INTRODUCTION TO PROJECT AT ECIL CAPITAL BUDETING Introduction to project: The term Capital Budgeting refers to long term planning for proposed capital outlay and their Financing . 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 decisions are one of the most important decisions, which affect both long and short run existence of a business. It has the major impact on the shareholders wealth in the long run. The project work has recognized the above two phases and conducted this study. The study aims at identifying the extent to which capital budgeting techniques and its related practices are used by the ECIL, and identifying reasonable justifications behind the use of such pattern. To evaluate the above, techniques such as PBP, ARR, NPV, PI, and IRR are used. The study also shows the practices related to capital budgeting techniques such as: cost of capital estimation methods, risk analysis techniques, and cash flow forecasting techniques, which are 1
Transcript
INTRODUCTION TO PROJECT AT ECILCAPITAL BUDETING
Introduction to project:
The term Capital Budgeting refers to long term planning for proposed capital outlay and their
Financing . 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 decisions are one of the most
important decisions, which affect both long and short run existence of a business. It has the major
impact on the shareholders wealth in the long run. The project work has recognized the above two
phases and conducted this study. The study aims at identifying the extent to which capital budgeting
techniques and its related practices are used by the ECIL, and identifying reasonable justifications
behind the use of such pattern. To evaluate the above, techniques such as PBP, ARR, NPV, PI, and IRR
are used. The study also shows the practices related to capital budgeting techniques such as: cost of
capital estimation methods, risk analysis techniques, and cash flow forecasting techniques, which are
not widely used by the ECIL within the domination of subjective judgment.
The term Capital Budgeting refers to long term planning for proposed capital outlay and their
financing. 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
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exclusively with investment proposals, which an 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 like land and buildings.
Cost of addition, expansion, improvement or alteration in the fixed assets.
R&D project cost, etc.
ECIL was setup under the Department of Atomic Energy, with a view to generate a strong indigenous
capability in the field of professional grade electronics.
Many industries these days require concepts of electronics in their production process. Electronics is
assuming increasing importance in the monitoring and control of production of many industries like
Engineering, Chemical and Metallurgical industries. In India, the electronics industry has growth in many
strides both in public and private sectors.
A part from this, in the field of industrial electronics , the government of India has taken initiations in
1960”s ton set up a industrial units in public sectors in order to produce industrial electronics system
with indigenous technology to meet the nation’s requirement in static areas. Electronics occupies a key
position in modern science and technology. It has a vital role to play in the field of Atomic Energy,
communication, defense education, Space technology and entertainment. Because of its dynamic
character, its pervasive nature and its significant impact on science, industry and society, Electronics is
today in the vanguard of the technology process. Technology process is both very rapid in this field.
An intensive promotional effort to both production and research and development is therefore essential
to ensure a rapid growth in this field. In this direction, the government of India and its agencies with the
aim of developing and promoting industrial Electronics system with indigenous know-how to attain Self-
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sufficiency in Atomic energy programmed started ELECTRONICS CORPORATION OF INDIA LIMITED on 11th
April 1967.
In any growing concern, capital budgeting is more or less a continuous process and
it is carried out by different functional areas of management such as production, marketing,
engineering, financial management etc. All the relevant functional departments play a crucial role in the
capital budgeting decision process of any organization, yet for the time being, only the financial aspects
of capital budgeting decision are considered to discuss. The role of a finance manager in the capital
budgeting basically lies in the process of critically & in-depth analysis and evaluation of various
alternative proposals, then to select one out of these alternatives. As already stated, the basic objectives
of financial management is to maximize the wealth of the share holders, therefore the objectives of
capital budgeting is to select those long term investment projects that are expected to make maximum
contribution to the wealth of the shareholders in the long run.
Objectives of project:
To study the capital budgeting techniques and their related practices that used by ECIL.
To study the reasons behind the selection of existing capital budgeting techniques by the ECIL rather
than others.
To evaluate the effect of the capital budgeting technique used on the ECIL’s performance.
To measure the present value of rupee invested by ECIL.
To understand an item wise study of the ECIL of financial performance of the company.
To summarize and make suggestions if any, for improving the financial positions of ECIL.
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To study the financial aspects for future expansion of ECIL.
To offer suggestion if required for the better investment proposal to ECIL.
Scope of project:
The scope of this project will not only be limited to understanding the finacial capital budgeting
practices employed in ECIL , but it will also analyze the finacial decisions taken by these units using
standed capital techniques there by analyzing the various projects undertaken by the ECIL.
1. To know the how money is acquired and from what sources.
2. In what way individual capital project alternatives are identified and evaluated by ECIL.
3. How minimum requirements of acceptability are set.
4. How final project selections are made by ECIL.
Methodology:
To achieve a fore said 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 interviews with officials. Information is collected by circulating questionnaires to the
officials of the finance department. A part from these some information is collected through the
personal interviews and suggestions collected from required personals.
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SECONDARY SOURCES:
These secondary data is the existing data which is collected by others that is sources are financial
journals, annual reports of the ECIL or ECIL website, and other concerned publications.
Limitations of project:
Lack of time is another limiting factor the schedule period 6 weeks are not sufficient to make the
study independently regarding Capital budgeting in ECIL.
The busy schedule of the officials in the ECIL is another Limiting factor. Due to the busy schedule of
officials may restrict me in collecting the complete information about organization.
Availability of confidential financial data is a constraint
There is no scope of gathering current information, as the auditing has not been done by the time of
the project work.
The study is carried basing on the information and documents provided by the organization with the
various employees and based on the interaction with the various employees of the respective
departments.
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COMPANY PROFILE
ABOUT ECIL
A. ECIL HISTORY
"Let us work up the embers of national pride latent in all of us and build up our morale so that we can
confidently aim high and achieve greater goals"
Dr. A.S.Rao,
Founder MD of ECIL
Ayyagari Sambasiva Rao, the founder managing director of the Electronics Corporation of India Limited
(ECIL), died on Friday at Nims Hospital, after a prolonged illness, family sources said. He was 89. He is
survived by his wife, four sons and three daughters.
A.S.Rao, was born in Mogallu of West Godavari district in the year 1914, obtained his engineering
degree from Stanford University in 1947 and joined the Department of Atomic Energy as a nuclear
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physicist to work with the likes of Homi J Bhabha. He was the director of radiation health protection and
electronics groups at Bhabha Atomic Research Centre (Barc) and later played a key role in setting up ECIL
in the city in 1967 when the DAE decided to go commercial in its electronics research.
ECIL was setup under the Department of Atomic Energy on 11th April, 1967 with a view to
generate a strong indigenous capability in the field of professional grade electronics. The initial
accent was on total self-reliance and ECIL was engaged in the Design, Development,
Manufacture and Marketing of several products with emphasis on three technology lines viz.
Computers, Control Systems and Communications. Over the years, ECIL pioneered the
development of various complex electronics products without any external technological help
and scored several 'firsts' in these fields prominent among them being country's
First Digital Computer
First Solid State TV
First Control & Instrumentation of Nuclear Power Plants
First Earth Station Antenna
First Computerized Operator Information System
First Radiation Monitoring & Detection Systems
First Automatic Message Switching Systems
First Operation & Maintenance Center For E-108 Exchange
The company played a very significant role in the training and growth of high caliber technical and
managerial manpower especially in the fields of Computers and Information Technology. Though the
initial thrust was on meeting the Control & Instrumentation requirements of the Nuclear Power
Program, the expanded scope of self-reliance pursued by ECIL enabled the company to develop various
products to cater to the needs of Defense, Civil Aviation, Information & Broadcasting,
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Telecommunications, Insurance, Banking, Police, and Para-Military Forces, Oil & Gas, Power, Space
Education, Health, Agriculture, Steel and Coal sectors and various user departments in the Government
domain. ECIL thus evolved as a multi-product company serving multiple sectors of Indian economy with
emphasis on import of country substitution and development of products & services that are of
economic and strategic significance to the country.
B. VISION, MISSION & OBJECTIVES
a. Vision
To contribute to the country in achieving self reliance in strategic electronics.
b. Mission
ECIL's mission is to consolidate its status as a valued national asset in the area of strategic
electronics with specific focus on Atomic Energy, Defence, Security and such critical sectors of
strategic national importance.
c. Objectives
To continue services to the country's needs for the peaceful uses Atomic Energy. Special and
Strategic requirements of Defense and Space, Electronics Security Systems and Support for Civil
Aviation sector.
To establish newer technology products such as Container Scanning Systems and Explosive
Detectors.
To explore new avenues of business and work for growth in strategic sectors in addition to
working for realizing technological solutions for the benefit of society in areas like Agriculture,
Education, Health, Power, Transportation, Food, Disaster Management etc.
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To progressively improve shareholder value of the company.
To strengthen the technology base, enhance skill base and ensure succession planning in the
company.
To re-engineer the company to become nationally and internationally competitive by paying
particular attention to delivery, cost and quality in all its activities.
To consciously work for finding export markets for the company's products.
C. BOARD OF DIRECTORS
In terms of Sec 617 of the Companies Act, 1956, ECIL is a Government Company. Presently, the
entire paid up capital of the Company is held by the President of India, including 3 shares held by his
nominees. The Board, as on 31.03.2010 comprises of nine Directors - Chairman & Managing Director,
three Whole-time Director and five Non-Executive Directors. The Board meets at regular intervals and is
responsible for the proper direction and management of the Company.
D. JOINT VENTURES
Electronics Corporation of India Limited (ECIL) entered into a collaboration with OSI Systems Inc.
(www.osi-systems.com) and set up a Joint Venture "ECIL-RAPISCAN LIMITED". This Joint Venture
manufacture the equipments manufactured by RAPISCAN, U.K and U.S.A with the same state of art
Technology. Requisite Technology is supplied by RAPISCAN and the final product is manufactured at
ECIL facility.
ECIL-RAPISCAN have supplied many X-RAY BAGGAGE/CARGO INSPECTION SYSTEMS (XBIS) of
this Technology to high profile Indian Customers like Customs, Airports Authority, Parliament House,
Defence, Air lines, State Police etc.
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ECIL-RAPISCAN exported XBIS to Tribhuvan International Airport, Kathmandu, Nepal, X-Ray generators
to USA and Malaysia. ECIL-RAPISCAN continue to receive large number of orders from existing as well
as new customers. This is basically due to our strength in
Latest International Technology,
Quality Assurance,
The exhaustive spares inventory to meet the spares requirement.
Strong Manufacturing and After Sales Service set up in 10 different centers located all over
India.
VIRTICLES
a. OVERVIEW
ECIL, established in 1967 under the Department of Atomic Energy had the primary objective of
productionising the products developed at BARC, Mumbai in order to support the Country’s Nuclear
Power and other Atomic Energy Programmes. Concurrently, it has endeavored to create a strong
indigenous / production base in the Country for professional grade electronics spanning from small
passive components to large and complex computer based systems. Though the initial thrust was on
meeting the C&I requirements of NPP, the expanded scope of self-reliance pursued by the Company
enabled it to develop various special purpose products and systems to cater to the needs of
Defence, Civil Aviation, Information & Broadcasting, Telecommunications, Space, Security, Oil & Ga
Power, Education and several other user departments in the Government domain s.
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The Company has thus evolved over the years as a multi-product Company serving multiple sectors
of Indian economy with emphasis on Import Substitution and development of products and services
that are of economic and strategic importance to the Country spanning the strategic sectors of
Atomic Energy, Defence, Space, Security, IT & eGovernance.
b. AEROSPACE
ECIL Played a pioneering role in supporting the ambitious programs of ISRO. ECIL’s Antenna Products
Division has its lineage that dates back to 1968, when ARVI Satellite Communication (ASCOM) group was
constituted by drawing experts from various organizations to execute the design, develop, manufacture,
install, test and commission the country’s 1st INTELSAT Class-A Earth Station Antenna at ARVI, Pune for
providing the gateway for overseas communications for the traffic originating around Mumbai region.
ASCOM Group has designed the 97ft Earth Station Antenna with a king post Elevation over Azimuth
pedestal, servo system and antenna control unit. The station was installed and commissioneds in 1968.
The Feed was imported. The control and servo system was developed by BARC. After the completion of
the above project, Microwave Antenna System Engineers Group {MASEG (ISRO)} was formed to further
the R&D activities on Microwave and satellite earth station antennas for providing communication
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facilities in the country.
The MASEG group got merged with ECIL in 1972, and Antenna Products Division was formed in ECIL
with the aim of taking up commercial production of Microwave and Earth station antennas.
In 1975, ECIL delivered another 97ft Earth Station Antenna with king post pedestal (similar to ARVI
Antenna) at Lachhiwala in Dehradun for providing the International gateway to the traffic originating
from Delhi region. The expertise gained during the execution of above two projects has firmed up the
knowledge base at ECIL to take up design and production of various types of communication antennas.
Communication antennas per se can broadly be classified into 3 types.
1. For Terrestrial Communication
a. Troposcatter antennas
b. Line of Sight (LoS ) antennas
2. for Satellite Communication
c. Ground/Earth Station Antennas
Troposcatter Antennas :
Large Bill Board antennas focus a high power radio beam at the
troposphere mid way between the transmitter and receiver. A
certain portion of the signal is refracted and received at a similar
antenna at the receiving station.
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Earth Station Antennas :
On the earth station front, ECIL continued its progress and delivered and installed 3 Nos. of 8m earth
station antennas at Port Blair, Kavaretti and Aizwal with indigenous design to bring the far flung areas of
Northeast into country’s telecom network.
When the INSAT programme was initiated, ECIL developed and
delivered 2 Nos. of reflectors required for 14m diameter Antennas for
TTC application at MCF, Hassan with control system by jointly working
with BARC. During the same period, ECIL also successfully absorbed the
limited know-how from NEC, Japan in productionising medium sized
Earth station antennas of diameter 11M, 7.5M and 4.5M.Several of
these antennas were delivered to various users like DOT, ONGC, NTPC
and MCF.
In 1987, ECIL successfully designed, developed, manufactured and
installed the 11M diameter full motion antenna for TTC application at
MCF, Hassan. The 32m diameter Wheel & Track antenna was installed
at ARVI, Pune which was executed jointly in collaboration with NEC,
Japan. During this period, ECIL acquired know-how for the indigenous
realization of a 32M Wheel & Track antenna employing the beam wave
guide feed from NEC, Japan.
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A full fledged Design Center exists, where more than 30 engineers work in the Antenna design
involving various disciplines of Structural, Mechanical, Microwave and Control systems aspects. The
center is well equipped with various software like NASTRAN, PATRAN, SIMULINK, Auto CAD, CATIA for
Structural and Mechanical designs, WASPNET for RF design etc. to provide cost effective solutions, many
pre and post processing support routines for verifying design compliance with regard to surface
accuracy, pointing error, system performance predictions, both for structural and RF are available in the
design center.
C.DEFENCE
ECIL has played a pioneering role in spurring the growth of Electronics Industry in the country. Spanning
miniature components to mammoth systems and encompassing control, communication & computer
technologies, today, ECIL is a multi-product, multi disciplinary and multi technology organization providing
cutting-edge technology solutions in the strategic areas of Atomic Energy, Defence, Space and Electronic
Security systems.
Multidisciplinary capability
ECIL’s expertise harnesses electronics & communication technologies to meet India’s defence
needs on land, sea and air. Some of the areas in which ECIL has contributed significantly to the
Defence Sector are:
1. Secure and Jam- resistant communications
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2. Electronic Warfare Systems & Simulators
3. COMINT & Interception Systems
4. Antenna, Satellite Communication Systems (SATCOM Systems), networks
5. Stabilized platforms for air-borne Radars
6. CI systems & Missile support Systems
7. Encryption and Secrecy Systems
8. Electronic Fuzes for artillery and Navy
9. Precision Electro-Mechanical components, sensors & Inertial Navigation Systems
E. NUCLEAR
Electronics Corporation of India was created essentially to meet the Control & Instrumentation
requirements of the Nuclear Power Programme of India by productionising the R&D efforts in the
Bhabha Atomic Research Centre (BARC). Right from its inception in 1967, it has been totally
supporting all the plans, programmes and endeavours of the Department of Atomic Energy in the
chosen areas of Electronics, Instrumentation, IT and Security. ECIL significantly facilitated India’s
Nuclear Energy Programme to reach greater heights. Today the company is proud to claim that all
the operating Nuclear Power Plants in the country are supported by the Instrumentation and
Control Systems engineered & manufactured by ECIL for the safe and reliable operation of the
Reactors. These offerings cover diverse Reactor technologies with the I & C footprints in the entire
Nuclear Fuel Cycle, starting from Ore extraction to the Spent-fuel management. It is a matter of
pride that the company made the country self-sufficient in this vital area of electronics, which is
significant in the context of technology denials clamped on the nation from time to time. ECIL thus
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contributed towards creating a strong and dependable indigenous Technology base in the Nuclear
Power area.
F. I.T AND eGOV
The first age : Mainframe Computing
A computer system consists of 3 basic functions – presentation, which manages the way users interact
with the system; application, which supports the logic of what to do with the data and data
management, which supports the storage of information.
The second age : Client Server Computing
New applications with graphics and user interfaces required decentralized processing at the user end.
Client Server computing distributed the work required to perform these functions among two or more
computers. A server is akin to the mainframe, in that it coordinates activities of all clients and handles
communications, but the processing is done largely at each client’s end.
The Third age : Network Centric Computing
We are now moving to a environment where connectivity between computers and even other devices
has pervaded computing. The network was born out of the C/S concept – it is now possible to connect
computers of different makes and yet enable them to work together. The popularity of the largest
network of them all, the Internet has established Network Centric computing as the next wave in
computing.
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With a totally different scenario in the country in Information Technology, at present ECIL is focusing on
applications in the following technologies:
3-tier architecture
Web technologies
ERP
Data Warehousing and Data Mining
Network Security
e-Governance ECIL apart from its own internal R&D efforts has also been acquiring know-how
from various R&D establishments and outsourcing R&D work to some of the academic
institutions.
CAREERS
a. TECHNICAL EXPERTS
Right from inception, ECIL has been a Technology-driven Company. Starting with supporting the
Country's Atomic Energy Programme, the Company pioneered a number of technologies and introduced
a number of products for the first time in the Country. In the formative years, ECIL was able to attract
the best brain to facilitate the pursuit of its endeavors.
The global village creator’s aftermath of liberalization, privatization and globalization attracted many
well trained technologists and managers from the Company and as a result the reservoir of the
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competencies started depleting. Attrition has become global phenomena and the worst hit is the
Electronics & IT field. Customer requirements are also changing dynamically and many of them,
especially in the areas of Strategic Electronics, are expecting Total solutions. In a highly competitive
market environment, with outsourcing as a business inevitability, every operation needs to hire the
services of Experts in select areas. Today, atleast a multi-disciplinary organization like ECIL, it is very
difficult, if not impossible to have the required expertise within the organization. The age of the
organization and also the retirement profile also aggravates the situation.
Therefore, top management of the Company decided to hire the services of experts in the areas of
relevance to the Company, to supplement the efforts of the Project Teams in the Strategic Business
Units and other service functions. The required expertise is sought in those areas, which are depleted
due to superannuation and some specialized areas which are non-existent to required levels within
Company and also essential. As a Policy, ECIL appoints experts in the following levels:
• Senior Technical Experts
• Technical Experts
b. HUMAN RESOURCE
ECIL was setup under the Department of Atomic Energy in the year 1967 with a view to generating a
strong indigenous capability in the field of professional grade electronics. The present employee
strength of the company is about 5100 (3000 officers and 2100 workmen). The company, which started
as a manufacturing company wedded to indigenization and self-reliance had a majority of human
resources deployed in manufacturing operations. The post-liberalization era posed a number of
challenges to the company especially in the area of HR, Due to the right sizing and restructuring
compelled by the market forces. With the help of Government of India, the company offered attractive
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Voluntary Retirement schemes to the employees which invited reasonable response. The company has
also intiated a number of programmes to retrain and redeploy the existing manpower so as to ensure
gainful employment and achievement of targets.
c. OUR CULTURE
We Embrace diversity, Diversity is a cornerstone of our culture.
Being an organization with a global foot print, you will notice our employees come from the most
diverse of backgrounds: be it location, race, educational background, faith, all working towards one
common goal. This diversity manifests to boundless energy, which percolates to all levels across the
organization.
MANAGEMENT SYSTEM
a. QUALITY MANAGEMENT SYSTEM
Standards And Quality Assurance Group (SQAG) at ECIL is a Corporate Quality Assurance Service
Facility. While the individual business groups have their own Quality Control / Quality Assurance
sections, this corporate facility caters to the common requirements.
Faculty for training personnel in Product divisions on ISO awareness and on Internal Quality
Audits, Helping in developing their quality system documentation, planning, conducting and
managing internal quality audits and reporting of audit results.
A well equipped and NABL accredited Calibration and Measurements Laboratory equipped with
standards traceable to National Standards and catering to the calibration requirements of the
Product divisions in the field of electro-technical measurements.
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An Environmental Test laboratory meant for both component / unit / system evaluation. It has
Dry / Damp heat chambers, Walk in chambers, Dust / Rain chambers, Vibration and bump test
facilities.
A Technical information Centre.
Equipped with such facilities with service as its motto SQAG has adapted and declared its quality
policy as "To render reliable and professional services in the fields of Quality Assurance, Testing and
Calibration to the satisfaction of its CUSTOMERS."
Standards and Quality Assurance Group (SQAG) is a Corporate Services Group catering to the needs of
all Production divisions in the following areas.
1. Standards
2. Quality Assurance
3. Environmental and Calibration Services
4. Industrial Engineering
b. ENVIRONMENT MANAGEMENT SYSTEM
In recent times, environmental concern is increasing among Public as they are facing air
pollution, traffic congestion, and land pollution due to dumping the waste (including electronic
waste) in open lands without proper disposal. This feeling is predominantly high at national and
international level. All environmental Scientists are alerting the nations from time to time by
bringing awareness and cautioning the ecological imbalances in the world. In this direction, all
nations have responded in their own way. As usual, Internal Organization for Standardization
(ISO) also showed their concern by constituting a Technical Committee and assigned the
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responsibility of formulating a standard with a view to certifying the organizations against that
standard. This certification results in practical realization of prevention of pollution and
conservation of energy. To this effect, ISO brought out a standard on Environmental
Management System – ISO 14001 in 1996. Later on it was revised in the year 2004 which is in
practice.
Top Management felt that, even though pollution in electronic industry is at low level which will
not affect anybody, the environmental management system should be implemented in ECIL to
demonstrate to customers, suppliers, employees and Society that no pollution will be created
by the very existence of the company through any act of theirs. It was therefore decided in
August, 2004 to implement the EMS in the company. It was also concluded that one certificate
should be obtained for the whole company covering all activities of all divisions.
PRODUCTS
a. TELECOM DIVISION
Products Major
customers
Surveillance Systems - GSM, CDMA, Satellite & Wire line monitoring Systems DAE
MOD
NTRO
NPCIL
Encryption systems - Wireless Encryption - Radios, CDMA, GSM Wire line Encryption-
Voice / Data / fax / IP / STM / Bulk
Design & Implementation of Access Control Systems & Integrated Security Systems
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MHA
Law Enforcing
agencies
Design & implementation of Network Solutions on turnkey basis
b. INSTRUMENTS AND SYSTEMS DIVISION
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c. CONTROL AND AUTOMATION DIVISION
Major products Customer
Product Sectors of operation / major
customers
X ray baggage inspection system
Directorate of Logistics,
Airports, Banks, Govt.
Departments, Courier
Services.
Nuclear Industrial Instruments Electronic Toll Collection, Weigh in
Capital budgeting is the planning process used to determine whether An organisation's
long term investments such as new machinery, replacement machinery, new plants, new
products, an research development projects are worth pursuing. It is budget for major capital, or
investment, expenditures.
• Capital Budgeting is a project selection exercise performed by the business enterprise.
• Capital budgeting uses the concept of present value to select the projects.
• Capital budgeting uses tools such as pay back period, net present value, internal rate of
return, profitability index to select projects.
CAPITAL BUDGETING
Definitions
“Capital budgeting is long term planning for making and financing proposed capital outlays”.
T.Horngreen
“Capital budgeting is concerned with allocation of the firm’s scarce financial resources among the
available market opportunities. The consideration of investment opportunities involves the comparison
of the expected future streams of earnings from a project with immediate and subsequent streams of
expenditure for it”.
A systematic approach to capital budgeting implies:
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a) the formulation of long-term goals
b) the creative search for and identification of new investment opportunities
c) classification of projects and recognition of economically and/or statistically dependent proposals
d) the estimation and forecasting of current and future cash flows
e) a suitable administrative framework capable of transferring the required information to the decision level
f) the controlling of expenditures and careful monitoring of crucial aspects of project execution
g) a set of decision rules which can differentiate acceptable from unacceptable alternatives is required.
Features of Capital Budgeting:
The important features, which distinguish capital budgeting decisions in other Day-to-day
decisions, are
Capital budgeting decisions involve the exchange of current funds for the benefits to be
achieved in future.
The futures benefits are expected and are to be realized over a series of years.
The funds are invested in non-flexible long-term funds.
They have a long terms are significant effect on the profitability of the concern.
They involve huge funds.
They are irreversible decisions. They are strategic decisions associated with high degree of risk.
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Importance of Capital Budgeting:
The importance of capital budgeting can be understood from the fact that an unsound
investment decision may prove to be fatal to the very existence of the organization.
The importance of capital budgeting arises mainly due to the following:
1. Large investment:
Capital budgeting decision, generally involves large investment of funds. But the funds
available with the firm are scarce and the demand for funds for exceeds resources. Hence, it is
very important for a firm to plan and control its capital expenditure.
2. Long term commitment of funds:
Capital expenditure involves not only large amount of funds but also funds for long-term or an
permanent basis. The long-term commitment of funds increases the financial risk involved in the
investment decision.
3. Irreversible nature:
The Capital expenditure decisions are of irreversible nature. Once, the decision for acquiring a
permanent asset is taken, it becomes very difficult to dispose of these assets without incurring
heavy losses.
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4. Long terms effect on profitability:
Capital budgeting decision has a long term and significant effect on the profitability of a concern.
Not only the present earnings of the firm are affected by the investments in capital assets but also
the future growth and profitability of the firm depends up to the investment decision taken today.
Capital budgeting decision has utmost importance to avoid over or under investment in fixed
assets.
5. Difficulties of investment decision:
The long terms investment decisions are difficult to be taken because uncertainties of future and
higher degree of risk.
6. Notional Importance:
Investment decision though taken by individual concern is of national importance because it
determines employment, economic activities and economic growth.
Kinds of Capital Budgeting:
Every capital budgeting decision is a specific decision in the given situation, for a given firm
and with given parameters and therefore, an almost infinite number of types or forms of capital
budgeting decisions may occur. Even if the same decision being considered by the same firm at
two different points of time, the decision considerations may change as a result of change in any
of the variables. However, the different types of capital budgeting decisions undertaken from
time to time by different firms can be classified on a number of dimensions. Some projects affect
other projects the firm is considering and analyzing. At the other extreme, some proposals are
pre-requisite for other projects. The projects may also be classified as revenue generating
projects or cost reducing projects. In general, the projects can be categorized as follows:
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1. From the point of view of firm's existence: The capital budgeting decisions may be
taken by a newly incorporated firm or by an already existing firm.
a) 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.
b) Existing: Firm : A firm which is already existing may also be required to take various
decisions from time to time to meet the challenges of competition or changing envi-
ronment. These decision may be :
i. Replacement and Modernization Decision: This is a common type of a capital
budgeting decision. All types of plant and machineries eventually require replacement. If
the existing plant is to be replaced because the economic life of the plant is over, then the
decisions may be known as a replacement decision. However, if an existing plant is to be
replaced because it has become technologically outdated (though the economic life may
not be over), the decision may be known as a modernization decision. In case of a
replacement decision, the objective is to restore the same or higher capacity, whereas in
case of modernization decision, the objective is to increase the efficiency and/or cost
reduction. In general, the replacement decision and the modernization decisions are also
known as cost reduction decisions.
ii. 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 manager is
required to evaluate the expansion program in terms of marginal costs and marginal
benefits.
iii. Diversification: Some times, the firm may be interested to diversify into new product
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lines, new markets, production of spare parts etc. In such a 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.
Assumptions 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 conditions
within which the financial aspects of different proposals are to be evaluated. Some of these
assumptions are:
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 estimates 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 decisions in the present chapter assume
that there is no scarcity of capital. It assumes that a proposal will be accepted or rejected
on the strength of its merits alone. The proposal will not be considered in combination
with other proposals to consider the maximum utilization of available funds.
Basic steps of Capital Budgeting
1. Estimate the cash flows
2. Assess the risky ness of the cash flows.
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3. Determine the appropriate discount rate.
4. Find the PV of the expected cash flows.
5. Accept the project if PV of inflows > costs. IRR > Hurdle Rate and/or payback < policy
The classification of investment projects
a) By project size
Small projects may be approved by departmental managers. More careful analysis and Board of Directors' approval is needed for large projects of, say, half a million dollars or more.
b) By type of benefit to the firm
an increase in cash flow a decrease in risk an indirect benefit (showers for workers, etc).
c) By degree of dependence
mutually exclusive projects (can execute project A or B, but not both) complementary projects: taking project A increases the cash flow of project B. substitute projects: taking project A decreases the cash flow of project B.
Conventional cash flow: only one change in the cash flow sign
e.g. -/++++ or +/----, etc
Non-conventional cash flows: more than one change in the cash flow sign,
e.g. +/-/+++ or -/+/-/++++, etc.
The analysis stipulates a decision rule for:
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I) accepting orII) rejecting
investment projects.
METHODS AND TECHNIQUES OF CAPITAL BUDGETING
There are many methods for evaluating the profitability of investment proposals. The various
commonly used methods are
Traditional methods:
1. Payback period method (P.B.P)
2. Accounting Rate of return method (A.R.R)
3. Discounted Payback
Time adjusted or discounting techniques:
1. Net Present value method (N.P.V)
2. Internal rate of return method (I.R.R)
3. Profitability index method (P.I)
4. Modified Internal Rate of Return (MIRR)
5. Equivalent Annual Annuity
1) Net Present Value:
Is also known as the discounted cash flow technique or NPV is the amount the shareholder’s wealth
would increase if the firm selected the project – if this number is positive then the firm should select the
project. Using the following formula we can find the NPV of the two projects.
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The NPV method is a modern method of evaluating investment proposals. This method takes in to
consideration the time value of money and attempts to calculate the return on investments by
introducing time element. The net present values of all inflows and outflows of cash during the entire
life of the project is determined separately for each year by discounting these flows with firms cost of
capital or predetermined rate. The steps in this method are
1. Determine an appropriate rate of interest known as cut off rate.
2. Compute the present value of cash outflows at the above-determined discount rate.
3. Compute the present value of cash inflows at the predetermined rate.
4. Calculate the NPV of the project by subtracting the present value of cash outflows, from present
value of cash inflows.
Decision rule:
If NPV is positive (+): accept the projectIf NPV is negative(-): reject the project
The NPV method is used for evaluating the desirability of investments or projects.
where:
Ct = the net cash receipt at the end of year tIo = the initial investment outlayr = the discount rate/the required minimum rate of return on investmentn = the project/investment's duration in years.
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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 of
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.
2) Internal Rate of Return (IRR):
The IRR is the discount rate that makes the net present value of the project equal to zero. A project’s IRR
should be compared to the company’s cost of capital or “hurdle rate.” The hurdle rate is the rate that
the project must exceed to create positive shareholder wealth effects. (Assume the hurdle rate (r) is
5%).
The internal rate of return method is also a modern technique of capital budgeting that takes in to
account the time value of money. It is also known as time-adjusted rate of return or trial and error yield
method. Under this method the cash flows of a project are discounted at a suitable rate by hit and trial
method, which equates the net present value so calculated to the amount of the investment. The
internal rate of return can be defined as “that rate of discount at which the present value of cash inflows
is equal to the present value of cash outflows”.
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Rules to follow:
Accept the proposal having the higher rate of return and vice versa.
If IRR>K, accept project. K = cost of capital.
If IRR<K, reject project.
Determination of IRR
When annual cash flows are equal over the life of the asset.
Initial Outlay
FACTOR = --------------------------- x 100
Annual Cash Inflow
When the annual cash flows are unequal over the life of the asset:
Pv of cash inflows at lower rate - Pv of cash outflows
IRR = LR + ------------------------------------------------------------------------- (hr-lr)
Pv of cash inflows at lower rate-Pv of cash inflows at higher rate
The steps involved here are:
1. Prepare the cash flow table using assumed discount rate to discount the net cash flows to the
present value.
2. Find out the NPV, & if the NPV is positive, apply higher rate of discount.
3. If the higher discount rate still gives a positive NPV, increase the discount rate further. Untill it
becomes zero.
4. If the NPV is negative, at a higher rate, NPV lies between these two rates.
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Advantages:
It takes into account, the time value of money and can be applied in situations 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 provides for uniform ranking of various 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.
Net present value vs internal rate of return
Independent vs dependent projects
NPV and IRR methods are closely related because:
i) both are time-adjusted measures of profitability, andii) their mathematical formulas are almost identical.
So, which method leads to an optimal decision: IRR or NPV?
a) NPV vs IRR: Independent projects
Independent project: Selecting one project does not preclude the choosing of the other.
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With conventional cash flows (-|+|+) no conflict in decision arises; in this case both NPV and IRR lead to the same accept/reject decisions.
Figure 6.1 NPV vs IRR Independent projects
If cash flows are discounted at k1, NPV is positive and IRR > k1: accept project.
If cash flows are discounted at k2, NPV is negative and IRR < k2: reject the project.
Mathematical proof: for a project to be acceptable, the NPV must be positive, i.e.
Similarly for the same project to be acceptable:
where R is the IRR.
Since the numerators Ct are identical and positive in both instances:
implicitly/intuitively R must be greater than k (R > k); If NPV = 0 then R = k: the company is indifferent to such a project; Hence, IRR and NPV lead to the same decision in this case.
b) NPV vs IRR: Dependent projects
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NPV clashes with IRR where mutually exclusive projects exist.
Example:
Agritex is considering building either a one-storey (Project A) or five-storey (Project B) block of offices on a prime site. The following information is available:
Initial Investment Outlay Net Inflow at the Year EndProject A -9,500 11,500Project B -15,000 18,000
Assume k = 10%, which project should Agritex undertake?
= $954.55
= $1,363.64
Both projects are of one-year duration:
IRRA:
$11,500 = $9,500 (1 +RA)
= 1.21-1
therefore IRRA = 21%
IRRB:
$18,000 = $15,000(1 + RB)
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= 1.2-1
therefore IRRB = 20%
Decision:
Assuming that k = 10%, both projects are acceptable because:
NPVA and NPVB are both positiveIRRA > k AND IRRB > k
Which project is a "better option" for Agritex?
If we use the NPV method:
NPVB ($1,363.64) > NPVA ($954.55): Agritex should choose Project B.
If we use the IRR method:
IRRA (21%) > IRRB (20%): Agritex should choose Project A. See figure 6.2.
Figure 6.2 NPV vs IRR: Dependent projects
Up to a discount rate of ko: project B is superior to project A, therefore project B is preferred to project A.
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Beyond the point ko: project A is superior to project B, therefore project A is preferred to project B
The two methods do not rank the projects the same.
3) Modified Internal Rate of Return (MIRR):
The modified IRR assumes that cash flows are reinvested at the company’s cost of capital.
The cash flows are first brought forward to their future values at the company’s cost of
capital. Next the “terminal value” is calculated by summing all of the future value cash
flows. Finally the terminal value is brought to the present value of the initial investment at
the MIRR rate. (Assume a cost of capital of 5%). Modified IRR (MIRR).
The MIRR is similar to the IRR, but is theoretically superior in that it overcomes two
weaknesses of the IRR. The MIRR correctly assumes reinvestment at the project’s cost of
capital and avoids the problem of multiple IRRs. However, please note that the MIRR is not
used as widely as the IRR in practice.
There are 3 basic steps of the MIRR:
1. Estimate all cash flows as in IRR.
2. Calculate the future value of all cash inflows at the last year of the project’s life.
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3. Determine the discount rate that causes the future value of all cash inflows determined
in step 2, to be equal to the firm’s investment at time zero. This discount rate is know as
the MIRR.
4) Profitability Index (PI) :
The profitability index is the present value of the project’s cash flows divided by the cost. (Assume a 5%
cost of capital) PI tells us how much profit we can earn for each dollar invested. Profitability ratio is
otherwise referred to as Benefit/Cost ratio. This is an extension of the Net Present Value Method. This is
a relative valuation index and hence is comparable across different types of the projects requiring
different quantum of initial investments.
Profitability index (PI) is the ratio of sent value of cash inflows to the present value of cash outflows.
The present values of the cash flows are obtained at a discount rate equivalent to the cost of capital.
The profitability index, or PI, method compares the present value of future cash inflows with the
initial investment on a relative basis. Therefore, the PI is the ratio of the present value of cash flows
(PVCF) to the initial investment of the project.
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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
PV of cash inflows
Profitability index = ------------------------------
PV of cash outflows
NPV
Net profitability index = -----------------------------
Initial Outlay
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
outflows and uneven cash inflows.
It takes into an 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 objective of maximum profitability.
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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.
5) Payback Period:
The payback period is the expected number of years required to recover the original investment.
The payback period method has three main flaws: 1) dollars received in different years are all given
the same weight 2) cash flows beyond the payback year are not considered 3) payback period analysis
does not provide an indication of how much shareholder wealth should increase (like NPV) and 4)
payback period analysis does not indicate how much the project will yield over the cost of capital (like
IRR).Payback period is the time duration required to recoup the investment committed to a project.
Business enterprises following payback period use "stipulated payback period", which acts as a standard
for screening the project.
Rules to follow:
A project is accepted if its payback period is less than the period specific decision rule.
A project is accepted if its payback period is less than the period specified by the
management and vice-versa.
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Pay Back Period
Initial Cash Outflow
= ------------------------------
Annual Cash Inflows
Advantages:
It is easy to understand and apply. The concept of recovery is familiar to every decision-maker.
Business enterprises facing uncertainty - both of product and technology - will benefit by the use
of payback period method since the stress in this technique is on early recovery of investment.
So enterprises facing technological obsolescence and product obsolescence - as in
electronics/computer industry - prefer payback period method.
Liquidity requirement requires earlier cash flows. Hence, enterprises having high liquidity
requirement prefer this tool since it involves minimal waiting time for recovery of cash outflows
as the emphasis is on early recoupment of investment.
Disadvantages:
The time value of money is ignored. For example, in the case of project.
A Rs.500 received at the end of 2nd and 3rd years are given same weightage. Broadly a rupee
received in the first year and during any other year within the payback period is given same
weight. But it is common knowledge that a rupee received today has higher value than a rupee
to be received in future.
But this drawback can be set right by using the discounted payback period method. The
discounted payback period method looks at recovery of initial investment after considering the
time value of inflows.
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Another important drawback of the payback period method is that it ignores the cash inflows
received beyond the payback period. In its emphasis on early recovery, it often rejects projects
offering higher total cash inflow.
6) Discounted Payback:
This method is similar to the payback period method except the cash flows are discounted by the
project’s cost of capital. The discounted payback period is the number of years required to recover the
investment from the discounted net cash flows. (Assume a cost of capital of 5%)
7) Accounting Rate of Return on Investment (ROI) :
Firms make capital investments to earn a satisfactory rate of return. Determining a satisfactory
rate of return depends on the cost of borrowing money, but other factors can enter into the
equation. Such factors include the historic rates of return expected by the firm. In the long run,
the desired rate of return must equal or exceed the cost of capital in the marketplace. The
accounting rate of return on investment (ROI) calculates the rate of return from an investment by
adjusting the cash inflows produced by the investment for depreciation. It gives an
approximation of the accounting income earned by the project.
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Accounting rate of return is the rate arrived at by expressing the average annual net profit
(after tax) as given in the income statement as a percentage of the total investment or average
investment. The accounting rate of return is based on accounting profits. Accounting profits are
different from the cash flows from a project and hence, in many instances, accounting rate of
return might not be used as a project evaluation decision. Accounting rate of return does find a
place in business decision making when the returns expected are accounting profits and not
merely the cash flows.
This method takes into account the earnings from the investment over the whole life. It is known as
average rate of return method because under this method the concept of accounting profit (NP after tax
and depreciation) is used rather than cash inflows. According to this method, various projects are
ranked in order of the rate of earnings or rate of return.
Rule to follow:
The project with higher rate of return is selected and vice – versa.
The return on investment method can be used in several ways, as
Average Rate of Return Method:
Under this method average profit after tax and depreciation is calculated and then it is divided by
the total capital out lay.
Average Annual profits (after dep. & tax)
Average rate of return = --------------------------------------------------- x 100
Net Investment
Advantages:
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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 profits are earned as a 20% rate of return in 2 ½ years is
considered to be better than 18% rate if return in 12 years.
This method cannot be applied to a situation where investment in project is to be made in parts.
8) Equivalent annual annuity:
What do you do when project lives vary significantly? An easy and intuitively appealing
approach is to compare the “equivalent annual annuity” among all the projects. The
equivalent annuity is the level annual payment across a project’s specific life that has a
present value equal to that of another cash-flow stream. Projects of equal size but different
life can be ranked directly by their equivalent annuity. This approach is also known as
