Capital Budgeting Practices in Punjab-based Companies

Agenda

To explore the Capital Budgeting Techniques

The impact of various factors on the selection of techniques.

Foreign studies

“Small business firms” Payback period was the

most popular method followed by ARR.

For inclusion of risk consideration, `higher required returns' were preferred by the firms

IRR was the number one choice followed by NPV.

Equipment replacement and expansion of existing business were the most common aspects of investment.

For measuring risk, `Sensitivity Analysis' was the most preferred method.

Indian studies . . .

Indian studies…

Pay Back Period method was found to be the most popular, followed by IRR and NPV.

For discount rate, companies specified `Minimum acceptable rate of return' and also WACC.

For considering investment risk, `Sensitivity analysis’ and ‘Conservative forecasts' were equally used.

Routine investments were financed through internal sources of funds, whereas growth investment generally utilized the external sources of funds.

Pay Back Period and ARR were the preferred methods, followed by NPV and IRR.

The present study….

Aims to unravel the status of capital budgeting in Punjab and throws light on the methods preferred by

Punjab-based companies while taking investment decisions.

Industry-wise Distribution of Sample

Industry No. of Companies

Cotton Spinning 2

Synthetic Fibers/Silk and Textiles 5

Electronics 1

Metal Alloys 4

General Engineering 5

Banking and Insurance 3

Chemical Dyes and Fertilizers 2

Others 10

Total 32

Age-wise Classification of

Companies

     Age of Company (in Years)

No. of Companies

Less than 5 2

6-9 7

10-19 8

More than 20 15

Total 32

Distribution of Sample on the

Basis of Ownership

    OwnershipNo. of

Companies

Public 22

Private 8

Co-operative 2

Total 32

Source: Primary Survey.

Purpose of Making Investment

Avenues for investment by Indian and foreign companies(1997-98)

Replacement Modernization Diversification

For the respondent companies central motivation for making investment was the expansion of existing business.Expansion of

BusinessEquipment

replacement Modernization

Role of Experience and Education - Companies with more educated and highly qualified personnel prefer more sophisticated techniques like NPV, IRR in contrast to the non-discounted techniques like Pay Back Period criterion preferred by the less qualified ones.

Determination of `Cut off Point' or `Discount Rate‘- Appropriate discount rate required to provide financial justification to the capital project.

21.6% cost of debt

47% WACC

1: CAPM model

30%time-

adjusted

less than half of the companies, made use of the time-adjusted or discounted capital budgeting models.

Methods for Calculating Cost of Capital

Consideration of Factors for Deciding Capital Budgeting Method

Easy understandabil

ity

Experience and

competency

Most firms do not follow academic advice or the prevalent financial theory.

Importance

Familiarity

Consideration of Risk in Capital Budgeting Decisions- Risk analysis is used in capital budgeting to find out the range of variation of results of a proposed project.

40.6%

30.4%

29%

=companies consider non-recovery of invested

funds as a major risk factor followed by fluctuations in

expected returns.

Methods for Incorporating Risk

Shorter Pay Back Period

Sensitivity Analysis

High Cut Off Rates

CAPM model

Two-way Distribution Table of Nature of Industry and

Methods of Incorporating Risk(in %)

Method of Incorporating

Risk

Industry

Cotton Spinn-ing Synthetic Fiber Silks

and Woolen & Textiles

Electronics and Electrical

Equipments

Metal Alloys

Shorter Pay Back Period 50.0 40.0 - 75.0

High Cut off Rates - 20.0 - -

Sensitivity Analysis 50.0 20.0 100 25.0

CAPM - 10.0 - -Total 100 100 100 100

Two-way Distribution Table of Nature of Industry and

Methods of Incorporating Risk(in %)

Methods of Incorporating Risk

Industry

General Engin- eering

Banking/ Finance/ Insurance

Chemical Dyes/ Pharma- ceuticals/ Fertilizers

Others Total

Shorter Pay Back Period

60.0 33.3 - 30.0 40.6

High Cut off Rates 40.0 33.3 100.0 20.0 25.0

Sensitivity Analysis - 33.3 - 40.0 28.1

CAPM - - - 10.0 6.3

Total 100 100 100 100 100

Usage of Multiple Capital Budgeting Techniques -30 of 32 companies used more than one capital budgeting method. 74% of the companies used more than one method for evaluating investment proposals.

Preferred capital budgeting technique - IRR and Pay Back Period methods are primarily used by Indian companies(‘89). NPV was not very popular in Punjab. MIRR method has not been introduced in any of the companies

TECHNIQUES USED TO

DETERMINE SIZE OF CAPITAL BUDGET

NPV IRR Discounted Pay Back

Pay Back Period 

Modified IRR ARR Profitability Index 

0

10

20

30

40

50

60

70

80

90

100

AlwaysOftenSometimesRarelyNever

Combined Effect of All the Techniques

Modern Techniques

*Note: All ratios discussed are in percentages

Alway

s

Often

Som

etim

es

Rarel

y

Never

0

20

40

60

80

100

120

Less than 10 mn10-99 mn100-499 mn500-999 mnMore than 1 bn

NET PRESENT VALUE

Alway

s

Often

Som

etim

es

Rarel

y

Never

0

20

40

60

80

100

120

Less than 10 mn10-99 mn100-499 mn500-999 mnMore than 1 bn

IRR

Alway

s

Often

Som

etim

es

Rarel

y

Never

0

10

20

30

40

50

60

70

80

Less Than 10 mn10-99 mn100-499 mn500-999 mnMore than 1 bn

Discounted Payback Period

Always Often SometimesRarely Never0

20

40

60

80

100

120

Less than 10 mn10-99 mn100-499 mn500-999 mnMore than 1 bn

Profitability Index

Non Discounted Cash Flow Techniques ORTraditional Techniques

*Note: All ratios discussed are in percentages

Alway

s

Often

Som

etim

es

Rarel

y

Never

0

5

10

15

20

25

30

35

40

45

50

Less than 10 mn10-99 mn100-499 mn500-999 mnMore than bn

Payback Period

Alway

s

Often

Som

etim

es

Rarel

y

Never

0

10

20

30

40

50

60

Less than 10 mn10-99 mn100-499 mn500-999 mnMore than 1 bn

ARR

TECHNIQUES USED TO

DETERMINE CAPITAL BUDGET

BASED ON AGE OF

COMPANY

NPV IRR Discounted Pay Back

Pay Back Period 

Modified IRR ARR Profitability Index 

-40

-20

0

20

40

60

80

100

AlwaysOftenSometimesRarelyNeverAlwaysOftenSometimesRarelyNever

Combined Effect of All the Techniques

Modern Techniques

*Note: All ratios discussed are in percentages

NET PRESENT VALUE IRR

Discounted Payback Period Profitability Index

Always Often Sometimes Rarely Never0

10

20

30

40

50

60

70

80

90

Less than 55 to 910 t0 19More than 20

Always Often Sometimes Rarely Never0

10

20

30

40

50

60

70

80

90

100

Less than 55 to 910 t0 19More than 20

Always Often Sometimes Rarely Never0

20

40

60

80

100

120

Less than5 to 910 t0 19More than 20 Total

Always Often Sometimes Rarely Never0

20

40

60

80

100

120

Less than 55 to 910 t0 19More than 20Total

Non Discounted Cash Flow Techniques ORTraditional Techniques

*Note: All ratios discussed are in percentages

Payback Period Discounted Payback Period

Always Often Sometimes Rarely Never

-40

-30

-20

-10

0

10

20

30

40

50

60

Less than 55 to 910 t0 19More than 20Total

Always Often Sometimes Rarely Never0

10

20

30

40

50

60

Less than 5 5 to 910 t0 19More than 20Total

TECHNIQUES USED TO

DETERMINECAPITAL

BUDGET BASED ON

NATURE OF INDUSTRY

Modern Techniques

*Note: All ratios discussed are in percentages

NET PRESENT VALUE IRR

Discounted Payback Period Profitability Index

N1 n=2

N2 n=5

N3 n=1

N4 n=4

N5 n=5

N6 n=3

N7 n=2

N8 n=10

0%

2000%

4000%

6000%

8000%

10000%

12000%

AlwaysOftenSometimesRarelyNever

N1 n=2

N2 n=5

N3 n=1

N4 n=4

N5 n=5

N6 n=3

N7 n=2

N8 n=10

0

20

40

60

80

100

120

AlwaysOftenSometimesRarelyNever

N1 n=2

N2 n=5

N3 n=1

N4 n=4

N5 n=5

N6 n=3

N7 n=2

N8 n=10

0

20

40

60

80

100

120

AlwaysOftenSometimesRarelyNever

N1 n=2

N2 n=5

N3 n=1

N4 n=4

N5 n=5

N6 n=3

N7 n=2

N8 n=10

0

20

40

60

80

100

120

AlwaysOftenSometimesRarelyNever

Non Discounted Cash Flow Techniques ORTraditional Techniques

*Note: All ratios discussed are in percentages

Payback Period Discounted Payback Period

N1 n=2

N2 n=5

N3 n=1

N4 n=4

N5 n=5

N6 n=3

N7 n=2

N8 n=10

0

20

40

60

80

100

120

AlwaysOftenSometimesRarelyNever

N1 n=2

N2 n=5

N3 n=1

N4 n=4

N5 n=5

N6 n=3

N7 n=2

N8 n=10

0

20

40

60

80

100

120

AlwaysOftenSometimes    RarelyNever

Conclusion

Companies still use non-discounted cash flow techniques, mostly Payback Period criterion to evaluate any new project.

CEO education and experience play an important role in selecting the capital budgeting technique.

As the size of capital budget increases,

companies avoid using discounted techniques like NPV.

Young companies prefer DCF techniques than the older ones.

Should move from the traditional non-discounted techniques towards the sophisticated discounted cash flow techniques.