1.1 INTRODUCTION

CAPITAL BUDGETING

Capital Budgeting is the process of making investment decisions in capital

expenditures. A capital expenditure may be defined as an expenditure the benefits of

which are expenditure the benefits of which are expected to be received over period of

time exceeding one year. The main characteristic of a capital expenditure is that the

expenditure is incurred at one point of time whereas benefits of the expenditure are

realized at different points of time in future.

The term Capital Budgeting refers to long term planning for proposed capital outlay

and their financial. It includes raising long-term funds and their utilization. It may be

defined as a firm’s formal process of acquisition and investment of capital.

Capital budgeting may also be defined as “The decision making process by which a

firm evaluates the purchase of major fixed assets”. It involves firm’s decision to

invest its current funds for addition, disposition, modification and replacement of

fixed assets.

It deals exclusively with investment proposals, which is essentially long-term projects

and is concerned with the allocation of firm’s scarce financial resources among the

available market opportunities.

Some of the examples of Capital Expenditure are

Cost of acquisition of permanent assets as land and buildings.

Cost of addition, expansion, improvement or alteration in the fixed assets.

R&D project cost, etc.,

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1.2 NEED FOR THE STUDY

Analyze the proposal for expansion or creating additional capacities.

Whether or not funds should be invested in long term projects such as

setting of an industry, purchase of plant and machinery etc.

To decide replacement of permanent asset such as building and

equipment’s.

To make financial analysis of various proposals regarding capital

investments so as to choose the best out of many alternative proposals.

To know how the company gets funds from various resources.

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1.3 OBJECTIVES OF THE STUDY

To study the technique of capital budgeting for decision- making in

HDFC.

To understand the practical usage of capital budgeting techniques

To study the relevance of capital budgeting in evaluating the project for

project finance in HDFC.

To measure the present value of rupee invested.

To understand the nature of risk and uncertainty

To understand an item wise study of the company financial performance of

HDFC.

To make suggestion if any for improving the financial position if the

company.

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1.4 METHODOLOGY

To achieve aforesaid objective the following methodology has been adopted. The

information for this report has been collected through the primary and secondary

sources.

Primary sources

It is also called as first handed information; the data is collected through the

observation in the organization and interview with officials. By asking question with

the accountants and other persons in the financial department. A part from these some

information is collected through the seminars, which were held by HDFC

Secondary sources

Secondary data has been collected from various sources such as:

Publications of the company

Business magazines

Journals, text books

Websites

Annual reports

In order to gain information on current practices and problems, the area chosen for

study are the emerging and competitive companies in and around Hyderabad City.

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1.5. COMPLEXITIES INVOLVED IN CAPITAL BUDGETING

DECISIONS:

Capital expenditure decision involves forecasting of future operating cash flows. Such

forecasting suffers from uncertainty because the future is highly uncertain.

Forecasting the future cash flows demands the necessity to make certain assumptions

about the behavior of costs and revenues in future. Fast changing environment makes

the technology considered for implementation many times obsolete. For example, the

arrival of mobile revolution totally made the pager technology obsolete. The firm’s

which invested in pagers faced the problem of pagers losing its relevance as a means

of communication. The firms with the ability to adapt the new knowhow in mobile

technology could survive the effect of this phase of technological obsolescence.

Others who could not manage the effect of change in technology had a natural death

and so most Capital expenditure decisions are irreversible. Estimation of future cash

flows of Capital budgeting decisions is really complex and difficult commitment of

funds on long term basis along with the associated problem of irreversibility of

decisions and difficulty in estimating cash flows makes Capital expenditure decisions

complex in nature.

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2.1. INTRODUCTION:

An efficient allocation of capital is the most important finance function in the modern

times. It involves decisions to commit the firm’s funds to the long term assets. Such

decisions are of considerable importance to the firm since they tend to determine its

size by influencing its growth, profitability and risk.

MEANING:

Capital budgeting is a required managerial tool. One duty of a financial manager is to

choose investments with satisfactory cash flows and rates of return. Therefore, a

financial manager must be able to decide whether an investment is worth undertaking

and be able to choose intelligently between two or more alternatives. To do this, a

sound procedure to evaluate, compare, and select projects is needed. This procedure

is called capital budgeting.

capital budgeting is also known as Investment Decision Making, Capital Expenditure

Decision, Planning Capital Expenditure and Analysis of Capital Expenditure.

DEFINITION:

According to Charles T.Horngreen, “Capital budgeting is long term planning for

making and financing proposed capital outlays.”

According to Lynch, “Capital budgeting consists in planning development of

available capital for the purpose of maximizing the long term profitability of the

concern.”

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NATURE OF INVESTMENTS:

The investment decisions of a firm are generally known as the capital budgeting, or

capital expenditure decisions. A capital budgeting decision may be defined as the

firm’s decisions to invest its current funds most efficiently in the long term assets in

anticipation of an expected flow of benefits over a series of years. The long term

assets are those which affect the firm’s operations beyond the one year period

CONCEPT OF CAPITAL BUDGETING:

The term capital budgeting refers to long term planning for proposed capital outlays

and their financing. Thus, it includes both rising of long term funds as well as their

utilization. It is the decision making process by which the firm evaluate the purchase

of major fixed assets firm’s decision to invest its current funds of. It involves addition,

disposition, modification and replacement of long term or fixed assets. However, it

should be noted that investment in current assets necessitated on account of

investment in a fixed asset, it also to be taken as a capital budgeting decision.

Capital budgeting is a many sided activity. It includes searching for new and

more profitable investment proposals, investigating engineering and marketing

considerations predict and making economic analysis to determine the potential of

each investment proposal.

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CHARACTERISTICS OF CAPITAL BUDGETING:

GROWTH: A firm’s decision to invest in long term assets has a decisive

influence on the rate and the direction of growths. A wrong decision can prove

disastrous for the continued survival of the firm. Unwanted or profitable

expansion of assets will result in heavy operating costs to the firm. On the

other hand, inadequate investment in assets would make it difficult for the

firm to compete successfully and maintain its market share.

RISK: A long term commitment of funds may also change the risk complexity

of the firm. If the adoption of the investment increases average gain but causes

frequent fluctuations in its earnings the firm will become more risky. Thus

investment decisions shape the basic risk character of the firm.

FUNDING: Investment decisions generally involve large amount of funds

which make it necessary for the firm to plan its investment programmes very

carefully and make an advance arrangement for procuring finances internally

or externally.

IRREVERSIBILITY: Most investment decisions are irreversible. It is

difficult to find a market for such capital items once they have been acquired.

The firm will incur heavy losses if such assets are scrapped. Investments

decisions once made cannot be reversed or may be reversed but a substantial

loss.

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COMPLEXITY: Another important characteristic feature of capital

investment decision is that it is the most difficult decision to make. Such

decisions are an assessment of future events which are difficult to predict. It is

really a complex problem to correctly estimate the future cash flow of an

investment. The uncertainty in cash flow is caused by economic, political and

technological forces.

NEED AND IMPORTANCE OF CAPITAL BUDGETING

The capital budgeting decisions are often said to be the most important part of

corporate financial management. Any decision that requires the use of resources is a

capital budgeting decision; thus the capital budgeting cover everything from abroad

strategic decisions at one extreme to say computerization of the office, at the other.

The capital budgeting decisions affect the profitability of a firm for a long period,

therefore the importance of these decisions are obvious. There are several factors and

considerations which make the capital budgeting decisions as the most important

decisions of a finance manager. The need and importance of capital budgeting may be

stated as follows:

LONG TERM EFFECTS : perhaps, the most important features of a capital

budgeting decisions and make the capital budgeting so significant is that these

decisions have long term effects on the risk and return composition of the

firm. These decisions affect of the firm to a considerable extent as the capital

budgeting decisions have long term implications and consequences. By taking

a capital budgeting decision, a finance manager in fact makes a commitment

to its future implications.

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SUBSTANTIAL COMMITMENTS: The capital budgeting decisions

generally involve large commitment of funds as a result substantial portion of

capital are blocked in the capital budgeting decisions. In relative terms

therefore, more attention is required for capital budgeting decisions, otherwise

the firm may suffer from the heavy capital losses in time to come. It is also

possible that the return from a projects may not be sufficient enough to justify

the capital budgeting decision.

IRREVERSIBLE DECISIONS: Most of the capital budgeting decisions are

irreversible decisions. Once taken, the firm may not be in a position to revert

back unless it is ready to absorb heavy losses which may result due to

abandoning a project in midway. Therefore, the capital budgeting decisions

should be taken only after considering and evaluating each and every minute

detail of the project, otherwise the financial consequences may be far

reaching.

AFFECT CAPACITY AND STRENGTH TO COMPETE: The capital

budgeting decisions affect the capacity and strength of a firm to face the

competition. A firm may loose competitiveness if the decision to modernize is

delayed or not rightly taken. Similarly, a timely decision to take over a minor

competitor may ultimately result even in the monopolistic position of the firm.

Thus the capital budgeting decisions involve a largely irreversible

commitment of Resources i.e., subject to a significant degree of risk. These

decisions may have far reaching effects on the profitability of the firm. These

decisions making process and strategy based on a reliable forecasting system.

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LARGE INVESTMENTS: Capital budgeting decisions, generally,

involves large investment of funds. But the funds available with the firm are

always limited and the demand for funds far exceeds the resources. Hence, it

is very important for a firm to plan and control its expenditure.

NATIONAL IMPORTANCE: Investment decision though taken by

individual concern is of national importance because it determined

employment, economic activities and economic growth.

Thus, we may say that without using capital budgeting techniques a firm

involve itself in a losing project. Proper timing of purchase, replacement,

Expansion and alteration of assets is essential

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CAPITAL BUDGETING PROCESS:

Capital budgeting is a complex process as it involves decisions relating to the

investment of current funds for the benefit to the achieved in future and the future is

always uncertain. However, the following procedure may be adopted in the process of

capital budgeting:

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2Screen

Proposals

7Review

Performance

3EvaluateVarious

Proposals

4Fix

Priorities

5Final

Approval

6Implement

TheProposals

1Identify

InvestmentProposals

CAPITAL BUDGETINGPROCESS

1. IDENTI FICATION OF INVESTMENT PROPOSALS:

The capital budgeting process begins with the identification of investment proposals.

Investment opportunities have to be identified or created; they do not occur

automatically. Investment proposal of various types may originate at different levels

within a firm. Most proposals, in the nature of cost reduction or replacement or

process or product improvement takes place at plant level. The contribution of top

management in generating investment ideas is generally confined to expansion or

diversification projects. The proposal may originate systematically in a firm.

In view of the fact that enough investment proposals should be generated to

employ the firm’s funds fully well and efficiently, a systematic procedure for

generating proposal may be evolved by a firm. In a number of Indian companies,

more than 50% of the investment ideas are generated at the plant level. Indian

companies uses a variety of methods to encourage idea generation.

2. SCREENING THE PROPOSALS: The expenditure planning committee screens

the various proposals received from different departments. The committee views these

proposals from various angles to ensure that these are in accordance with the

corporate strategies, selection criterion of the firm and also do not lead to

departmental imbalances.

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3. EVALUATION OF VARIOUS PROPOSALS: The evaluation of projects should

be performed by group of experts who have no axe to grind. For example, the

production people may generally interested in having the most modern type of

equipment and increased production even of productivity is expected to be low and

goods cannot be sold this attitude can bias their estimates of cash flows of the

proposed projects.

Similarly, marketing executives may be too optimistic about the sales

prospects of goods manufactured, and overestimate the benefits of a proposed new

product. It is therefore, necessary to ensure that projects are scrutinized by an

impartial group and that objectivity is maintained in the evaluation process.

A company in practice should take all care in selecting a method or methods of

investment evaluation. The criterion or criteria selected should be a true measure of

evaluating if the investment is profitable(in terms of cash flows), and it should lead

the net increase in the company’s wealth(that is, its benefits should exceeds its costs

adjusted for time value and risk).

4. FIXING PRIORITIES: After evaluating various proposals, the unprofitable or

uneconomic proposals may be rejected straight away. But it may not be possible for

the firm to invest immediately in all the acceptable proposals due to limitation of

funds. Hence, it is very essential to rank the various proposals and to establish

priorities after considering urgency, risk and profitability involved therein.

5. FINAL APPROVAL AND PREPARATION OF CAPITAL EXPENDITURE

BUDGET: Proposals meeting the evaluation and criteria are finally approved to be

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included in the capital expenditure budget. However, proposals involving smaller

investment may be decided at the lower for expenditure action. The capital

expenditure budget lays down the amount of estimated expenditure to be incurred on

fixed assets during the budget period.

6. IMPLEMENTING PROPOSAL: Preparation of a capital expenditure budgeting

and incorporation of a particular proposal in the budget does not itself authorize to go

ahead with the implementation of the project a request for authority to spend the

amount should further be made to the capital expenditure committee which may like

to review the profitability of the project, in the changed circumstances.

Further, while implementing the project, it is better to assign responsibilities

for completing the project within the given time frame and cost limit so as to avoid

unnecessary delays and cost over runs. Network techniques used in the project

management such as PRRT and CPM can also be applied to control and monitor the

implementing of the projects.

7. PERFORMANCE REVIEW: A capital projects reporting system is required to

review and monitor the performance of investment projects after the completion and

during their life. The follow up comparison of the actual performance with original

estimate not only ensure better forecasting. Based on the follow up feedback, the

company may reappraise its projects and take remedial action. Indian company’s

practices control of capital expenditure through the use of regular project reports.

Some companies required quarterly reporting, monthly, half yearly and yet a few

companies require continuous reporting. In most of the companies the evaluation

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reports include information on expenditure to date stage of physical completion, and

revised total cost.

3.1. CAPITAL BUDGETING APPRAISAL METHODS/TECHNIQUES:

There are several methods for evaluating and ranking the capital investment

proposals. In case of all these method the main emphasis is on the return which will

be derived on the capital invested in the projects. In other words, the basic approach is

to compare the investment in the project with the benefits derived there from.

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TRADITIONAL OR NON-DISCOUNTING:

A. PAY BACK PERIOD:

The payback is one of the most popular and widely recognized traditional methods of

evaluating investment proposals. It is defined as the number of years required to

recover the original cash outlay invested in a project. If the project generates constant

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Capital BudgetingTechniques

Traditional or non-discounting

Time- adjusted or discounted cash flows

Pay back periodAccounting rate of return

Net present valueProfitability indexInternal rate of return

annual cash inflows, the payback period can be computed by dividing cash outlay by

the annual cash inflows.

Payback period = Initial investment Annual cash flow

Accept reject rule:

Many firms use the payback period as accept/reject criterion as well as a method of

ranking projects.

If the payback period calculated for the project is less than the maximum or standard

payback period set by the management, it would be accepted, If not it would be

rejected.

As a ranking method it gives highest to the project which has the shortest payback

period and lowest ranking to the project with highest payback period.

In case of two mutually exclusive projects, the project with the shortest payback

period will be selected

EVALUATION OF PAYBACK PERIOD:

It is simple to understand and easy to calculate

It is costless than most of the sophisticated techniques which require a lot of the time

the use of computers

ADVANTAGES:

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Simple to understand and easy to calculate.

It saves in cost; it requires lesser time and labour as compared to other

methods of capital budgeting.

In this method, as a project with a shorter payback period is preferred to the

one having a longer pay back period, it reduces the loss through obsolescence.

Due to its short- time approach, this method is particularly suited to a firm

which has shortage of cash or whose liquidity position is not good.

DISADVANTAGES:

It does not take into account the cash inflows earned after the payback period

and hence the true profitability of the project cannot be correctly assessed.

This method ignores the time value of the money and does not consider the

magnitude and timing of cash inflows.

It does not take into account the cost of capital, which is very important in

making sound investment decision.

It is difficult to determine the minimum acceptable payback period, which is

subjective decision.

It treats each assets individual in isolation with other assets, which is not

feasible in real practice.

B. ACCOUNTING RATE OF RETURN METHOD:

The accounting rate of return (ARR), also known as the return on investment (ROI),

used accounting information, as revealed by financial statements, to measure the

profitability of an investment.

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The accounting rate of return is found out by dividing the average after tax profit by

the average investment. The average Investment would be equal to half of the original

investment if it is depreciated constantly.

Alternatively, it can be found out dividing the total of the investment’s book value

after depreciation by the life of the project. The accounting rate of return, thus, is an

average rate and can be determined by the following equation:

ARR=Average annual income (after tax & depreciation)Average investment

Where,

Average investment = Original investment 2

ACCEPT OR REJECT CRITERION

As an accept or reject criterion, this method will accept all those projects whose ARR

is higher than the minimum rate established by the management and reject those

projects which have ARR less than the minimum rate.

This method would rank a project as number one if it has highest ARR and lowest

rank would be signed to the project with lowest ARR.

EVALUATION OF ARR METHOD

It is simple to understand and use

The ARR can be readily calculated form the accounting data; unlike in the

NPV and IRR methods, no adjustments are required to arrive at cash flows of

the project.

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The ARR rule incorporates the entire stream of in calculating the project’s

profitability.

ADVANTAGES:

It is very simple to understand and easy to calculate.

It uses the entire earnings of a project in calculating rate of return and hence

gives a true view of profitability.

As this method is based upon accounting profit, it can be readily calculated

from the financial data.

DISADVANTAGES:

It ignores the time value of money.

It does not take in to account the cash flows, which are more important than

the accounting profits.

It ignores the period in which the profit are earned as a 20% rate of return in 2

½ years is considered to be better than 18%rate of return in 12 years.

This method cannot be applied to a situation where investment in project is to be

made in parts.

DISCOUNTED CASH FLOW METHOD:

Discounted cash flow method or time adjusted technique is an improvement over pay

back method and ARR. In evaluating investment projects, it is important to consider

the timing of returns on investment. Discounted cash flow technique takes into

account both the interest factor and the return after the pay back period. Following are

the methods of discounted cash flow method:

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NET PRESENT VALUE METHOD:

Net present value method is the classic economic method of evaluating the investment

proposals. It is considered as the best method of evaluating the capital investment

proposal. It is widely used in practice. The cash inflow to be received at different

period of time will be discounted at a particular discount rate.

It is one of the discounted cash flow techniques explicitly recognizing the

time value of money. It correctly postulates that cash flows arising at different time

periods differ in value and are comparable only when their equivalent present values

are found out.

The following steps are involved in the calculation of NPV:

An appropriate rate of interest should be selected to discount cash flows. Generally it

is referred to the cost of capital.

The present value of cash inflow will the calculated by using this discounted rate.

Net present value should be found out by subtracting present value of cash out flows

from present value of cash inflows.

The net present value is the difference between the total present value of future cash

inflows and the present value of future cash outflows.

ACCEPT OR REJECT CRITERION:

Net present value is used as an accept or reject criteria.

In case NPV is positive (NPV›0) the project is selected for investment

If NPV is negative (NPV<0) the project is rejected

A project may be accepted if NPV=0

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The positive net present value is contribute to the net wealth of the shareholders

which should result in the increased price of a firm’s share.

The NPV method can be used to select between mutually exclusive projects the one

with the higher NPV should be selected. Using the NPV method, project would be

ranked in order of net present values; that is first rank will be given to the project with

highest positive present value and so on.

ADVANTAGES:

It recognizes the time value of money and is suitable to apply in a situation

with uniform cash outflows and uneven cash inflows.

It takes in to account the earnings over the entire life of the project and gives

the true view if the profitability of the investment

Takes in to consideration the objective of maximum profitability.

DISADVANTAGES:

More difficult to understand and operate.

It may not give good results while comparing projects with unequal

investment of funds.

It is not easy to determine an appropriate discount rate.

INTERNAL RATE OF RETURN METHOD:

The internal rate of return (IRR) method is another discounted cash flow technique

which takes account of the magnitude and timing of cash flows. Internal rate of return

is that rate at which the sum of discounted cash inflows equals the sum of discounted

cash outflows.

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It is the rate of discount which reduces the net present value of an investment to zero.

It is called internal rate because it depends mainly on the outlay and proceeds

associated with the project and not on any rate determined outside the investment.

Other terms used to describe the IRR method are yield of an investment, marginal

efficiency of capital, rate of return over cost, time adjusted rate of return and so on.

The concept of internal rate of return is quite simple to understand in the case of a one

period project.

CALCULATION OF INTERNAL RATE OF RETURN:

Calculate cash flow after tax

Calculate fake payback period or factor by dividing the initial investment by average

cash flows.

Look for the factor in the present value annuity table in the year’s column until you

arrive at a figure which is closest to the fake payback period.

Calculate NPV at that percentage

If NPV is positive take a rate higher and if NPV is negative take a rate lower and once

again calculate NPV

Continue step4 until you arrive two rates, one giving positive NPV and another

negative NPV.

Use interpolating to arrive at the actual IRR i.e.…. actual IRR can be calculated by

using the following formula.

Present value _ Cash IRR at lower rate out flow X diff. in the rates

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Present value _ present value at lower rate at higher rate

The more simple words, IRR can be calculated by trial an error method

Which means the unknown discount factor which makes NPV=0 con be calculated by

substituting various values which is tedious process. Therefore the above method may

be used.

ACCEPT OR REJECT CRITERION:

The accept or reject rule, using the IRR method, is to accept the project if its internal

rate of return is higher than the opportunity cost of capital(r>k) note k is also known

as the required rate of return, or cutoff, or hurdle rate.

The project shall be rejected if its internal rate of return is lower than the opportunity

cost of capital (r<k). The decision maker may be indifferent if the internal rate of

return is equal to opportunity cost of capital.

Thus, the IRR rule is

Accept if r>k

Reject if r<k

May accept if r=k

EVALUATION OF IRR METHOD:

It recognizes the time value of money

It considers all cash flows occurring over the entire life of the project to

calculate its rate of return

It is consistent with the share holder’s wealth maximization objective

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ADVANTAGES:

It takes into account, the time value of money and can be applied in situation

with even and even cash flows.

It considers the profitability of the projects for its entire economic life.

The determination of cost of capital is not a pre-requisite for the use of this

method.

It provide for uniform ranking of proposals due to the percentage rate of

return.

This method is also compatible with the objective of maximum profitability.

DISADVANTAGES:

It is difficult to understand and operate.

The results of NPV and IRR methods may differ when the projects under

evaluation differ in their size, life and timings of cash flows.

This method is based on the assumption that the earnings are reinvested at the

IRR for the remaining life of the project, which is not a justified assumption.

PROFITABILITY INDEX:

Yet another time adjusted method of evaluating the investment proposals is the

benefit cost ratio or profitability index (PI).

It is the ratio of the present value of cash inflows, at the required rate of return, to the

initial cash out flow of the investment. It may be the gross or net. Net=gross-1

The formula to calculate benefit cost ratio or profitability index is as follows:

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PI= PRESENT VALUE OF CASH INFLOWSINITIAL CASH OUTLAY

ACCEPT OR REJECT CRITERION:

The following are the PI acceptance rules:

Accept if PI>1

Reject if PI<1

May accept if PI=1

When PI is greater than one, then the project will have net present value.

EVALUATION OF PI METHOD:

It recognizes the time value of money

It is a variation of the NPV method, and requires the same computation as the NPV

method.

In the PI method, since the present value of cash inflows is divided by the initial cash

out flows, it is a relative measure of projects profitability.

ADVANTAGES:

Unlike net present value, the profitability index method is used to rank the

projects even when the costs of the projects differ significantly.

It recognizes the time value of money and is suitable to applied in a situation

with uniform cash outflow and uneven cash inflows.

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It takes into account the earnings over the entire life of the project and gives

the true view of the profitability of the investment.

Takes into consideration the objectives of maximum profitability.

DISADVANTAGES:

More difficult to understand and operate.

It may not give good results while comparing projects with unequal

investment funds.

It is not easy to determine and appropriate discount rate.

It may not give good results while comparing projects with unequal lives as

the project having higher NPV but have a longer life span may not be as

desirable as a project having some what lesser NPV achieved in a much

shorter span of life of the asset.

PROBLEMS AND DIFFICULTIES IN CAPITAL BUDGETING:

The capital budgeting decisions are not critical and analytical in nature, but also

involve various difficulties which a finance manger may come across. The problems

in capital budgeting decision may be as follows:

FUTURE UNCERTAINTY:

All capital budgeting decisions involve long term which is uncertain. Even if every

care is taken and the project is evaluated to every minute detail, still 100% correct and

certain forecast is not possible. The finance manager dealing with the capital

budgeting decision, therefore, should try to be as analytical as possible. The

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uncertainty of the capital budgeting decisions may be with reference to cost of the

project, future expected returns from the project, future competition, expected demand

in future, legal provisions, political situation etc.

TIME ELEMENT:

The implication of a capital budgeting decision are scattered over a long period, the

cost and benefit of a decision may occur at different point of time. As a result, the cost

and benefits of a capital budgeting decision are generally not comparable unless

adjusted for time value of money. These total returns may be than the cost incurred,

still the net benefit cannot be ascertained unless the future benefits are adjusted to

make them comparable with cost. Moreover, the longer the time period involved, the

greater would be the uncertainty.

MEASUREMENT PROBLEM:

Some times a finance manager may also face difficulties in measuring the cost and

benefits of a project’s in quantitative terms. For example, the new product proposed to

be launched by a firm may result in increase or decrease in sales of other products

already being sold by the same firm. This is very difficult to ascertain because the

sales of other products may increase or decrease due to other factors also.

ASSUMPTION IN CAPITAL BUDGETING:

The capital budgeting decision process is a multi-faceted and analytical process. A

number of assumptions are required to be made. These assumptions constitute a

general set of condition within which the financial aspects of different proposals are

to be evaluated. Some of these assumptions are:

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1. Certainty with respect to cost and benefits: it is very difficult to estimate the

cost and benefits of a proposal beyond 2-3 years in future. However, for a

capital budgeting decision, it is assumed that the estimate of cost and benefits

are reasonably accurate and certain.

2. Profit motive: Another assumption is that the capital budgeting decisions are

taken with a primary motive of increasing the profit of the firm. No other

motive or goal influences the decision of the finance manager.

3. No Capital Rationing: The capital Budgeting decision in the present chapter

assumes that there is no scarcity of capital. It assumes that a proposal will be

accepted or rejected in the strength of its merits alone. The proposal will not

be considered in combination with other proposals to the maximum utilization

of available funds.

TYPES OF CAPITAL BUDGETING DECISIONS

FROM THE POINT OF VIEW OF FIRM’S EXISTENCE:

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NEW FIRM: A newly incorporated firm may be required to take different decisions

such as selection of a plant to be installed, capacity utilization at initial stages, to set

up or not simultaneously the ancillary unit etc.

EXISTING FIRM: A firm which is already existing may also required to take

various decisions from time to time to meet the challenges of competition or changing

environment. These decisions may

REPLACEMENT AND MODERNIZATION DECISION:

The main objective of modernization and replacement is to improve operating

efficiency and reduce costs. Cost savings will reflect in the increased profits, but the

firm’s revenue may remain unchanged. Assets become outdated and obsolete with

technological changes. The firm must decide to replace those asserts with new assets

that operate more economically.

If Cement Company changes from semi automatic drying equipment to fully

automatic drying equipment, it is an example of modernization and replacement.

Replacement decisions help to introduce more efficient and economical assets and

therefore, are also called reduction investments. However, replacement decisions

which involve substantial modernization and technological improvements expand

revenues as well as reduced costs.

EXPANSION: Some times, the firm may be interested in increasing the installed

production capacity so as to increase the market share. In such a case, the finance

31

manager is required to evaluate the expansion program in terms of marginal costs and

marginal benefits.

DIVERSIFICATION: Some times, the firm may be interested to diversify into new

product lines, markets, production of spare parts etc. in such case, the finance

manager is required to evaluate not only the marginal cost and benefits , but also the

effect of diversification on the existing market share and profitability. Both the

expansion and diversification decisions may also be known as revenue increasing

decisions.

2. FROM THE POINT OF VIEW OF DECISION SITUATION:

The capital budgeting decision may also be classified from the point of view of the

decision situation as follows:

MUTUALLY EXCLUSIVE DECISIONS:

Two or more alternative proposals are said to be mutually exclusive when acceptance

of one alternative result in automatic rejection of all other proposals. The mutually

exclusive decisions occur when a firm has more than one alternative but competitive

proposal before it. For example, if a company is considering investment in one of two

temperature control system, acceptance of one system will rule out the acceptance of

another.

Thus, two or more mutually exclusive proposals cannot both or all be accepted. Some

technique has to be used for selecting the better or the one. Once this is done, other

alternative automatically get eliminated.

32

CONTINGENT DECISIONS OR DEPENDENT PROPOSALS:

These are proposals whose acceptance depends on the acceptance of one or more

other proposals. For example a new machine may have to be purchased on account of

substantial expansion of plant.

In this case investment in the machine is dependent upon expansion of plant. When a

contingent investment proposal is made, it should also contain the proposal on which

it is dependent in order to have a better perspective of the situation. Any capital

budgeting decision must be evaluated by the finance manager in its totality. The

contingent decision, if any, must be considered and evaluated simultaneously.

INDEPENDENT PROPOSALS:

These are proposals which do not compete with one another in a way that acceptance

of one precludes the possibility of acceptance of another. In case of such proposals the

firm may straight “accept or reject” a proposal on the basis of a maximum return on

investment required.

ACCEPT-REJECT DECISIONS:

An accept-reject decision occurs when a proposal is independently accepted or

rejected with out regard any other alternative proposal. This type of decision is made

when (i) proposal’s cost and benefit neither affect nor are affected by the cost and

benefits of other proposals, and (ii) accepting or rejecting one proposal has not impact

on the desirability of other proposals, and (iii) the different proposals being

considered are competitive.

RATIONALE FOR CAPITAL EXPENDITURE:

Efficiency is the rationale underlying all capital decisions. A firm has to continuously

invest in new plant or machinery for expansion of its operations or replace worn-out

33

machinery for maintaining and improving its efficiency. The overall objectives are to

maximize the profits and thus optimizing the return on investment. Thus capital

expenditure can be of two types:

EXPENDITURE INCREASING REVENUE:

Such a capital expenditure brings mire revenue to the firm either by expansion of

present operations or development of a new product line. In both the cases new fixed

assets are required.

EXPENDITURE REDUCING COSTS:

Such capital expenditure reduces the total cost and there by adds to the total earnings

of the firm. For example, when an asset is worn out becomes obsolete, the firm has to

decide whether to continue with it or replace it by a new machine.

While taking such a decision the firm compares the required cash outflows for the

new machine with the benefit in the form of reduction in operating costs as a result of

replacement of the old machine by a new one. The firm will replace the machine only

when it finds it beneficial.

CAPITAL RATIONING DECISION:

In situations where the firm has unlimited funds, all independent investment proposals

yielding return greater than some predetermined level are accepted. However this

34

situation does not occur in the practical business scenario. They have fixed capital

budget, a large number of projects compete for these limited funds and the firms try to

ration them. The firm allocates the funds to the projects in a manner that maximizes

long-run returns. Thus, capital rationing refers to a situation in which a firm has more

acceptable investments than it can finance. It is concerned with the selection of the

proposal among various projects based on their accept-reject decision.

Capital rationing employs ranking of the acceptable investment projects. The projects

can be ranked on the basis of a predetermined criterion such as the rate of return. The

projects are ranked in the descending order of the rate of return.

Capital rationing involves choice of combination of available projects in a way to

maximize the total net present value, given the capital budget constraint. The ranking

of the project can be done on the basis of profitability index or IRR. The procedure to

select the package of projects will relate to whether the project is divisible or

indivisible, the objective being the maximization of total NPV by exhausting the

capital budget is as far as possible.

INVESTMENT EVALUATION CRITERIA:

The three steps are involved in the evaluation of an investment:

Estimation of cash flows

Estimation of required rate of return

35

Application of a decision rule for making the choice

The investment decision rules may be referred to as capital budgeting techniques, or

investment criteria. A sound appraisal technique should be used to measure the

economic worth of the investment project. The essential property of a sound

technique is that it should maximize the shareholder’s wealth.

The following are characteristics should be possessed by the sound investment

criterion:

It should consider all the cash flows to determine the true profitability of the

project.

It should provide for an objective and unambiguous way of separating good

projects from bad projects

It should help ranking of projects according to their profitability.

It should recognize the fact that bigger cash flows are preferable to smaller

ones and early cash flows are preferable to later ones.

It should help to choose among mutually exclusive projects that project which

maximizes the shareholder’s wealth.

It should be a criterion which is applicable to any conceivable investment

project independent of others.

Choosing among several alternatives.

A criterion which is applicable to any conceivable project.

DATA ANALYSIS

Various methods are used for ascertainment of profitability of capital expenditure.

The practical usages of these methods are discussed here under:

36

PAY BACK METHOD:

This method tells us the number of years required to recover the initial investment of

that asset. It is calculated

Payback period = Initial Investment Annual cash flowThe shorter the payback period, lesser the risk of investment and greater its liquidity.

TO ILLUSTRATE:

YEAR 1 2 3 4 5

PROJECT X 10000 20000 40000 50000 80000

PROJECT Y 20000 40000 60000 80000 -

These cash flows are earned from investment of Rs.200000 for each project.

The annual cash inflows are not constant so we calculate cumulative cash inflows in

order to compute the payback period.

Project-X:

Year Cash inflows Cumulative cash inflows

1 20000 20000

2 30000 (20000+30000)

3 40000 (50000+40000)

4 50000 (90000+50000)

5 80000 (140000+80000)

Initial investment = 200000

Amount received up to the 4th year = 140000

Amount to be received in 5th year = 60000(200000-140000)

Cash flows after taxes in 5th year = 80000

37

PBP = 4Yrs + 60000 80000

= 4 + 0.75 years

= 4 years and 9 months

Project-Y

Year Cash inflows Cumulative cash inflows

1 20000 20000

2 40000 (20000+40000)

3 50000 (60000+50000)

4 70000 (110000+70000)

5 40000 (180000+40000)

Initial investment = 200000

Amount received up to the 4th year = 180000

Amount to be received in 5th year = 20000

(200000-180000)

Cash flows after taxes in 5th year = 40000

PBP = 4Yrs + 20000 40000

= 4 + 0.50 years

= 4 years and 6 months

Hence, from the above given projects, project-Y has to be selected. As it payback

period is less than project-X.

AVERAGE RATE OF RETURN:

This method represents the ratio of average annual profit (after taxes) to the average

investment in the project. It is calculated

ARR= Average Annual Profit after taxes X100 Annual Average investment

38

TO ILLUSTRATE:

A project requires an investment of Rs.1200000 and has a scrap value of Rs.200000

after five years. It is expected to yield profits after depreciation and taxes during the

five years amounting to Rs.250000, Rs.300000, Rs.350000, Rs.400000 and

Rs.200000. Calculate the average rate of return on the investment.

SOLUTION:

Total profit = Rs. 250000+300000+350000+400000+200000

= Rs. 1500000

Average profit = 1500000 5

= Rs. 300000

New investment in the project = Rs. 1500000 – 200000 (Scrap value)

= Rs. 1300000

Average rate of return = Average Annual profit X 100 Net Investment in the Project

= 300000 X100 1300000 = 23.076%

This method is based on accounting information rather upon cash flows. This method

is simple and makes use of readily available accounting information. Once average

return is expected it can be readily compared with the expected return, to determine

whether a particular proposal for capital expenditure should be accepted or rejected.

DISCOUNTED PAY BACK PERIOD

Discounted cash flow method or time adjusted technique is an improvement over pay

back method and ARR. In evaluating investment projects, it is important to consider

39

the timing of returns on investment. Discounted cash flow technique takes into

account both the interest factor and the return after the payback period.

TO ILLUSTRATE:

The Alpha Company Ltd. is considering the purchase of a new machine. Two

alternative machines (A and B) have been suggested each costing Rs.400000. Earning

after taxation is expected to be as follows:

YEAR CASH FLOW OF MACHINE-A CASH FLOW OF MACHINE-B

1

2

3

4

5

40000

120000

160000

240000

160000

120000

160000

200000

120000

80000

The company has a target of return on capital of 10% and on this basis. You are

required to compare the probability of the machines and state which alternative you

consider financially preferable.

SOLUTION:

The profitability of the machine can be compared on the basis of net present value of

cash inflows as follows:

40

PRESENT VALUE OF CASH FLOWS

Year Discount Cash inflow Present value

Cash inflows

Present value

1

2

3

4

5

0.91

0.83

0.75

0.68

0.62

40000

120000

160000

240000

160000

36400

99600

120000

163200

99200

518400

120000

160000

200000

120000

80000

109200

132000

150000

81600

49600

523200

Machine-A Machine-B

Net present value 518400 523200

(-) Initial Investment (400000) (400000)

118400 123200

P.I=Present Value of Cash Inflows = 518400 = 523200 Initial Investments 400000 400000

= 1.29 = 1.30

The net present values as well as the profitability index are higher in case of Machine

B and hence Machine B will be preferred.

NET PRESENT VALUE:

The Net present Value (NPV) method is the classic economic method of evaluating

the investment proposals. It is one of the discounted cash flow techniques explicitly

41

recognizing the time value of money. It correctly postulates that cash flows arising at

different time periods differ in value and the comparable only when their equivalent

present values are found out.

NPV = PRESENT VALUE OF CASH INFLOWS –

PRESENT VALUE OF CASH OUTFLOW

TO ILLUSTRATE:

A company is considering investment in a project that costs Rs.200000. The project

has an expected life of 5 years and zero salvage value. The company uses straight line

method of depreciation. The company’s tax rate is 40%. The estimated earnings

before depreciation and before tax from the project are as follows:

Year 1 2 3 4 5

CFBT 70000 80000 120000 90000 60000

PVCF 0.909 0.826 0.751 0.683 0.621

You are required to calculate the present value at 10% and advise the company

SOLUTION:

Calculation of Cash Flows

42

Years Earnings before

dep.& tax

Depreciation EBT Tax EAT Cash Flows(EAT+Dep.)

PV@

10%

PVof

CashFlow

1

2

3

4

5

70000

80000

120000

90000

60000

40000

40000

40000

40000

40000

30000

40000

80000

50000

20000

12000

16000

32000

20000

8000

18000

24000

48000

30000

12000

58000

64000

88000

70000

52000

0.909

0.826

0.751

0.683

0.621

52722

52864

66088

47810

32292

Total present value of cash inflows = 251776

Less: present of Initial cost = (200000) = 51776

The net present value of the project is 51776.

PROFITABILITY INDEX METHOD:

It is also a time-adjusted method of evaluating the investment proposals. PI also called

benefit cost ratio or desirability factor is the relationship between present value of

cash inflows and the present values of cash outflows. Thus

Profitability index = PV of cash inflows PV of cash outflows

TO ILLUSTRATE:

The initial cash outlay of a project is Rs.50000 and it generates cash inflows of

Rs.20000, Rs.15000, Rs.25000 and Rs.10000 in four years. Using present value index

43

method, appraise profitability of the proposed investment assuming 10% rate of

discount.

SOLUTION:

Calculations of present values and profitability index:

Year Cash Inflows Present Value Factor @10% Present Value

1

2

3

4

20000

15000

25000

10000

0.909

0.826

0.751

0.683

18180

12390

18775

6830

56175

Profitability Index = Present value of Cash Inflows Initial Cash Outlay

= 56175 50000

Profitability Index = 1.1235

As the P.I is higher than 1, the proposal can be accepted.

INTERNAL RATE OF RETURN (IRR):

The Internal Rate of Return (IRR) method is another discounted cash flow technique,

which makes account of the magnitude and timing of cash flows. Others terms used to

describe the IRR Method are yield on investment, marginal efficiency of capital, rate

44

of return over cost and so on. The concept of internal rate of return is quite simple to

understand in the case of one-period projects.

TO ILLUSTRATE:

Initial Investment Rs.60000

Life of the Asset 4 years

Estimated Net Annual Cash Flows:

1st Year 15000

2nd Year 20000

3rd Year 30000

4th Year 20000

Calculate Internal Rate of Return.

SOLUTION:

Cash Flow Table at various Assumed Discount Rates of 10%, 12%, 14% & 15%

YearAnnualCash Flow

Dis rate 10% Dis rate 12% Dis rate 14% Dis rate 15%P.V.F P.V

Rs.P.V.F P.V

Rs.P.V.F P.V

Rs.P.V.F P.V

Rs.1

2

3

4

15000

20000

30000

20000

0.909

0.826

0.751

0.683

13635

16520

22530

13660

66345

0.892

0.797

0.711

0.635

13380

15940

21330

12700

63350

0.877

0.769

0.674

0.592

13155

15380

20220

11840

60595

0.869

0.756

0.657

0.571

13035

15120

19710

11420

59285

The present value of net cash flows at 14% rate of discount is Rs.60595 and at 15%

rate of discount it is Rs.59285. So the initial cost of investment which is Rs.60000

45

falls in between these two discount rates. At 14% the NPV is +595 but at 15% the

NPV is -715, we may say that

Present value _ Cash IRR= at lower rate out flow X diff. in the rates

Present value _ present value at lower rate at higher rate

IRR= 14% + 595 X (15% - 14 %) 595 + 715

= 14.45%

INTRODUCTION:

SLOGAN:“With you right through”.

46

” Helping Indians experience the joy of home ownership”.

The road to success is a tough and challenging journey in the dark where only

obstacles light the path. However, success on a terrain like this is not without a

solution.

As HDFC found out over three decades ago, in 1977 the solution for success is

customer satisfaction. All you need is the courage to innovate, the skill to understand

your clients and the desire to give them your best. HDFC’s objective from the

beginning has been to enhance residential housing stock and promote home

ownership. Now, HDFC’s offerings range from hassle free home loans and deposit

products, to property related services and a training facility.

HDFC also offers specialized financial services to their customer base through

partnerships with some of the best financial institutions worldwide.

OBJECTIVES AND BACKGROUND:

Against the trend of rapid urbanization and a changing socio-economic scenario, the

demand for housing has grown explosively. The importance of housing sector in the

economy can be illustrated by a few key statistics. According to the National Building

Organization (N.B.O), the demand for housing is estimated at two million units per

year and the total housing short fall of estimated to be 19.4 million units, of which

12.76 million units is from rural areas and 6.64 million units is from urban areas. The

housing industry is second largest employment generator in the country. It is

estimated that the budgeted two million units would lead to the creation of an

additional ten million man-years of direct employment and another 15 million man-

years of indirect employment

BACKGROUND:

47

HDFC was incorporates in the year 1977, with the primary objective of meeting a

social need that of promoting home ownership by providing long-term finance to

house holds for their housing needs. HDFC was promoted with an initial share capital

of Rs.100 millions.

BUSINESS OBJECTIVES:

The primary objective of HDFC is to enhance residential housing stock in the country

through the provision of housing finance in a systematic and professional manner and

to promote home ownership. Another objective is to increase the flow of resources to

the housing sector by integrating housing finance sector with overall domestic

financial markets.

ORGANIZATIONAL GOALS:

1. Develop close relationships with individual households.

2. Maintain its position has a premier housing finance institution in the country.

3. Transform ideas into viable and creative solutions

4. Provide consistently high returns to shareholders.

5. To grow through diversification, by leveraging off the existing client base.

CONSULTANCY SERVICES:

HDFC is a unique example of housing finance company that has demonstrated the

viability of market oriented housing finance in a developing country. It is viewed as a

market leader in the Housing finance sector in India. The World Bank considers

HDFC a model private sector housing finance company in developing countries and a

provider of technical assistance for new and existing institutions in India and abroad.

48

HDFC’s executives have undertaken consultancy assignments related to housing

finance and urban development on behalf of multi lateral agencies allover the world.

HDFC has also served as consultant to international agencies such as World Bank,

United States’ Agency for International Development (USAID), Asian Development

Bank, United Nations’ Centre for Human Settlements, Common wealth Development

Corporation (CDC) and United Nations Development Programme (UNDP).

At the national level, HDFC’s executives have played a key role in formulating

national housing policies and strategies. Recognizing HDFC’s executives to join a

number of comities and task force related to housing finance, urban development and

capital markets.

SUBSIDARY & ASSOCIATE COMPANIES:

HDFC Bank.

HDFC Mutual Fund.

HDFC Standard Life Insurance Company.

HDFC Securities.

HDFC Reality.

HDFC Chubb General Insurance Company ltd.

Intel net Global services.

Credit Information Bureau (India) Ltd.

Other Companies Co-Promoted by HDFC.

49

HOUSING DEVELOPMENT FINANCE CORPORATION

HDFC Bank was incorporated in August 1994 in the name of ‘HDFC Bank Limited’,

with its registered office in Mumbai, India. The Bank commenced operations as a

Scheduled Commercial Bank in January 1995. The Housing Development Finance

Corporation Limited (HDFC) was amongst the first to receive an ‘in principle’

approval from the Reserve Bank of India (RBI) to set up a bank in the private sector,

as part of the RBI’s liberalization of the Indian Banking Industry in 1994.

Headquartered in Mumbai, HDFC Bank, has a network of over 531 branches spread

over 228 cities across India. All branches are linked on an online real-time basis.

Customers in over 120 locations are serviced through Telephone Banking. The Bank

also has a network of about over 1054 networked ATMs across these cities. HDFC

Bank’s ATM network can be accessed by all domestic and international Visa,

MasterCard, Visa Electron, Maestro, Plus, Cirrus and American Express Credit,

Charge cardholders. The Bank’s expansion plans take into account the need to have a

presence in all major industrial and commercial centers where its corporate customers

are located as well as the to build a strong retail customer base for both deposits and

loan products. Being a clearing settlement bank to various leading stock exchanges,

the Bank has branches in the centers where the NSE/BSE has a strong and active

member base. HDFC Bank also has Private Banking Group which offers investment

advisory and portfolio management services to its clients.

HDFC Bank has won many awards for its excellent service. Major among them are

“Best Bank in India” by Hong Kong-based Finance Asia magazine in 2006 and

“Company of the Year” Award for Corporate Excellence 2005-05. Business Today

has declared HDFC Bank the “Best Bank” for the year 2007. Net Profit for the nine

months ended 31st December 2007 up by 31.3%.

50

PROMOTERS

HDFC is India's premier housing finance company and enjoys an impeccable track

record in India as well as in international markets. Since its inception in 1977, the

Corporation has maintained a consistent and healthy growth in its operations to

remain the market leader in mortgages. Its outstanding loan portfolio covers well over

a million dwelling units. HDFC has developed significant expertise in retail mortgage

loans to different market segments and also has a large corporate client base for its

housing related credit facilities. With its experience in the financial markets, a strong

market reputation, large shareholder base and unique consumer franchise, HDFC was

ideally positioned to promote a bank in the Indian environment

BUSINESS FOCUS

HDFC Bank's mission is to be a World-Class Indian Bank. The objective is to build

sound customer franchises across distinct businesses so as to be the preferred provider

of banking services for target retail and wholesale customer segments, and to achieve

healthy growth in profitability, consistent with the bank's risk appetite. The bank is

committed to maintain the highest level of ethical standards, professional integrity,

corporate governance and regulatory compliance. HDFC Bank's business philosophy

is based on four core values - Operational Excellence, Customer Focus, Product

Leadership and People.

BUSINESS STRUCTURE

The authorized capital of HDFC Bank is Rs.450 crore (Rs.4.5 billion). The paid-up

capital is Rs.311.9 crore (Rs.3.1 billion). The HDFC Group holds 22.1% of the bank's

equity and about 19.4% of the equity is held by the ADS Depository (in respect of the

bank's American Depository Shares (ADS) Issue). Roughly 31.3% of the equity is

51

held by Foreign Institutional Investors (FIIs) and the bank has about 190,000

shareholders. The shares are listed on the Stock Exchange, Mumbai and the National

Stock Exchange. Shares are listed on the New York Stock Exchange (NYSE) under

the symbol "HDB".

MANAGEMENT

Mr. Jadish Capoor took over as the bank's Chairman in July 2002. Prior to this, Mr.

Capoor was a Deputy Governor of the Reserve Bank of India.

The Managing Director, Mr. Aditya Puri, has been a professional banker for over 25

years and before joining HDFC Bank in 1994 was heading Citibank's operations in

Malaysia. The Bank's Board of Directors is composed of eminent individuals with a

wealth of experience in public policy, administration, industry and commercial

banking. Senior executives representing HDFC are also on the Board. Senior banking

professionals with substantial experience in India and abroad head various businesses

and functions and report to the Managing Director. Given the professional expertise

of the management team and the overall focus on recruiting and retaining the best

talent in the industry, the bank believes that its people are a significant competitive

strength.

TECHNOLOGY

HDFC Bank operates in a highly automated environment in terms of information

technology and communication systems. All the bank's branches have online

connectivity, which enables the bank to offer speedy funds transfer facilities to its

customers. Multi-branch access is also provided to retail customers through the

branch network and Automated Teller Machines.(ATMs).

52

BUSINESSES

WHOLESALEBANKING:

The Bank's target market ranges from large, blue-chip manufacturing companies in

the Indian corporate to small & mid-sized corporate and agri-based businesses. For

these customers, the Bank provides a wide range of commercial and transactional

banking services, including working capital finance, trade services, transactional

services, cash management, etc. The bank is also a leading provider of structured

solutions, which combine cash management services with vendor and distributor

finance for facilitating superior supply chain management for its corporate customers.

Based on its superior product delivery / service levels and strong customer

orientation, the Bank has made significant inroads into the banking consortia of a

number of leading Indian corporate including multinationals, companies from the

domestic business houses and prime public sector companies. It is recognized as a

leading provider of cash management and transactional banking solutions to corporate

customers, mutual funds, stock exchange members and banks.

Retail banking services

The objective of the Retail Bank is to provide its target market customers a full range

of financial products and banking services, giving the customer a one-stop window

for all his/her banking requirements. The products are backed by world-class service

and delivered to the customers through the growing branch network, as well as

through alternative delivery channels like ATMs, Phone Banking, and Net Banking

and Mobile Banking.

53

The HDFC Bank Preferred program for high net worth individuals, the HDFC Bank

Plus and the Investment Advisory Services programs have been designed keeping in

mind needs of customers who seek distinct financial solutions, information and advice

on various investment avenues. The Bank also has a wide array of retail loan products

including Auto Loans, Loans against marketable securities, Personal Loans and Loans

for Two-wheelers. It is also a leading provider of Depository Participant (DP) services

for retail customers, providing customers the facility to hold their investments in

electronic form.

HDFC Bank was the first bank in India to launch an International Debit Card in

association with VISA (VISA Electron) and issues the MasterCard Maestro debit card

as well. The Bank launched its credit card business in late 2002. By September 30,

2006, the bank had a total card base (debit and credit cards) of 5.2 million cards. The

Bank is also one of the leading players in the "merchant acquiring" business with over

50,000 Point-of-sale (POS) terminals for debit / credit cards acceptance at merchant

establishments.

Treasury

Within this business, the bank has three main product areas - Foreign Exchange and

Derivatives, Local Currency Money Market & Debt Securities, and Equities. With the

liberalization of the financial markets in India, corporate need more sophisticated risk

management information, advice and product structures. These and fine pricing on

various treasury products are provided through the bank's Treasury team. To comply

with statutory reserve requirements, the bank is required to hold 25% of its deposits in

government securities. The Treasury business is responsible for managing the returns

and market risk on this investment portfolio

54

CREDIT RATING

HDFC Bank has its deposit programmers rated by two rating agencies - Credit

Analysis & Research Limited. (CARE) and Fitch Ratings India Private Limited. The

Bank's Fixed Deposit programme has been rated 'CARE AAA (FD)' [Triple A] by

CARE, which represents instruments considered to be "of the best quality, carrying

negligible investment risk". CARE has also rated the Bank's Certificate of Deposit

(CD) programme "PR 1+" which represents "superior capacity for repayment of short

term promissory obligations". Fitch Ratings India Pvt. Ltd. (100% subsidiary of Fitch

Inc.) has assigned the "tAAA (ind)" rating to the Bank's deposit programme, with the

outlook on the rating as "stable". This rating indicates "highest credit quality" where

"protection factors are very high". HDFC Bank also has its long term unsecured,

subordinated (Tier II) Bonds of Rs.4 billion rated by CARE and Fitch Ratings India

Private Limited. CARE has assigned the rating of "CARE AAA" for the Tier II Bonds

while Fitch Ratings India Pvt. Ltd. has assigned the rating "AAA (Ind)" with the

outlook on the rating as "stable". In each of the cases referred to above, the ratings

awarded were the highest assigned by the rating agency for those instruments.

Corporate Governance Rating

The bank was one of the first four companies, which subjected itself to a Corporate

Governance and Value Creation (GVC) rating by the rating agency, The Credit Rating

Information Services of India Limited (CRISIL). The rating provides an independent

assessment of an entity's current performance and an expectation on its "balanced

value creation and corporate governance practices" in future. The bank has been

assigned a 'CRISIL GVC Level 1' rating which indicates that the bank's capability

with respect to wealth creation for all its stakeholders while adopting sound corporate

governance practices is the highest.

55

HDFC was incorporated in 1977 as the first specialized Mortgage Company in India.

HDFC provides financial assistance individuals, corporate and developers for the

purchase or construction of residential housing. It also provides property services

(e.g. property identification, sales services and valuation), training and consultancy.

Of these activities, housing finance remains the dominant activity. HDFC has a client

base of around 10, 00,000 borrowers, around 8, 50,000 depositors, over 92,000

shareholders and 50,000 deposit agents, as at December 31, 2010. HDFC has raised

funds from international agencies such as the World Bank, IFC (Washington),

USAID, DEG, ADB and KfW, international syndicated loans, domestic term loans

from banks and insurance companies, bonds and deposits. HDFC Standard Life

Insurance Company Limited, promoted by HDFC was the first life insurance

company in the private sector to be granted Certificate of Registration (on October 23,

2001) by the Insurance Regulatory and Development Authority to transact life

insurance business in India.

AWARDS AND ACCOLADES:

HDFC ranked no.3-‘India’s Best managed Companies’ by Finance Asia Clean

Sweep by HDFC at the 43rd ABCI Awards.

National Award for Excellence in Corporate Governance by the Institute Of

Companies Secretaries of India.

2nd best company for Corporate Governance in India by The Asset Magazine.

The Economic Times Lifetime achievement Award – 2009

(Mr. Deepak Parekh, Chairman, HDFC ltd.).

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One of the top ten- Most Admired Companies in India’ – 2004 by Business

barons.

One of the top ten – Most Admired CEO’s in India – 2004 by Business Barons

(Mr. Deepak Parekh).

India’s second Best Managed Company-2009 by Financial Asia.

India’s biggest wealth creator in the banking and financial services by the

fourth Business Today-Stern Steward Survey.

Highest rating for ‘ Governance and Value Creation ‘ by CRISIL>

Best ‘Managed Financial Institutions in India’ by Fox Pitt Survey.

HDFC Bank began operations in 1995 with a simple mission: to be a "World-

class Indian Bank".

As part of the Asian Banker Awards 2004.

In 2010, HDFC Bank was selected by Business World as "One of India's Most

Respected Companies" as part of The Business World Most Respected

Company Awards 2010.

In 2010, HDFC Bank won the award for "Operational Excellence in Retail

Financial Services" – India.

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INTRODUCTION:

HDFC involved in industrial financing. They extend term loans for acquiring fixed

assets and also working capital term loans. When they are to extend term loans for

acquiring fixed assets like land building, machinery etc they appraise the project to

establish the financial, economic and technically viability of the project while

extending long term loans HDFC use capital budgeting techniques. The basic idea of

using capital budgeting is to compare ,whether, the amount invested on the project at

certain rate of return is more or less when compared to the required rate of return

At HDFC internal rate of return method is used to appraise an industrial

project. The internal rate of return calculated is compared with the required rate of

return. If the internal rate of return calculated is more than the required rate of return,

the project is accepted if not, it should be rejected. Here it needs to be explained the

meaning of required rate of return. Generally, the concern’s required rate of return is

the concern’s cost of capital and the cost of capital is the rate of return on a project

that will have unchanged the market price of shares. Thus, the cost of capital is the

required rate of return needed to justify the use of capital.

The cost of capital on term loans is the interest rate that is changed on

disbursal of funds. HDFC change interest rates ranging from 11% to 14.5% depends

upon the nature of the project and scheme of financial assistance. Therefore the cost

of capital on loans and advances is the interest rate changed by the term lending

institutions. Hence, the required rate of return is the interest rate changed by the

financial institutions for extending term loan assistance. For example, if the HDFC

changes interest at 14%, then the concern’s cost of capital or required rate of return is

14%. This required rate is compared at the concern’s internal rate of returns.

Extending or rejecting the proposal depends upon the more or less of the IRR over the

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cost of capital. Therefore the viability of the project is determined among other

parameters with reference to the rate of earnings over the desired rate of return that is

the earnings expected over the cost of capital of the project that is interest rate. It is

always seen that the earnings made by the project is more than the interest rate to

accept the project other wise the project is rejected.

USE OF IRR TECHNIQUE IS EXPLAINED WITH THE HELP OF THE

FOLLOWING EXAMPLE

M/S ventech private limited has approached HDFC for a term loan RS. 1500 lakhs for

expansion of their existing paper mill at Hyderabad. The total project cost of the

expansion is worked at RS.2060 lakhs and the overall project cost is worked at

RS.3003 lakhs as given below:

(RS in lakhs)

Project cost Existing Proposed Total

Land 70.00 --- 70.00

Buildings 233.00 200.00 433.00

Plant & machinery 518.00 1580.00 2098.00

Factory equipment 4.00 --- 4.00

Electrical 20.00 --- 20.00

Computers & furniture 7.00 --- 7.00

Vehicles 21.00 --- 21.00

Deposits 30.00 --- 30.00

Working capital margin 40.00 280.00 320.00

943.00 2060.00 3003.00

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The project has been appraised by HDFC and worked out the following

economics for the project:

Capacity utilisation = 90% Sales = RS.3314 lakhs

MANUFACTURING EXPENSES (A)

(RS. In lakhs)

Raw materials 1553.00

Con 31.00

Power & fuel 303.00

Wages 50.00

Repairs & maintenance 54.00

Taxes 42.00

Other inputs 42.00

2076.00

ADMINISTRATIVE EXPENSES (B)

(RS. In lakhs)

Management remunerating 12.00

Salaries 22.00

Other expenses 42.00

76.00

Total cost of production (A+B) 2151.00

Gross profit 1163.00

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FINANCIAL EXPENSES

Interest on term loans 230.00

Interest on bank borrowing 65.00 295.00

868.00

Depreciation 355.00

Operating profit 513.00

Provision for taxation 173.00

Profit after tax 340.00

Net profit before taxes 808.00

Interest added back, but after depreciation

The project cost is met as under:

(RS. In lakhs)

Existing proposed Total

Equity share capital 175.00 407.00 582.00

Reserves & surplus 76.00 153.00 229.00

Term loan fromNTPC 494.00 1500.00 1994.00

Unsecured loans 198.00 --- 198.00

943.00 2060.00 3003.00

The cash flows are generated for 8years at follows:

(RS. In lakhs)CASH INFLOW 1ST

YR2ND YR

3RD YR

4TH YR

5TH YR

6TH YR

7TH YR

8TH YR

E.B.I.T 808 914 937 963 981.01 995 1003 1008

DEPRECIATION 355 311 267 229 196.35 169 145 124

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TOTAL 1163 1225. 1204 1191 1177.37 1163 1148 1132

The procedure adopted for calculating IRR is as given:

The project cost is arrived at, which consists of both fixed and current assets. In the

instant case, the fixed assets comprised of RS.2683.00 lakhs and current assets

comprised of RS.320.00 lakhs.

The following assumptions are made:

The life of the project is assumed at 15 years

The residual value of fixed assets at the end of 15 years is taken as ‘NIL’ excluding

cost at land.

The realizable value of current assets is at 100%

The interest rate changed for the term loan being sanctioned is assumed at 12%.

The term loan being sanctioned is expected to be repaid in a period of 8 years.

The outlay is expected to be spent in a period of 3 years as Follows:

(RS. In lakhs)

O year 2683

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1st year 920

3rd year 52 3655IRR can be calculated manually or by using computers. The IRR is calculated by

using computer as follows is as under:

Year Capital out lay benefits Net benefits Discounted benefits

construction 2683.25 0.00 -2683.25 -2683.25

1st 920.00 1162.57 242.57 180.34

2nd 51.00 1225.45 1174.34 649.05

3rd 0.00 1203.76 1203.76 494.62

4th 0.00 1190.87 1190.87 363.78

5th 0.00 1177.37 1177.37 267.38

6th 0.00 1163.16 1163.16 196.38

7th 0.00 1148.28 1148.28 144.13

8th 0.00 1132.62 1132.62 105.69

9th 0.00 1132.62 1132.62 78.57

10th 0.00 1132.62 1132.62 58.41

11th 0.00 1132.62 1132.62 43.43

12th 0.00 1132.62 1132.62 32.39

13th 0.00 1132.62 1132.62 24.00

14th 0.00 1132.62 1132.62 17.84

15th 0.00 2333.21 2333.21 27.33

Re projects IRR is worked at 34.5%

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OBSERVATIONS:

The IRR for the instant project proposal is worked out at 34.5%

The cost of capital or cut off rate is interest rate charged by HDFC that is 12%

Since the IRR is more than the cost of capital the project is accepted for financial

assistance

Suitability of IRR technique to project finance:

One of the discounted capital budgeting techniques, the IRR is widely used in project

finance proposals because of its suitability. It is defined rate of discount at which the

present values of inflows are equal to present value of out flows.

In project finance decisions it is easy to determine the cost of capital,

which is equivalent to the interest rate charged. Therefore it is easy to calculate the

present values of inflows and outflows by discounting the values at the cost of capital.

The project’s whose IRR is more than the cut off rate is accepted and vice versa. The

data required for arriving at the cash flows are easily calculated and thus the decision

making is fast.

Where as another model, capital budgeting technique net present value

methods is most suitable for decisions involved buying machinery items etc. Selection

of automatic or manual machinery.

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In view of the above HDFC is using IRR technique for their project finance

proposals.

HDFC has been instrumental in industrial development of Andhra Pradesh.

During the 25th of its long saga, the corporation has financed above RS6000 cr to

nearly 86000 cr enterprises.

The corporation has generated direct and indirect employment.

The corporation has completed 25 years of service and to mark this occasion Golden

Jubilee Celebration was conducted during 2006-2007

HDFC has achieved tremendous results during 2006-2007 in its key areas of

operation. There is a 26% growth in sanction, 21% in disbursements over the previous

year.

The performance of the corporation is highest among all in the country. As a result the

corporation has attained No. one position in the country for the 5th year

The evaluation techniques are broadly classified into two types i.e traditional

technique and discounted cash flow technique.

The traditional technique includes net pay back period, average rate of return

The discounted cash flow technique includes Net Present Value, Internal Rate Of

Return, Profitability Index.

In HDFCC a project is appraised to examine the financial viability of the project.

HDFC works out Internal Rate Of Return in appraisal of the project among the capital

budgeting technique.

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An accept-reject criterion has been applied for all the capital budgeting methods.

The result in this case study suggests that the project can be accepted.

The corporation may consider using of other capital budgeting techniques like Pay

Back Period, Average Rate Of Return, Net Present Value, Profitability Index in the

appraisal of the project, which will enhance the quality of the appraisal.

CONCLUSIONS

All the techniques of capital budgeting presume that various

investment proposals under consideration are mutually

exclusive which may not practically be true in some particular

circumstances.

The techniques of capital budgeting require estimation of

future cash inflows and outflows. The future is always

uncertain and the data collected for future may not be exact.

Obviously the results based upon wrong data may not be

good.

There are certain factors like morale of the employees,

goodwill of the firm, etc., which cannot be correctly quantified

but which otherwise substantially influence the capital

decision.

Urgency is another limitation in the evaluation of capital

investment decisions.

Uncertainty and risk pose the biggest limitation to the

techniques of capital budgeting.

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LIMITATION OF THE STUDY:

Lack of time is another limiting factor, i.e., the schedule period of 8 weeks

are not sufficient to make the study independently regarding Capital

Budgeting in HDFC.

The busy schedule of the officials in the HDFC is another limiting factor.

Due to the busy schedule officials restricted me to collect the complete

information about organization.

Non-availability of confidential financial data.

The study is conducted in a short period, which was not detailed in all

aspects.

All the techniques of capital budgeting are not used in HDFC. Therefore it

was possible to explain only few methods of capital budgeting.

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BIBLOGRAPHY:

Financial Management -- I.M. Pandey

Management Accountancy -- Khan & Jain

Financial Management -- S.N. Maheshwari

Advanced Accountancy -- S.P. Jain & K.V. Narayana

Financial Management -- Prasanna Chandra

Management Accountancy -- Sharma & Shashi K. Gupta

HDFC Annual reports

WWW.hdfc.com

WWW.HDFCINDIA.COM

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