Tag: tools for financial analysis

The real rate of return formula is the sum of one plus the nominal rate divided by the sum of one plus the inflation rate which then is subtracted by one. The formula for the real rate of return can be used to determine the effective return on an investment after adjusting for inflation.

Risk is the probability of damage, loss or threat. Risk in capital budgeting implies that the decision maker knows the probability of cash flows. The decision maker after analysing the risk will have of fair idea of the cash flows that might arise from the decision that is made. 

A proposal is not a capital budgeting proposal if it brings short-term benefits only. Capital budgeting decisions involve huge funds and are long term decisions, it benefits the firm in long term. As they involve huge costs one wrong decision would have a big effect on the business.

Profitability index is an index that identifies the relationship between cost and profitability of a project. Profitability Index. when applied to divisible projects impliedly assumes that project cannot be taken in parts has to be accepted fully, NPV is linearly proportionate to part of the project taken up and NPV is additive in nature. 

Capital budgeting is based on cash flows because there is discounting and other factors used which can be done only on cash. Moreover, cash can be spent and not profit. Cash is more important than profit as the company has to focus on many costs. As in the long run the company will succeed if it focuses mote on cash flow statement. 

The factors that increase riskiness of a capital budgeting project are industry specific risk, competition risk and project risk. Industry specific risk/market risk are the risks that might occur due to change in the industry, competition risks are the risk that can occur because of the competitors strategy and lastlyt project risk are the risk that are associated with the project as whether or not the project will be profitable or not. 

Risk aversion means the tendency of a person to avoid a decision/investment when there is risk involved. Risk aversion is a personal trait of a person. Risk-aversion of an investor cannot be measured by market rate of return, risk free rate of return or portfolio profit. 

Generally the first year is taken as the base year. The figure of base year is taken as 100. Trend percentage is calculated by following formula:

Commonly used tools of financial analysis are: Comparative statements, Common size statements, trend analysis, ratio analysis, funds flow analysis, and cash flow analysis.