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Unit 3 of 4 · MBA Sem 2

Unit 3: Leverage and capital budgeting

Corporate Finance and Policy notes · PTU syllabus (MBA 206-21)

3 min read6 topics10 exam questions
On this page
  1. Unit summary
  2. Business and financial risk
  3. Operating and financial leverage; trading on equity
  4. Nature and process of capital budgeting
  5. Investment evaluation criteria
  6. Risk analysis in capital budgeting
  7. Capital rationing
  8. Key terms
  9. Quick revision
  10. Important questions

Unit summary

Fixed costs magnify returns and risks, and long-term investment choices shape a firm for years. This unit covers business and financial risk, operating and financial leverage, trading on equity, the nature and process of capital budgeting, evaluation criteria — payback, ARR, NPV, benefit–cost ratio and IRR — risk analysis and capital rationing.

After this unit you can

  • Distinguish business and financial risk
  • Compute operating, financial and combined leverage
  • Explain the capital budgeting process and evaluation criteria
  • Apply risk analysis and capital rationing

PTU syllabus topics

  • Business and financial risk
  • operating and financial leverage
  • trading on equity
  • nature and process of capital budgeting
  • investment evaluation criteria (payback, ARR, NPV, benefit-cost ratio, IRR)
  • risk analysis and capital rationing
Key formulasLeverage and capital budgeting

  • Operating leverage

    Contribution / EBIT

  • Financial leverage

    EBIT / EBT

  • Combined leverage

    Contribution / EBT

  • NPV

    Σ CFt / (1 + k)^t − initial outlay

  • Benefit-cost ratio

    PV of inflows / initial outlay

1

Topic 1

Business and financial risk

  • Business risk: variability of EBIT due to the nature of business — demand variability, price variability, input costs, operating leverage.
  • Financial risk: additional variability of EPS and risk of default due to debt (financial leverage).
  • Total risk is reflected in the combined leverage (DOL × DFL).
2

Topic 2

Operating and financial leverage; trading on equity

Leverage is the use of fixed costs (operating or financial) to magnify returns.

Key formulasLeverage

  • Operating leverage

    DOL = Contribution / EBIT

  • Financial leverage

    DFL = EBIT / EBT

  • Combined leverage

    DCL = DOL × DFL = Contribution / EBT

Example

Sales ₹10 lakh, variable cost ₹6 lakh, fixed cost ₹2 lakh, interest ₹1 lakh. Contribution = 4 lakh, EBIT = 2 lakh, EBT = 1 lakh. DOL = 2, DFL = 2, DCL = 4 — a 10% rise in sales raises EBT by 40%.

Trading on equity: using debt to increase the return to equity shareholders when the return on investment exceeds the cost of debt.

3

Topic 3

Nature and process of capital budgeting

Capital budgeting is the process of planning and evaluating long-term investment proposals — new plant, expansion, replacement, R&D.

  • Importance: large funds, long-term effects, irreversible, affects risk and growth.
ProcessCapital budgeting process
  1. 1

    Identify investment opportunities

  2. 2

    Estimate cash flows

    Incremental, after-tax

  3. 3

    Evaluate proposals

    Payback, ARR, NPV, IRR, PI

  4. 4

    Select projects

  5. 5

    Implement

  6. 6

    Post-completion audit

  • Cash flow after tax (CFAT) = Profit after tax + Depreciation (non-cash).
4

Topic 4

Investment evaluation criteria

ClassificationMethods of capital budgeting
Evaluation methods

  • Non-discounted

    Payback period, accounting rate of return (ARR)

  • Discounted

    Net present value, profitability index (benefit–cost ratio), internal rate of return, discounted payback

Key formulasCapital budgeting formulas

  • Payback period

    Initial investment ÷ Annual CFAT (equal flows); cumulative method for unequal flows

  • ARR

    Average annual profit after tax ÷ Average investment × 100

  • Average investment

    (Initial cost − Salvage) ÷ 2 + Salvage + Working capital

  • NPV

    PV of cash inflows − PV of outflows

  • Profitability index

    PV of inflows ÷ PV of outflows

  • IRR

    Rate at which NPV = 0 (by interpolation)

Example

Project cost ₹1,00,000; CFAT ₹30,000, ₹40,000, ₹50,000, ₹30,000 for 4 years; cost of capital 10%. Payback = 2 years + 30,000/50,000 = 2.6 years. PV factors 0.909, 0.826, 0.751, 0.683 → PV = 27,270 + 33,040 + 37,550 + 20,490 = ₹1,18,350. NPV = ₹18,350 (accept). PI = 1.18.

MethodMeritsDemerits
PaybackSimple; emphasises liquidityIgnores time value and post-payback cash flows
ARRUses accounting data; considers whole lifeIgnores time value; uses profit not cash
NPVTime value; maximises wealth; additiveNeeds cost of capital; ignores size differences
IRRTime value; easy to compare with costMultiple IRRs possible; reinvestment assumption at IRR
PIUseful under capital rationingMay conflict with NPV for mutually exclusive projects

Exam tip

For mutually exclusive projects, if NPV and IRR conflict, prefer NPV — it assumes reinvestment at the cost of capital, which is more realistic.

5

Topic 5

Risk analysis in capital budgeting

  • Sensitivity analysis: how much a key variable (sales volume, price, cost, discount rate) can change before NPV becomes zero.
Key formulasSensitivity

  • Sensitivity margin (%)

    NPV ÷ PV of the cash flow affected by the variable × 100

Example

NPV ₹20 lakh; PV of sales revenue ₹200 lakh → sales can fall by 10% before NPV = 0 — a highly sensitive variable.

  • Limitations: changes one variable at a time; no probabilities.
  • Risk-adjusted discount rate (RADR): add a risk premium to the discount rate for riskier projects; or use project-specific beta via CAPM (adjusting for gearing — asset beta and equity beta).
Key formulasBeta adjustments

  • Asset (ungeared) beta

    βa = βe × E ÷ [E + D (1 − t)]

  • Re-geared equity beta

    βe = βa × [E + D (1 − t)] ÷ E

  • Certainty equivalent approach: convert risky cash flows into certain equivalents and discount at the risk-free rate.
  • Other techniques: probability distribution of cash flows (expected NPV and its standard deviation), decision trees, simulation (Monte Carlo), scenario analysis.
6

Topic 6

Capital rationing

Capital rationing occurs when funds are limited and the firm cannot accept all profitable (positive NPV) projects.

  • External rationing: market imperfections, inability to raise funds. Internal rationing: self-imposed budget limits.
  • Divisible projects: rank by PI and accept in order until funds run out (partly accept the last).
  • Indivisible projects: try feasible combinations and choose the one with the highest total NPV.

Key terms

Business risk
Variability of EBIT from operations
Financial leverage
Use of fixed-charge funds to magnify EPS
NPV
Present value of inflows minus present value of outflows
IRR
Discount rate at which NPV is zero
Capital rationing
Limit on funds available for investment

Quick revision

  • Business vs financial risk.
  • DOL = C/EBIT; DFL = EBIT/EBT; DCL = C/EBT; trading on equity.
  • Capital budgeting process: identify, evaluate, select, implement, review.
  • Payback, ARR, NPV, PI (benefit–cost), IRR; NPV vs IRR conflicts.
  • Risk: sensitivity, RADR, certainty equivalent, decision tree; capital rationing.

Important exam questions

Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).

Short-answer questions

  1. Q1.Distinguish business and financial risk.
  2. Q2.Define degree of operating leverage.
  3. Q3.What is trading on equity?
  4. Q4.State two merits of NPV.
  5. Q5.What is the profitability index?
  6. Q6.What is capital rationing?

Long-answer questions

  1. Q1.Explain operating, financial and combined leverage with an example.
  2. Q2.Explain the process of capital budgeting.
  3. Q3.Compare NPV and IRR methods of evaluation.
  4. Q4.Discuss techniques of risk analysis in capital budgeting.

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