Rate of Return (IRR)

The internal rate of return (IRR) is a discounting cash flow technique which gives a rate of return earned by a project.
The internal rate of return is the discounting rate where the total of initial cash outlay and discounted cash inflows are equal to zero. In other words, it is the discounting rate at which the net present value (NPV) is equal to zero.

How is the Internal Rate of Return computed?

For the computation of the internal rate of return, we use the same formula as NPV. To derive the IRR, an analyst has to rely on trial and error method and cannot use analytical methods. With automation, various software (like Microsoft Excel) is also available to calculate IRR. In Excel, there is a financial function that uses cash flows at regular intervals for calculation.

The rate at which the cost of investment and the present value of future cash flows match will be considered as the ideal rate of return. A project that can achieve this is a profitable project. In other words, at this rate the cash outflows and the present value of inflows are equal, making the project attractive.

For independent investment opportunities,
if the IRR > cost of capital, then the project should be undertaken, since a rate of return is being earned by the project that is greater than the amount that has to be paid out to the providers of capital. Thus, the project is earning a surplus over and above the cost of funds and thus shareholders’ wealth will be increased.
If the IRR < cost of capital, then the project, should not be undertaken, as going ahead with the project will have the result of reducing the shareholders’ wealth.
For mutually exclusive investment opportunities, the IRR decision rule involves undertaking that investment that has the highest IRR, provided that the IRR is greater than the cost of capital.
According to number of studies, IRR is more widely used than NPV. The main reason for this appears to be that people in business are more used to thinking in terms of rates of return than in terms of NPVs or surpluses.
IRR = R1 + NPV / (NPV1 – NPV2 ) * (R2- R1)
R1 = Lower discount rate chosen
R2 = Higher discount rate chosen

Question: The NPV of a project is Rs. 2 lac at 10% discount rate & (-) .5 lac at 11% discount rate. Calculate IRR of the project

= 10 + 2 / [2 – (-) .5 ] * (11-10)

= 10 + .8 * 1

= 10.8 = 11%

Non-Discounted Cash Flow Methods For Investment Appraisal

Payback Period Method

All investment appraisal techniques are seeking to identify whether the cash flows, resulting from an investment, are sufficient to make the investment worthwhile.
The payback method adopts the most straightforward approach to this problem.
It simply seeks to measure the length of time that will be taken before the receipts from the investment are sufficient to payback the cost of the investment.
The receipts from the investment are measured as the net cash flows resulting from the project being undertaken (i.e., the difference between the total amount of cash receipts and total amount of cash outlays in each period).

To illustrate the use of the payback method, consider two potential investment projects that each cost 50,000 and those that have net cash flows as follows:

Examination of the net cash flows of the two projects tells us that the initial outlays of 50,000 is recouped in four years for the project A and in five years for the project B,
Thus, the project A has a payback period of 4 years and the project B has a payback period of five years.
To use payback method, it is necessary first to establish a payback period within which all acceptable projects must recoup the outlay of the investment.

For example, a business, with a considerable potential cash flow problems and severe capital rationing, may opt for a short payback period, say 3 years. In this case, neither the project A nor B, would be acceptable.

In contrast, if a 4 year payback period were chosen, then the project A would be acceptable, but project B would not be, while a 5 year payback
Would make both the projects acceptable to the company.

Payback method has several shortcomings that make its use highly undesirable

It takes no account of the time value of money
The choice of the payback period is arbitrary
With the payback, the only cash flows to be considered are those that fall in the payback period
Using payback may well lead to an increase in risk, since by demanding rapid payback, companies are building in a bias towards the acceptance of risky projects.

Question: A firm requires an initially cash outflow of Rs.20000 & cash inflow for 5 years are Rs.5000, 7000, 6000, 6000, 8000. Calculate Payback period?

In 3 years recover = 18000

Next 2000 = 2000/6000 = 1/3

= 3.33 years

Question: A project cost is Rs. 190000 and its scrap value is Rs.10000. It yield an annual cash flow of Rs. 20000 for 10 years. Calculate its payback period?

Project Cost – Scrap Value / Annual Cash Flow

= 190000 – 10000/ 20000

= 9 years

Question: XYZ is planning to start a project which requires the total outlay of Rs.15 lakh to purchase machinery having a life of 10 years and salvage value is 100000

Year ending profit before dep & Tax is 2 lakh

Tax rate = 30%

Calculate Annual cash flow and Payback period?

Solution

Cash Outflow = 15 lakh – 1 lakh = 14 lakh

PBD&T = 2 lakh

(-) Dep = 15 lakh- 1 lakh / 10 = 1.4 lakh

PBT = 60000

(-)Tax = 18000

PAT = 42000

Annual Cash Inflow = 42000 + 1.4 lakh = 1.82 lakh

Accounting Rate of Return Method (ARR)

Accounting Rate of Return (ARR): The accounting rate of return (also known as Average Rate of Return or Simple Rate of Return) measures the profitability of an investment by using the accounting profit given in the financial statements.

It is computed as under:

ARR = Average profit after tax / Average value of investment

Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the project’s life time.
It should be noted that the accounting income is arrived after providing for depreciation whereas in other methods like NPV or IRR, we take the cash flows of the project into consideration.
Average investment may be calculated as the sum of the beginning and ending book value of the investment divided by 2 (the underlying assumption being that the book value is getting reduced under the straight line method of depreciation).

For example: If investment in a project is Rs. 10 lac, the life of the project is 6 years and the scrap value is Rs. 1 lac, the average investment will be Rs. (10 lac- 1 lac) divided by 2, i.e. Rs. 4.5 lac. In this example, if the scrap value is estimated at Rs, 0, the average investment will be Rs. 5 lac.

Another variation of ARR formula uses initial investment instead of average investment.
Under this method, a project will be accepted if its Accounting Rate of Return is higher than the minimum rate of return set by the management.

This method can also be used to rank various projects on the basis of their ARRs. The project having a higher ARR will be ranked higher than the project having a lower ARR.

Advantages:

Like Payback period method, this method is simple to understand and involves simple calculations.
It considers the entire stream of income over the life of the project for evaluating the profitability of the project.

Question: A company is planning to start a business which requires Rs. 100000 to purchase of machinery having a life of 5 years.

Next 5 years expected profit before dep & tax = 100000, 50000, 40000, 30000, 25000. Income tax @30%. Calculate ARR?

= (101500/5) / (100000/2) *100

= 40.6%

Important Points About Term Loans

Banks provide term loans normally for acquiring the fixed assets like land, building, plant and machinery, infrastructure etc., (personal loans, consumption loans, educational loans, etc., being exceptions) while the working capital loans are provided for sustaining the working capital, i.e. current assets level.
In exceptional cases, banks provide term loans for current assets also. This is called Working Capital Term Loan (WCTL). As we are aware, the business enterprise is supposed to bring a part of its funds required to maintain the desired level of current assets from its long term sources (capital or term liabilities), called NWC, so that the stipulated current ratio can be maintained. If the enterprise is not able to bring in the required amount of NWC, it will feel liquidity crunch and business operations will be affected. In such cases, banks may provide WCTL.
Working capital loans are normally sanctioned for one year but are payable on demand. Term loans are payable as per the agreed repayment schedule, which is stipulated in the terms of the sanction. Therefore, for the purpose of matching assets and liabilities of the bank, term loans are considered long term assets while working capital loans are considered as short term assets.
As a term loan is expected to be repaid out of the future cash flows of the borrower, the DSCR assumes great importance while considering term loans, while for working capital loans, the liquidity ratios assume greater importance
There is no uniform repayment schedule for all term loans. Each term loan has its own peculiar repayment schedule depending upon the cash surplus of the borrower. Thus, in case of a salaried person, where income level is constant, the repayment can be through EMI system and in case of a farmer, the repayment of principal and interest may coincide with the cropping pattern.

In case of industrial enterprises, normally, banks stipulate monthly/quarterly repayment of principal along with all the accumulated interest.

Project Appraisal

Project appraisal can be broadly taken in the following steps:

Appraisal of Managerial Aspects
Technical Appraisal
Economic Appraisal

Appraisal of Managerial Aspects:

The appraisal of managerial aspects involves seeking the answer to the following questions:

What are the credentials of the promoters?
What is the financial stake of promoters in the project? Can they bring additional funds in case of contingencies arising out of delay in project implementation and changes in market conditions?
What is the form of business organisation? Who are the key persons to be appointed to run the business?

Technical Appraisal:

The technical feasibility of a project involves the following aspects:

location
Products to be manufactured, production process
Availability of infrastructure
Provider of technology
Details of proposed construction
Contractor for project execution
Waste disposal and pollution control
Availability of raw materials
Marketing arrangements

Economic Appraisal:

The economic/financial feasibility of a project involves the following aspects.

Return on Investment: The usual methods used are the NPV, IRR, payback period, cost benefit ratio, accounting rate of return, etc
Break-even Analysis: A project with a high break-even point is considered riskier compared to the one with lower break-even point.
Sensitivity Analysis: As market conditions are uncertain, a small change in the prices of raw materials or finished goods may have a drastic impact on the viability of a project. Sensitivity analysis examines such impact.

Infrastructure Projects

The sectors included in the definition of “Infrastructure” are as per the Gazette Notifications issued by the Ministry of Finance, Government of India, from time to time.

Presently, the following infrastructure sectors qualify under ‘infrastructure lending’:

Transport: This includes Roads and bridges, Ports, Inland Waterways, Airport, Railway Track, tunnels, viaducts, bridges and Urban Public Transport (except rolling stock in case of urban road transport).
Energy: This includes Electricity Generation, Electricity Transmission, Electricity Distribution, Oil pipelines, Oil/Gas/Liquefied Natural Gas (LNG) storage facility and Gas pipelines.
Water & Sanitation: This includes Solid Waste Management, Water supply pipelines, Water treatment plants, Sewage collection, treatment and disposal system, Irrigation (dams, channels, embankments etc.), Storm Water Drainage System and Slurry Pipelines.
Communication: This includes Telecommunication (Fixed network), Telecommunication towers, Telecommunication & Telecom Services.
Social and Commercial Infrastructure: This includes Education Institutions (capital stock), Hospitals (capital stock), Common infrastructure for industrial parks, SEZ, tourism facilities and agriculture markets, Fertilizer (Capital investment), Post-harvest storage infrastructure for agriculture and horticultural produce including cold storage, Terminal markets, Soil-testing laboratories, Cold Chain, Hotels and Convention Centers with certain restrictions regarding project cost.

Disbursal Of Term Loans

If the term loan is to be disbursed in one go, e.g., purchase of a machine/ready house, the borrower is asked to deposit his margin with the bank, his loan account is debited by the amount of the loan and the entire amount to be paid to the buyer, is remitted to him by the bank.
If any amount has already been paid to the buyer by the customer, satisfactory proof, like details of bank account etc. of this payment is obtained, and this is considered to be a part of his contribution (margin).
In exceptional cases, like personal loans or consumption loans, the amount may be credited to the account of the customer with the bank.
In cases where the execution of the project is spread over a period of time, the disbursement is normally related to the progress of the project.

RBI guidelines in respect of disbursement of project loans are as under:

At the time of financing projects banks generally adopt one of the following methodologies as far as determining the level of promoters’ equity is concerned.

Promoters bring their entire contribution upfront before the bank starts disbursing its commitment.
Promoters bring certain percentage of their equity (40% – 50%) upfront and balance is brought in stages.
Promoters agree, ab initio, that they will bring in equity funds proportionately as the banks finance the debt portion. RBI has advised the banks to have a clear policy regarding the Debt Equity Ratio (DER) and to ensure that the infusion of equity/fund by promoters should be such that the stipulated level of DER is maintained at all times.

Syndication Of Loans

The term ‘Syndication’ is normally used for sharing a long-term loan to a borrower by two or more banks.
This is a way of sharing the risk, associated with lending to that borrower, by the banks and is generally used for large loans.
The borrower, intending to avail the desired amount of loan, gives a mandate to one bank (called Lead bank) to arrange for sanctions for the total amount, on its behalf.
The lead bank approaches various banks with the details.
These banks appraise the proposal as per their policies and risk appetite and take the decision.
The lead bank does the liaison work and common terms and conditions of sanction may be agreed in a meeting of participating banks, arranged by the lead bank.
Normally, the lead bank charges ‘Syndication fee’ from the borrower.