A promoter pools a fixed amount of investment in a business at the current year. When the project is completed and starts yielding positive results he reaps a series cash flow over a period of years. The pattern consists of a current investment of one lump sum, and getting a recurring return in the future, say (assume) for a period of ten years. Can he sum of the aggregate return yielded in the period of ten years and compare the amount with the initial investment made by him. This is wrong, since we know time increments money, i.e. Rs.100/- today becomes Rs.110/- next year assuming the prevailing interest rate at 10%. If we borrow an overdraft of Rs.1000/- in our bank account and offer to repay the same after a lapse of three months, the bank manager demands something more than Rs.1000/- which we originally borrowed, representing the interest or hire charges for the use of the money for the period it was held by us. This feature of money-value linked to the time factor is conceptualised by the standard called "time value of money". The time value of money means that a rupee received today is different from the worth of a rupee to be received in future. A rupee receivable in future is less valuable than the rupee held today. On this yardstick the future value of a rupee held today is arrived at by the formulae of applying a compounding factor. Similarly the present value of a future cash flow can be ascertained by applying the discounting factor.

The concept of time value of money is used to determine the comparative value of different rupee amounts at different points of time into equivalent value of a particular point of time (present or future). This is calculated either by compounding the present value money to a future date and arriving at the value of the present money at those dates in future, or by discounting the future money to present date and arrive at the present value of the cash flow accruing at a future span of time. We will see how this method is applied in analysis tool called "Discounted Cash Flow" in evaluating Capital Investment Projects.

One of the multiple roles of the finance manager is to strive in achieving a right balance between risk and return. Risk and return go hand in hand. One cannot hope for returns without facing/overcoming inherent risks in each kind of venture. Investment decision therefore involve a trade-off between risk and return. Risk in business is defined as the chance that the actual outcome on the investment will differ from the expected outcome. Leverage analysis is the technique used by business firms to quantify risk-return relationship of different alternative capital structures. Leverage in financial analysis represents the influence of financial variable over some other related financial variable. These financial variables may be costs, output, sales revenue, EBIT (earnings before interest & tax), EPS (Earning per share) etc. There are three commonly used measures of leverage in financial analysis. These are-

1. Operating Leverage

2. Financial Leverage

3. Combined Leverage

Operating leverage is defined as the "firm's ability to use fixed operating costs to magnify effect of changes in sales on its earnings before interest and taxes." Operating leverage occurs- when a firm has fixed costs, which must be met regardless of volume of sales. When the firm has fixed costs, the %-age change in profits due to change in sales level is greater than the %-age change in sales. With positive (i.e. greater than zero) fixed operating costs, a change of 1% change in sales produces a more than 1% change in EBIT. A measure of this effect is referred to as the Degree of Operating Leverage (DOL), which measures the level of operating income (EBIT)to change in the level of output and gives management an indication of the response in profits it can expect if the level of sales is altered. Specifically DOL is defined as the percentage of change in operating income (EBIT) divided by the percentage of change in the level of output (Q)

Where    Q=Quantity Produced and sold
V = Variable Cost per unit
P = Selling price per unit
F = Operating fixed cost

Financial leverage is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT/Operating profits, on the firm's earnings per share. The financial leverage occurs when a firm capital structure contains obligation of fixed financial charges e.g. interest on debentures, dividend on preference shares etc. along with owner's equity to enhance earnings of equity shareholders. The fixed financial charges do not vary with operating profits or EBIT. They are fixed and are to be paid irrespective of level of operating profits or EBIT. The ordinary shareholders of the firm are entitled to residual income i.e. earnings after fixed financial charges. The measure for financial leverage is called DFL (Degree of financial leverage)

Thus the effect of changes in operating of profit or EBIT on the level of earnings per share (EPS) is measured by financial leverage. It is calculated as:

(%-age change in EPS / %-age change in EBIT) or (Increase in EPS / EPS divided by
    Increase in EBIT / EBIT)

The financial leverage is favourable when the firm earns more on the investments/assets financed by the sources having fixed charges. It is obvious that the shareholders gain in a situation where the company earns a high rate of return and pays a lower rate of return to the supplier of long term funds. Financial Leverage in such cases is therefore also called "Trading on Equity"

By combining operating and financial leverages into a combined leverage a firm can bring balance between operating as well as financial risks. Such a combined leverage measures the effect of a %-age change in sales on %-age change in EPS. i.e.

Combined Leverage = Operating Leverage x Financial Leverage
=(%-age change in EBIT / %-age Change in Sales) x (%-age Change in EPS / %-age change in EBIT)
=%-age Change in EPS / %-age Change in Sales

For evaluating investment decision involving capital outlay, a finance manager uses the following tools of analysis for arriving at risk-minimised capital budgeting.

• Average Rate of Return (ARR - ARR means the average annual yield on the project. Using this tool, profit after tax and depreciation as percentage of total business is considered. The rate is compared with the rate expected in other projects, or with the minimum rate or cut-off rate assumed. Selection of the project for implementation is done based on this analysis.

• Payback Period - In this method the period at which the entire cost of the project will be completely recovered is calculated. It is the period within which total cash flows from the project equals the cost of the project. A project with a lower pay back period is preferred over a project whose payback period is longer

• Internal Rate of Return - This is the rate of interest at which the present value of a project is equal to zero, or in other words, it is the rate which equates the present value of cash inflows to the present value of cash outflows. This is arrived at by discounting future anticipated cash out flows by a discount factor that brings it equal to the cash outflow incurred presently. The discount factor represents the IRR.

• Net Present Value (NPV) - This is also referred as the "discounted cash flow method". This method takes into consideration the concept of time value of money. The net present value of an investment proposal is defined as the sum of present values of all cash inflows less the sum of present value of all cash outflows. While under NPV method the rate of discounting is known (the firm's cost of capital) under IRR method the rate which makes NPV zero has to be found out.

• Profitability Index (also referred as Benefit-Cost Ratio) - Is used for comparing a number of proposals each involving different cash inflows to find out the "Desirability Factor" or "Profitability Index". In general terms a proposal can be considered if the Profitability Index is greater than 1. The Profitability Index is calculated as under:

  Sum of discounted cash in flows / Initial cash outlay or Total discounted cash outflow.

Profitability can also be improved by efficient management of the current assets (Working Capital Management) in respect of Inventory, Receivables and Cash.