CAPITAL BUDGETING

CHAPTER I

INTRODUCTION

INTRODUCTION

CAPITAL BUDGETING

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.

In the form of either debt or equity, capital is a very limited resource. There is a

limit to the volume of credit that the banking system can create in the economy.

Commercial banks and other lending institutions have limited deposits from which they

can lend money to individuals, corporations, and governments. In addition, the Federal

Reserve System requires each bank to maintain part of its deposits as reserves. Having

limited resources to lend, lending institutions are selective in extending loans to their

customers. But even if a bank were to extend unlimited loans to a company, the

management of that company would need to consider the impact that increasing loans

would have on the overall cost of financing.

The argument that capital is a limited resource is true of any form of capital, whether

debt or equity (short-term or long-term, common stock) or retained earnings, accounts

payable or notes payable, and so on. Even the best-known firm in an industry or a

community can increase its borrowing up to a certain limit. Once this point has been

reached, the firm will either be denied more credit or be charged a higher interest rate,

making borrowing a less desirable way to raise capital.

Faced with limited sources of capital, management should carefully decide

whether a particular project is economically acceptable. In the case of more than one

project, management must identify the projects that will contribute most to profits and,

consequently, to the value (or wealth) of the firm. This, in essence, is the basis of capital

budgeting.

CAPITAL BUDGETING

Capital Budgeting is the process of allocating capital within the firm to the best use.  This

decision process is carried out by applying a number of Discounted Cash Flow (DCF)

decision models.  The four standard models usually employed include:

 

NPV        Net Present Value

PI             Profitability Index

IRR          Internal Rate of Return

MIRR      Modified Internal Rate of Return

 

Since all four methods are based on DCF methods, all are superior to non-DCF based

methods such as the Payback method.  Not all of these methods are equally valuable in all

situations.  There are some theoretical weaknesses with the IRR reinvestment rate

assumption and some practical weaknesses associated with the possibility of multiple

IRR's when the cash flows of a project change sign over time.  The MIRR method

addresses the reinvestment rate assumption weakness by the possibility of multiple IRR's

still remains.  The NPV is the most appealing method since it presents the present value

dollar addition to the wealth of the firm associated with a project without the theoretical

or practical shortcomings of the IRR.  The NPV's related measure, the PI, allows for

comparison of projects of different sizes within the NPV framework. Typically, when

analyzing a project, all four methods are applied as their results provide different types of

information.  Frequently all four methods provide the same accept / reject

recommendation but the IRR methods sometimes does provide a recommendation that

conflicts with the other methods.  These topics are discussed in greater detail in the

textbook readings.

 

CAPITAL BUDGETING

A Reminder: Focus on incremental after-tax cash flows.

First consider each project against the alternative choice of doing nothing.  Incre-

mental cash flows are then easily identified.

We then compare different alternative investments based on NPV, PI, IRR, and

MIRR and the relationship between investment choices.

As an advanced analysis, we consider alternative uses of existing facili-

ties.  Specifically, we identify any secondary uses of existing facilities and esti-

mate all incremental after-tax cash flows associated with this alternative.   This al-

ternative use becomes just another project that is analyzed and considered.

We can then include this new analysis into our comparison.

  

Some cautionary notes: 

Make sure all tax implications are considered.

Make sure all known future salvage related cash flows are included.

Make sure all incremental cash flows are include:

Make sure sunk costs are ignored.

Make sure we ignore all interest and other financing costs.

Capital Budgeting Definition¶

Most small to medium sized companies have no idea how to approach capital

investments. They treat it as if it were an operating budget decision rather than a long-

term, strategic decision that will impact their cash flow, efficiency of their daily

operations, income statement, and taxable income for years to come. They need your help

understanding the importance of and then making the right capital budgeting decisions.

Capital budgeting decisions relate to decisions on whether or not a client should invest in

a long-term project, capital facilities and/or capital equipment/machinery. Capital budget

decisions have a major effect on a firm's operations for years to come, and the smaller a

firm is, the greater the potential impact, since the investment being made could represent

a substantial percent of the firm's assets.

Capital Project Examples¶

CAPITAL BUDGETING

Capital projects are usually identified by functional needs or opportunities, although

many are also identified as a result of risk evaluation or strategic planning. Some typical

long-term decisions include whether or not to:

• Buy new office equipment, cars or trucks;

• Add to or renovate existing facilities, including the purchase of new capital

equipment/machinery; 

• Expand plant or process operations;

• Invest in facilities for a new product line or to expand services;

• Continue or discontinue an existing product line;

• Replace existing capital equipment/machinery with new equipment/machinery;

• Invest in software to meet technology-based needs or systems designed to help improve

process and/or efficiency;

• Invest in R&D or intangible assets;

• Build or expanding a foreign or satellite operation;

• Reorganize assets or services; or,

• Acquire another company.

Capital investment (or, expenditure) decisions are more commonly referred to as capital

budgeting decisions since they involve resource allocation, particularly for the production

of future goods and services, and the determination of cash out-flows and cash-inflows,

which need to be planned and budgeted over a long period of time. It is important that

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you get involved right from the start to guide them through this process since this is a

very complicated accounting issue.

Capital Budgeting Phases¶

The phases of the capital budgeting process include:

• Description of the need or opportunity;

• Identification of alternatives;

• Evaluation of the options and the relevant cash flows of each;

• Selection of best alternative; and

• Conducting a post-completion audit of the projects.

Identifying Capital Budgeting Needs¶

The first step is to identify the need or opportunity. This is usually done at the mid-

management level and is the result of a shared vision of company goals and strategies

coupled with a "where the rubber meets the road" perspective of "local" clients needs,

tastes and behavior. They see a need or opportunity and communicate it to senior

management, usually in the form of proposals which both include identification of the

need or opportunity, and potential solutions and/or recommendations. Senior management

then evaluates the merit of each proposed opportunity and makes a determination of

whether or not to look into it further.

While project need identification is usually a de-centralized function, capital initiation

and allocation decisions tend to remain a highly centralized undertaking. The reason for

this revolves around the need for capital rationing, especially when funds are limited and

upper-management wishes to maximize its returns/benefits from any capital projects

undertaken. 

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The information needed to make this determination usually comes from both internal and

external sources, and is based on both financial and non-financial considerations.

Interestingly enough, the factors examined in this process can be both firm-specific and

market-based in nature. It is that this point that companies should be seeking qualified

financial guidance since the consequences of both a poor decision and of the

implementation of a good decision can be far-reaching.

Capital Project Evaluation¶

Upper management must develop an objective methodology so that alternate capital

projects can be evaluated on a reasonable basis. Both quantitative and qualitative issues

must be considered and the whole organization should be used as a resource.

Marketing should provide data on sales trends, new demand and opportunities for new

products. Managers at every level should be identifying resources that are available to

upper-management that may lead to the use of existing facilities to resolve the need/take

advantage of the opportunity. They should also be communicating any needs they/their

departments or divisions have that should be part of the capital decision. Financial

analysts, or in their absence, qualified external financial experts such as your firm, should

be involved in identifying the target cost of capital, the evaluation of startup costs and the

calculation of cash flows for those projects chosen for evaluation purposes. Calculating

the appropriate discount rate and calculating conservative cash flows is a critical part of

this process that is best served by an independent accounting firm that can look at the

project/these issues impartially. Estimation bias can be dangerous.

The objective is to evaluate (predict) how well each capital asset alternative will do and to

determine if the net benefits to the firm are consistent with the required capital allocation,

given the scarcity of resources most firms are faced with.

Measurements Used in Capital Budgets¶

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The purpose of the evaluation phase is to predict how well a new asset will benefit the

firm. Possible measures, which you should help the firm develop, that should be

considered include:

• Net income managers evaluate the incremental increase in accounting net income

between alternatives; 

• Net cash flow this is the most widely used measure; this measure looks at the actual

cash flows (out and then in) resulting from the capital investment for each alternative;

these need to be evaluated for both overall value (several techniques will be discussed

next) and from the standpoint of the effect on daily cash flow and the ability of the firm to

meet its financial obligations in a timely manner; projects with high projected future

returns may not be as attractive when adjusted for the time value of money or the costs

involved in borrowing funds to meet operating obligations such as payrolls and accounts

payable;

• Cost savings many capital investments are not designed to generate revenues directly

but are, instead, designed to save costs and increase productivity; these projects are best

evaluated on the basis of incremental savings generated; 

• Equality of cash flows cash flows tend to vary from year to year; the timing of cash

flows may be an important consideration to the firm

• Salvage value and functionality of an existing asset when replacing it with a new asset

while the historical cost of an existing asset is not relevant to a capital budgeting decision,

the net proceeds from disposal of the existing equipment is; so is the question of how well

existing equipment operates given that capital budgeting decisions are only concerned

with incremental costs and incremental savings/profits;

• Depreciation, earnings and income tax effects need to be considered based on the form

of the firm (sole proprietorship, partnership, corporation, etc.), and the differences in the

financial and tax accounting treatments available to the firm, especially as they apply to

salvage value, useful lives and allowed depreciation methods, and, consideration of the

marginal tax rate (which may vary from country to country); most firms fail to consider

this cost or choose a tax or financial accounting treatment that does not maximize the

CAPITAL BUDGETING

firm's return on invested capital; 

• Inflation the effects of inflation need to be considered in estimating cash flows as well,

especially if is projected to increase in future periods and varies between capital projects

being considered;

• Risk considerations political risk, monetary risk, access to cash flows, economic

stability, and inflation should all be considered in the evaluation process since all are

hidden costs in the capital budgeting process; and,

• Interest and the cost of capital the venture has to have a return that is greater than its

cost of capital, adjusted for tax benefits, if any.

The firm should also make a subjective decision as to its preferences in terms of

characteristics of projects in addition to the regular selection criteria it has set. For

example, does the firm prefer:

• Projects with small initial investments? Earlier cash flows? Or, perhaps, shorter payback

times? 

• New projects or expansion of the existing operations?

• Domestic projects or foreign operations?

• If the firm is risk neutral, would the prospects of additional potential cash flows in

riskier investments make a capital project more attractive?

Evaluating Risk of Capital Projects¶

Risk also needs to be analyzed carefully, regardless of which valuation method is used to

evaluate the project. The more popular risk-assessment techniques include Sensitivity

Analysis, Simple Probability Analysis, Decision-Tree Analysis, Monte Carlo Simulations

and Economic Value Added (EVA):

• Sensitivity Analysis considers what will happen if key assumptions change and

identifies the range of change within which the project will remain profitable;

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• Simple Profitability Analysis assesses risk by calculating an expected value for future

cash flows based on their probability of success to future cash flows;

• Decision-tree Analysis builds on Simple Profitability Analysis by graphically outlining

potential scenarios and then calculating each scenario's expected profitability based on the

project’s cash flow/net income; this technique allows managers to visualize the project

and make more informed decisions, although decision trees can become very complicated

considering all the scenarios that should be considered (e.g., inflation, regulation, interest

rates, etc.);

• Monte Carlo Simulations use econometric/statistical probability analyses to calculate

risk; and,

EVA, which is growing in popularity, is a performance measure that adjusts residual

income for "accounting distortions" that decrease short-term income but have long-term

effects on shareholder wealth (e.g., marketing programs and R&D would be capitalized

rather than expensed under EVA).

Once the risk has been assessed, which valuation method should the firm/you use for a

project? The answer depends on considerations such the nature of the investment (the

timing of its cash flows, for instance), uncertainty about the economy and the time value

of money if it is a very long term capital project.

Capital Project Evaluation Methods

The four most popular methods are:

• The Payback Period Method, which favors earlier cash flows and selects projects based

on the time it takes to recover the firm's investment; weaknesses in this method include

the facts it does not consider cash flows after the payback period and it does not consider

the time values of money; a common practice is to use this method to select from projects

with similar rates of return that have been evaluated using a discounted cash flow (DCF)

CAPITAL BUDGETING

method (e.g., this is often referred to as the Payback Method based on Discounted Cash

Flows or Break-Even Time Method);

• The Accounting Rate of Return (ARR) Method, which uses accounting income/GAAP

information, is calculated as the average annual income divided by the initial or average

investment; the projected return is normally compared to a target ARR based on the firm's

cost of capital, the company's past performance and/or the riskiness of the project.

• The Net Present Value(NPV) Method, which is based on the time value of money and is

a popular DCF method; the NPV Method discounts future cash flows (both in- and out-

flows) using a minimum acceptable cost of capital (usually based on the weighted

average cost of capital or WACC, adjusted for perceived risk) that is referred to as the

"hurdle rate"; the NPV is as the difference between the present value of net cash inflows

and cash outflows, and a $0 answer implies that the project is profitable and that the firm

recovered its cost of capital; and,

• The Internal Rate of Return (IRR) Method, which is based on the time value of money,

calculates the interest rate that equates the present value of cash outflows and cash

inflows; this calculated rate of return is then compared to the required rate of return, or

hurdle rate, to determine the viability of the capital projects. 

Soft Costs and Benefits in Capital Budgeting

Other considerations the firm/you should consider as part of the valuation process are

"soft" costs and benefits. Soft costs and benefits are difficult to quantify by are real non-

the-less. Examples of soft costs might be a capital investment in a manufacturing process

that results in added pollution to the atmosphere. A soft benefit might be the enhancement

of a firm's overall image as a result of investing in R&D for high-tech products. Ignoring

soft benefits and costs can lead to strategic mistakes, especially if you are talking about

investments in advanced manufacturing technology. Soft benefits and costs need to be

CAPITAL BUDGETING

estimated and then included as part of the method used to determine if a capital project is

desirable. 

Post Completion Project Evaluation

Once the project has been chosen and put into operation, a post completion audit of the

project should be undertaken by a qualified financial services firm, such as yours, which

can evaluate the project objectively. This audit by an independent party will function as a

control mechanism to ensure that the capital project is performing as expected and, in the

event it is not, to make it easier to terminate the project by eliminating any bias of those

involved in the project. It will also serve as a learning mechanism for upper management

as they compare actual performance to expected results, and improve the processes and

estimates they use in future investment decisions. 

It should be noted that this control mechanism, which can be expensive, is essential to the

success of future capital investment decisions, especially considering the long life of most

capital projects. 

One final word regarding implementation of this control mechanism; successful post-

completion auditing processes require that upper management understand that the purpose

of the audit is to learn from past experiences,. Managers should not be penalized for the

decisions they made but should, instead, be given the opportunity to learn from them.

SCOPE OF THE STUDY: 

SCOPE The study covers the calculation of payback period, Average rate of

return, Net present value, Profitability index, internal rate of return etc. Also the study

includes the decisions as to be made for investment process. These percentages help in

analyzing the funds for investment purpose.

CAPITAL BUDGETING

NEED FOR THE STUDY:

Capital budgeting decisions are of paramount importance in financial

decision-making. Special care should therefore be taken in making these decisions on

account of following reasons.

Heavy investments.

Long term commitment on funds

Irreversible decisions

Long term impact of profitability

Most difficult to make.

CAPITAL BUDGETING

Wealth maximization of shareholders.

Cash forecast.

OBJECTIVES OF THE STUDY

The objectives of the study are:

To understand the need of organizations to identify and invest in high quality

capital projects.

To evaluate capital projects using traditional methods of investment appraisal and

discounted cash flow methods.

To evaluate the investment proposal by using capital budgeting techniques.

CAPITAL BUDGETING

METHODOLOGY OF THE STUDY

The information for the study is obtained from two sources namely.

Primary Sources

Secondary Sources

Primary Sources:

It is the information collected directly without any references. It is mainly through

interactions with concerned officers & staff, either individually or collectively; some of

the information has been verified or supplemented with personal observation. These

sources include.

Thorough interactions with the various department Managers.

Secondary Sources:

CAPITAL BUDGETING

This data is from the number of books and records of the company, the annual

reports published by the company and other magazines. The secondary data is obtained

from the following.

Collection of required data from annual records, monthly records, internal

records

Other books and Journals and magazines

Annual Reports of the company

Limitations

a) Lack of knowledge. Some of the lack full-fledged knowledge of the concept and

its difficult to collect a specific opinion from them.

b) Time limitation. The duration of the project is short to collect the required

information accurately.

c) How money is acquired and from what Praga tools?

d) How individual capital project alternatives are identified and evaluated?

e) How minimum requirements of acceptability are set?

CAPITAL BUDGETING

CAPITAL BUDGETING

CHAPTER II

REVIEW

OF

LITERATURE

CAPITAL BUDGETING

FINANCIAL DECISION IN A FIRM

CAPITAL BUDGETING DECISION

The first and perhaps the most important decisions that any firm has to make is to

define the business or businesses that is wants to be this decision has a significant bearing on

how capital is allocated in the firm.

CAPITAL STRUCTURE DECISIONS

Once a firm has decided on the investment projects it wants to undertake, it has to

figure out ways and means of financing them. The key issues in capital structure decisions are:

what is the optimal debt-equity ration of the firm? Which specific instruments of equity and

debt finance should the firm employ? Which capital markets should the firm access?

DIVIDEND DECISIONS

Determining the dividend policy is an important task. The dividend decision involves

what percentage of profit to be paid of the shareholder. A number of factors affect the

dividend decision such as market price of the share earnings, tax positions etc.

WORKING CAPITAL MANAGEMENT

Working capital management, also referred to as short-term financial management,

refers to the day-to-day financial activities that deal with current assets (inventories, debtors,

short-term holdings of securities, and cash) and current liabilities (short-term debt, trade

creditors, accruals and provisions).

The key issues in working capital management are:

What is the optimal level of inventory for the operations of the firm?

How much cash should the firm carry on hand? Etc

A business proposal regardless of whether it is a new investment or acquisition of

another company or restructuring initiative-raises the value of the firm only if the present

value of the future stream of net cash benefit expected from the proposal is greater than the

initial cash outlay required to implement the proposal.

CAPITAL BUDGETING

RISK-RETURN TRADEOFF

The alternative course of action typically has different risk-return implications. A large

plant may have a higher expected return and a higher risk exposure, where a small plant has

may have a lower expected return and a lower risk exposure. A higher debt-equity ratio,

compared to a lower debt-equity ratio, May reduced the cost of capital but expose the firm to

greater risk..

LONG TERM SOURCES OF FINANCE

It is natural phenomenon that the firm is always in deficit of funds. There are two

methods of rising of funds.

1) LONG TERM SOURCES

2) SHORT TERM SOURCES

Capital budgeting decisions involve long-term funds. The different long-term sources of

finance generally followed by companies are.

EQUITY CAPITAL:-

Equity capital represents ownership capital, as equity shareholders collectively own the

company. They enjoy the rewards and bear the risk of ownership. However, their liability of

the owner in a proprietary firm and the partners in a partnership concern is limited to their

capital contributions.

CAPITAL BUDGETING

INTERNAL ACCRUALS:-

The internal accruals of a firm consist of depreciation charges and retained earnings.

Depreciation represents the allocation of capital expenditure to various periods over which the

capital expenditure is expected to benefit the firm. Retained earnings are that portion of equity

earnings, which are ploughed back to the firm. Because retained earnings are the sacrifice

made by the equity shareholders, they are referred to as internal equity.

PREFERENCE CAPITAL:-

It represents a hybrid form of financing as it has many features of both ordinary shares

and debenture. Preference share may be issued with or without maturity date. The holder of

preference shares get divided at a fixed rate and have preference over ordinary shareholders.

DEBENTURES:-

For large publicity traded firms, debentures are viable alternative to term loans. Akin to

promissory notes, debentures are instruments for raising long-term debt. Debentures holders

are the creditors of the company. The obligation of the company towards its debenture holder

is similar to that of borrower who promises to pay interest and principal at specified times.

TERM LOANS:-

Term loans for more than a year maturity. It is generally available for a period of 10

years. Interest on term loans is tax deductible. They are obtained from banks and specially

created financial institutions like IFCI, ICICI and IDBI etc the purpose of term lands is mostly

to finance the company’s capital expenditure. They are generally obtained of financing large

expansion, modernization or diversification projects. Hence this method of financing is also

called project financing. This is the most widely used source of financing.

CAPITAL BUDGETING

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Business firms have scarce resources that must be allocated among competitive uses. The

financial management provides a framework for firms to take these decisions widely.

The investments decision includes not only those that create revenues and profits but also

those that reduce cost. So, the investments decisions and the decisions relating to assets

composition of the firm.

A capital expenditure, from the accounting point of view, is an expenditure that

is shown as an asset on the balance sheet. This asset, expect in the case of a one-depreciable

asset like land , is depreciated over its life in accounting the classification of an expenditure as

capital or revenue expenditure is governed by a certain conventions, by some provisions of

law, and by the management’s desire to enhance and depress reported profits. Often, outlays

on R&D, major advertising campaign, and reconditioning of plant and machinery may be

treated as revenue expenditure for accounting purposes, been though they are expected to

generate a stream of benefits in future and therefore, quality or being capital expenditure.

CAPITAL BUDGETING HAS THREE DISTINCTIVE FEATURES:-

They have long-term consequences

They often involve substantial outlay.

They may be difficult or expensive.

FEATURES:-

It involves exchange of current funds for the benefits to be achieved in future.

Future benefits are expected to be realized over a series of years.

There is relatively high degree of risk.

They are invariable decisions.

They have long-term and significant effect on profitability of the concern.

CAPITAL BUDGETING

IMPORTANCE

Capital budgeting is of a paramount importance in financial decision-making.

Capital budgeting decision affects the profitability of the firm. They also have a bearing

on the competitive position of the enterprise. Capital budgeting decisions determine the

future destiny of the company.

An opportunity investment decision can yield spectacular returns where as an

ill-advised and incorrect investment decision can endanger the very survival

even of the large sized firms.

A capital expenditure decisions has its effect over a long-term time span and

inevitably affects the company’s future cost structure.

Capital investment decisions are not easily reversible, without much financial

loss to the firm.

Capital investment involves cost and the majority of the firms have scares

capital resources

Capital investment decisions are of national importance because of it

determines employment, economic activities and economic growth.

This underlines the need for thoughtful, wise and correct investment decisions

CAPITAL BUDGETING

NEED FOR CAPITAL BUDGETING:-

Capital budgeting decisions are vital to an organization as they include the decisions as

to.

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

an industry, purchase of plant and machinery etc.

To analyse the proposal for expansion or creating additional capacities.

To decide the replacement of permanent asset such as building and equipments.

To make financial analysis of various proposals regarding capital investment so as

to choose the best out of many alternative proposals.

DIFFICULTIES:

Capital budgeting are not easy to take there are no of factors responsible for this

The benefits from investments are received in some future period. The future is

uncertain. Therefore, an element of risk is involved. A failure to forecast correctly

will lead to serious errors, which can be corrected lonely at a considerable

expenses

Problems are also arising because cost incurred and benefits received from capital

Budgeting decisions occur at different time period. They are not logically

comparable because of the time value of money.

It is not often possible to calculate in strictly quantitative term, all the benefits of

the cost relating to a particular investment decision.

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RATIONALE:-

The rationale underlying the capital budgeting decisions is efficiently. Thus a firm

must replace wrong and obsolete plant and machinery, acquire fixed assets for current or

new products and make straight investment decisions. This will enable the firm to achieve

the objectives of maximizing the profits. The quality of these decisions is improved by

capital budgeting.

Capital budgeting decisions can be of two types:

1) Those which expand revenues

2) Those which reduces costs

INVESTMENT DECISIONS EFFECTING REVENUE:

Investment decisions are expected to bring in additional revenue there by raising the

size of firms total revenue. They can be the result of either expansion of present

operations of the development of new product line these decisions involved acquisition of

new fixed assets.

INVESTMENT DECISIONS REDUCCUIND COST:-

These decisions add the total revenue of the firm. These investment decisions are

subject to less uncertainty. This is because the firm has a better “feel” for potential cost

saving as it can examine past production and cost data.

CAPITAL BUDGETING

THERE ARE THREE TYPES OF CAPITAL BUDGETING

DECISIONS:

1) Accept-reject decisions:

This is a fundamental decision capital budgeting. If the project is

accepted, - the firm invests in it. If the proposal is rejected, the firm does not

invest in it so, by applying this criterion, all independent projects are accepted.

Independent projects are projects that do not compete with one another in such a

way the acceptance a project preclude the possibility of acceptance of another.

2) Mutually exclusive projects decision:

These are projects, which, compete with other projects in such a way that

the acceptance of one will exclude the acceptance of other projects. The

alternatives are mutually exclusive and only one may be chosen. Mutually

exclusive investment decisions acquired significance when more than one

proposal is acceptable under accept-reject criterion.

3) Capital rationing decisions:

Capital rationing refers to situation in which the firm has more

acceptable investments requiring greater amount of finance then is available

with the firm. It is concerned with selection of group of investment proposals

actable under accept-reject criterion under financial constraints.

EVALUATION OF INVESTMENT PROPOSLS:

At each point of time a business firm has a number of proposals regarding various

number of projects in which it can invest funds. But funds available with the firms are

always limited and it’s not possible to invest in the entire proposal at a time

In selecting the criterion, the following two fundamental principles must be kept into

view.

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The bigger, the better principles: the principle means that other things being equal

bigger benefits are preferable to small ones.

The bird in hand principles: this principle means that other things being equal,

early benefits as other things are seldom equal.

Bother the above principles have to be applied to take the right decision

TECHNIQUES OF CAPITAL BUDGETING

The methods of appraising capital expenditure proposals can be classified in to two

broad categories:

1. Traditional or undiscounted cash flow techniques

2. Discounted or time adjusted cash flow techniques

DISCOUNTED CASH FLOW METHODS

The distinguishing characteristics of discounted cash flow capital budgeting techniques

are that they taking in to consideration the time value of money while evaluating the cost

and benefits of the project. They also take into consideration the benefits and cost

occurring during an entire life of the project.

NET PRESENT VALUE METHOD (NPV)

NPV may be defined as the summation of the present values of the cash proceeds in

each year minus the summation of the present values of the net cash outflows in each

year.

The net present value (NPV) of a project is the sum of the present values of all the

cash-flows positive as well as negative that are expected to occur over the life of the

projects.

The generally formula of NPV is:-

n

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NPV of project = -------- Initial investment

Ct

T=1(1+rt) t

Where Ct = Cash flow at the end of year t

RT = Discounted rate for year t

The steps to be followed for adopting the NPV methods:

1) Determine an appropriate rate of the interest that should be selected as a

minimum required rate of return. This rate should be the minimum rate of return

below which the investor considers that does pay him the invested amount.

2) Compute the present value of total investment outlay; if the total investment is

to be made in the initial year, the present value shall be the same the cost of

investment.

3) Compute the present value of total investment proceeds i.e. cash inflows at the

above determined discounted rate

4) Calculate the NPV of each project by subtracting the present value of cash out

flow for each project.

The present value of rupee 1 due in any number of years can be found by using the

following formula.

1

PV = -----

(1+r)t

Where PV = Present value

r = rate of interest

t = number of years

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ACCEPT OR REJECT CRITERION:

If NPV >ZERO, ACCEPT

If NPV< ZERO, REJECT

In case of mutually, exclusive projects, the various proposals would be ranked in order to

descending order. The proposal with higher NPV is to be accepted.

MERITS:-

1) It recognizes the time value of money.

2) It is sound method of appraisal as it considers the total benefits arising out of the

proposal over its lifetime.

3) Changing discount rate can be built in to the NPV calculation by altering the

denominators. This rate normally changes because longer the time span, lower the

value of money and higher, the discount rate

4) This method is very useful for selection of normally exclusive projects.

DEMERITS:

A. It is difficult to calculate to understand

B. The present value method involves the calculation of required rate of return to

discount the cash flows, which present serious problems.

C. It is an absolute measure.

D. This method may not give satisfactory results in case of projects having different

effective lives.

INTERNAL RATE OF RETURN (IRR):

The internal rate of return (IRR) of a project is the discount rate, which makes its

NPV equal to “0”.Put differently, it is the discount rate, which equates the present value

of future cash flows with the initial investment. It is the value or r in the following

equation:

Investment = n

CAPITAL BUDGETING

T = Ct

-------

1(i+r)

Where,

Ct = Cash flow at the end of the year

r = internal rate of return (IRR)

t = life of the project

Applying following stapes can calculate IRR

Step 1

Calculate cash flow after tax

Step 2

Calculation fake payback period

Fake PBP = Initial investment

------------------------

Average cash flow

Step 3

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

at figure until you closest to the fake PBP

Step 4

Note the corresponding percentage.

Step 5

Calculate NPV at that percentage

CAPITAL BUDGETING

Step 6

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

again calculate NPV

Step 7

Continue Step5 until we arrive at low rates one giving positive NPV and another giving

negative NPV.

STEPS

Actual IRR can be calculated by using the following formula:

LR + P.V of cash inflows at LR-P.V cash outflows

IRR = --------------------------------------------------------------------------------- (HR-LR)

P.V of cash inflows at LR-P.V of cash inflows at HR.

Where,

R = interest rate,

LR = lower rate

HR = Higher rate

ACCEPT OR REJECTION CRITERION:-

ACCEPT: If the IRR is greater than the cost of capital.

REJECT: If the IRR is less than the cost of capital.

MERITS:

It recognizes the time value of money.

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

calculate its return.

It is consistent with the shareholders wealth maximization objective.

CAPITAL BUDGETING

DEMERITS:

It gives misleading and inconsistent results when the NPV of a project

does not decline with discount rates.

It also fails to indicate a correct choice between mutually exclusive

projects under certain situations.

PROFITABILITY INDEX METHOD (PI)

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

initial cash outflow of the investment. Using the profitability index PI or benefits cost

ratio (BCR) a project will qualify often acceptance if its PI exceeds one. The NPV will be

positive greater than one and will negative when the PI is less than one. Thus, NPV& PI

approaches give the same results regarding the investment proposal. The selection of

project with the PI method can also be done on the basis of ranging. PI depends upon cash

inflows before depreciation and after tax. It makes into consideration the scrap value.

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.

investmentInitialPVCFPI

In this method, a project with a PI greater than 1 is accepted, but a project is rejected

when its PI is less than 1. Note that the PI method is closely related to the NPV approach.

In fact, if the net present value of a project is positive, the PI will be greater than 1. On

the other hand, if the net present value is negative, the project will have a PI of less than

1. The same conclusion is reached, therefore, whether the net present value or the PI is

used. In other words, if the present value of cash flows exceeds the initial investment,

there is a positive net present value and a PI greater than 1, indicating that the project is

acceptable.

CAPITAL BUDGETING

PI is also known as a benefit/cash ratio.

Accept project if PI > 1.

Reject if PI < 1

The formula to calculate PI or BCR is as follows:

Total present value of cash inflows

PI = ------------------------------------------------

Total present value of cash outflows

MERITS:

It gives due consideration to the time value of money.

Since the present value of cash inflows is divided by initial cash outflows it is a

relative measure of the projects profitability.

DEMERITS:

It is difficult to understand

It involves more computation than traditional methods.

TRADITIONAL OR NON-DISCOUNTED TECHNIQUES:

1. PAY BACK PERIOD METHOD (PBP):

Pay back measures the number of years required by the cash flows after tax to pay back

the original outlay required in an investment proposal. It depends upon cash inflows

before depreciation and after tax. Payback period does not consider the scrap value. There

are two ways of calculating the PBP.

The first method can be applied when the cash inflows are uniform.

Original investment

PBP = ------------------------------------------

Constant Annual Cash Inflows

CAPITAL BUDGETING

The annual cash flow represents the earnings i.e. estimated cash savings resulting

from the proposed investment.

If the calculated PBP is less than the standard, project is accepted and vice versa

The second method is used when projects cash flows are not equal and vary from year

to year. Payback period is calculated.

2. DISCOUNTED PAY BACK METHOD:

This is developed due to the limitation of the PBP method that it ignores time value

of money. Hence, an improvement is made where the present values of all inflows are

cumulated in order of time. The time at which the cumulated present value of cash

inflows equals the present value of cash outflows is known as discounted PBP. The

project, which gives a shorter discounted payback period, is accepted.

REASONS FOR POPUIARITY OF PEP:

Despite its serious short comings the PBP is widely used in appraising

investments.

The PBP May be regarded roughly as the reciprocal for the IRR when the annual

cash inflow is constant and the life of the project fairly long.

The PBP is somewhat akin to the breakeven point. A rule of thumb, it serves as a

useful shortcut in the process of informational of generation and evaluation

The PBP conveys information about the rate at which the uncertainty associated

with a project is resolved. The shorter the PBP the faster the uncertainty

associated with the project is resolved and vice versa

ACCEPT OR REJECT CRITERION:

The payback period method can be used as a decision criterion to accept or reject

investment proposals. If a single investment is being considered, if the annual pay back

period is less than the predetermined payback period the project will be accepted, if not it

would be rejected.

CAPITAL BUDGETING

When the mutually exclusive projects consideration they may be ranked according

to the length of the payback period. The project with shortest pay back may be assigned.

MERITS:

It is the best method incase o evaluation of single project.

It is to calculate and simple to understand.

It is bases on the cash flow analysis.

DEMERITS:

It completely ignores all cash flows after the payback period.

It completely ignores time value of money.

In case the cash flow is unequal the payback period can be found by adding up the cash

flows until the total is equal to the initial cash outlay of the project.

3. ACCOUNTING RATE OF RETURN (ARR):

Average rate or return is also known as accounting rate or return method. It is based on

accounting information rather than cash flows. ARR is a technique that helps us in

knowing the particular project, from which decision can be made to accept or reject the

investment proposal.

According to ARR as an accept / reject criterion, the actual ARR would compared with

the predetermined or a minimum required rate of return or cut off rate. A project can be

accepted if the actual ARR is higher than the minimum desired ARR, otherwise it is liable

to reject

ARR depends upon profit after depreciation and tax (PAT), ARR neglects the scrap

value. The time value of money is not taken into consideration.

Average annual profit after tax

ARR = ------------------------------------------------- *100

Average investment

Average Investment = Net Additional working capital + Salvage value +

CAPITAL BUDGETING

1/2(Original Investment-Salvage value).

Total cash flow after tax

Average Annual profit after tax = --------------------------------

Life of the project

ACCEPT OR REJECT CRITERION:

The actual average rate or return is compared with pre-determined or minimum

required rate of return or cut off rate. A project would qualify to be accepted, if the actual

rate of return is higher than the minimum desired average of return.

It more than one alternative proposal are under consideration, the average rate of return

may be arranged in descending order of magnitude starting with the proposal with the

highest average rate of return.

MERITS:

It is simple to understand and easy to calculate,

The entire stream of incomes is used to calculate the average rate of return.

Comparison between Five Techniques in Capital Budgeting

ADVANTAGES AND DISADVANTAGES OF IRR AND NPV

A number of surveys have shown that, in practice, the IRR method is more popular

than the NPV approach. The reason may be that the IRR is straightforward, but it uses

cash flows and recognizes the time value of money, like the NPV. In other words, while

the IRR method is easy and understandable, it does not have the drawbacks of the ARR

and the payback period, both of which ignore the time value of money.

CAPITAL BUDGETING

The main problem with the IRR method is that it often gives unrealistic rates of

return. Suppose the cutoff rate is 11% and the IRR is calculated as 40%. Does this mean

that the management should immediately accept the project because its IRR is 40%. The

answer is no! An IRR of 40% assumes that a firm has the opportunity to reinvest future

cash flows at 40%. If past experience and the economy indicate that 40% is an unrealistic

rate for future reinvestments, an IRR of 40% is suspect. Simply speaking, an IRR of 40%

is too good to be true! So unless the calculated IRR is a reasonable rate for reinvestment

of future cash flows, it should not be used as a yardstick to accept or reject a project.

Another problem with the IRR method is that it may give different rates of return.

Suppose there are two discount rates (two IRRs) that make the present value equal to the

initial investment. In this case, which rate should be used for comparison with the cutoff

rate? The purpose of this question is not to resolve the cases where there are different

IRRs. The purpose is to let you know that the IRR method, despite its popularity in the

business world, entails more problems than a practitioner may think.

2. WHY THE NPV AND IRR SOMETIMES SELECT DIFFERENT PROJECTS:

When comparing two projects, the use of the NPV and the IRR methods may give

different results. A project selected according to the NPV may be rejected if the IRR

method is used.

Suppose there are two alternative projects, X and Y. The initial investment in

each project is $2,500. Project X will provide annual cash flows of $500 for the next 10

years. Project Y has annual cash flows of $100, $200, $300, $400, $500, $600, $700,

$800, $900, and $1,000 in the same period. Using the trial and error method explained

before, you find that the IRR of Project X is 17% and the IRR of Project Y is around

13%. If you use the IRR, Project X should be preferred because its IRR is 4% more than

the IRR of Project Y. But what happens to your decision if the NPV method is used?

The answer is that the decision will change depending on the discount rate you use. For

instance, at a 5% discount rate, Project Y has a higher NPV than X does. But at a

discount rate of 8%, Project X is preferred because of a higher NPV.

CAPITAL BUDGETING

The purpose of this numerical example is to illustrate an important distinction: The

use of the IRR always leads to the selection of the same project, whereas project selection

using the NPV method depends on the discount rate chosen.

PROJECT SIZE AND LIFE

There are reasons why the NPV and the IRR are sometimes in conflict: the size and

life of the project being studied are the most common ones. A 10-year project with an

initial investment of $100,000 can hardly be compared with a small 3-year project costing

$10,000. Actually, the large project could be thought of as ten small projects. So if you

insist on using the IRR and the NPV methods to compare a big, long-term project with a

small, short-term project, don’t be surprised if you get different selection results. (See the

equivalent annual annuity discussed later for a good way to compare projects with

unequal lives.)

DIFFERENT CASH FLOWS

Furthermore, even two projects of the same length may have different patterns of

cash flow. The cash flow of one project may continuously increase over time, while the

cash flows of the other project may increase, decrease, stop, or become negative. These

two projects have completely different forms of cash flow, and if the discount rate is

changed when using the NPV approach, the result will probably be different orders of

ranking. For example, at 10% the NPV of Project A may be higher than that of Project B.

As soon as you change the discount rate to 15%, Project B may be more attractive.

WHEN ARE THE NPV AND IRR RELIABLE?

Generally speaking, you can use and rely on both the NPV and the IRR if two

conditions are met. First, if projects are compared using the NPV, a discount rate that

fairly reflects the risk of each project should be chosen. There is no problem if two

projects are discounted at two different rates because one project is riskier than the other.

Remember that the result of the NPV is as reliable as the discount rate that is chosen. If

the discount rate is unrealistic, the decision to accept or reject the project is baseless and

unreliable. Second, if the IRR method is used, the project must not be accepted only

because its IRR is very high. Management must ask whether such an impressive IRR is

possible to maintain. In other words, management should look into past records, and

existing and future business, to see whether an opportunity to reinvest cash flows at such

CAPITAL BUDGETING

a high IRR really exists. If the firm is convinced that such an IRR is realistic, the project

is acceptable. Otherwise, the project must be reevaluated by the NPV method, using a

more realistic discount rate.

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:

Estimate all cash flows as in IRR.

Calculate the future value of all cash inflows at the last year of the project’s life.

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.

MIRR is better than IRR because

MIRR correctly assumes reinvestment at project’s cost of capital.

MIRR avoids the problem of multiple IRR

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 equivalent annual cost, equivalent annual cash flow, or simply equivalent

annuity approach. The equivalent annual annuity is solved for by this equation:

Equivalent Annuity = PV (Cash Flows) / (present value factor of n-year annuity)

CAPITAL BUDGETING

PROJECT DECISION ANALYSIS

MAKING GO/NO-GO PROJECT DECISION

Virtually all general managers face capital-budgeting decisions in the

course of their careers. The most common of these is the simple “yes” versus

“no” choice about a capital investment. The following are some general

guidelines to orient the decision maker in these situations.

Focus on cash flows, not profits. One wants to get as close as possible to the

economic reality of the project. Accounting profits contain many kinds of

economic fiction. Flows of cash, on the other hand, are economic facts.

Focus on incremental cash flows. The point of the whole analytical exercise is to

judge whether the firm will be better off or worse off if it undertakes the project.

Thus one wants to focus on the changes in

cash flows effected by the project. The analysis may require some careful

thought: a project decision identified as a simple go/no-go question may hide a

subtle substitution or choice among alternatives. For instance, a proposal to invest

in an automated machine should trigger many questions: Will the machine

expand capacity (and thus permit us to exploit demand beyond our current limits)?

Will the machine reduce costs (at the current level of demand) and thus permit us

to operate more efficiently than before we had the machine? Will the machine

create other benefits (e.g., higher quality, more operational flexibility)? The key

economic question asked of project proposals should be, “How will things change

(i.e., be better or worse) if we undertake the project?”

Account for time. Time is money. We prefer to receive cash sooner rather than

later. Use NPV as the technique to summarize the quantitative attractiveness of

the project. Quite simply, NPV can be interpreted as the amount by which the

market value of the firm’s equity will change as a result of undertaking the

project.

Account for risk. Not all projects present the same level or risk. One wants to be

compensated with a higher return for taking more risk. The way to control for

variations in risk from project to project is to use a discount rate to value a flow of

cash that is consistent with the risk of that flow.

CAPITAL BUDGETING

These 4 precepts summarize a great amount of economic theory that has stood

the test of time. Organizations using these precepts make better investment decisions

than organizations that do not use these precepts.

THE PROCESS OF PROJECT EVALUATION

Carefully estimate expected future cash flows.

Select a discount rate consistent with the risk of those future cash flows.

Compute a “base-case” NPV.

Identify risks and uncertainties. Run a sensitivity analysis.

Identify “key value drivers”.

Identify break-even assumptions.

Estimate scenario values.

Bound the range of value.

Identify qualitative issues.

Flexibility

Quality

Know-how

Learning

Decide

CAPITAL BUDGETING

A.CAPITAL RATIONING

Exists whenever enterprises cannot, or choose not to, accept all value-creating

investment projects. Possible causes:

Banks and investors say “NO”

Managerial conservatism

Analysis is required. One must consider sets of projects, or “bundles”, rather than

individual projects. The goal should be to identify the value-maximizing bundle of

projects.

The danger is that the capital-rationing constraint heightens the influence of

nonfinancial considerations, such as the following:

Competition among alternative strategies

Corporate politics

Bargaining games and psychology

The outcome could be a sub-optimal capital budget, or, worse, one that destroys

value!

Some remedies are the following:

Relax and eliminate the budget constraint.

Manage the process rather than the outcomes.

Develop a corporate culture committed to value creation.

CAPITAL BUDGETING

MERGER AS A CAPITAL BUDGET:

Under this method the merger decision should be considered as project investment

decision, the NPV mergers should be determined by comparing the present values of the

acquisition firm after merger.

NPV = (PV of merger firm X holding value of acquiring firms) - (PV of acquiring firm),

RISK AND UNCERTAINITY IN CAPITAL BUDGETING:-

All the techniques of capital budgeting requires the estimation of future cash

inflow and cash outflows. The cash flows are estimated abased on the following factors.

Expected economic life of the project.

Salvage value of the asset at the end of the economic life.

Capacity of the product.

Selling price of the product.

Production cost.

Depreciation.

Rate of Taxation

Future demand of the product, etc.

But due to uncertainties about the future the estimates of demand, production, sales

costs, selling price, etc cannot be exact, for example a product may become obsolete

much earlier than anticipated due to un expected technological developments all these

elements of uncertainties have to be take into account in the form of forcible risk while

making an investment decision. But some allowances for the element of risk have to be

proved.

FACTORS INFLUENCING CAPITAL EXPENDITURE DESCISIONS:

CAPITAL BUDGETING

There are many factors financial as well as non financial which influence the capital

expenditure decisions and the profitability of the proposal yet, there are many other

factors which have to be taken into consideration while taking a capital expenditure

decisions. They are

1) URGENCY:

Sometime an investment is to be made due to urgency for the survival of the firm

or to avoid heavy losses. In such circumstances, proper evaluation cannot make though

profitability tests. Examples of each urgency are breakdown of some plant and machinery

fire accidents etc.

2) DEGREE OF UNCERTAINTY:

Profitability is directly related to risk, higher the profits, greater is the risk or

uncertainty.

3) INTANGIBLE FACTORS:

Sometimes, a capital expenditure has to be made due to certain emotional and

intangible factors such as safety and welfare of the workers, prestigious projects, social

welfare, goodwill of the firm etc.

4) AVAILABILITY OF FUNDS:

As the capital expenditure generally requires the previsions of laws solely

influence by this factor and although the project may not be profitable. Yet the investment

has to be made.

5) FUTURE EARNINGS:

A project may not be profitable as competed to another today, but it may be

profited to increase future earnings.

Sometimes project with some lower profitability may be selected due to constant

flow of income as compared to another project with an irregular and uncertain inflow of

income..

CAPITAL BUDGETING

CAPITAL EXPENDITURE CONTROL:

Capital expenditure involves no-flexible long-term commitments of funds. The

success of an enterprise in the long run depends up on the effectiveness with which the

management makes capital expenditure decision. Capital expenditure decisions are very

important as their impact is more or less permanent on the well being and economic

health of the enterprise. Because of this large scale mechanization and automation and

importance of capital expenditure for increase in the profitability of a concern. It has

become essential to maintain an effective system of capital expenditure control.

OBJECTIVES CONTROL OF CAPITAL EXPENDITURE:

To make an estimate of capital expenditure and to see that the total cash outlay is

within the financial resources of the enterprise

To ensure timely cash inflows for the projects so that no availability of cash may

not be problem in the implementation of the problem.

To ensure that all capital expenditure is properly sanctioned.

To properly coordinates the projects of various departments

To fix priorities among various projects and ensure their follow-up.

To compare periodically actual expenditure with the budgeted ones so as to avoid

any excess expenditure.

To measure the performance of the project.

To ensure that sufficient amount of capital expenditure is incurred to keep pace

with rapid technological development.

To prevent over expansion.

STEPS INVOLVED IN CONTROL OF CAPITAL EXPENDITURE:

CAPITAL BUDGETING

Preparation of capital expenditure budget.

Proper authorization of capital expenditure.

Recording and control of expenditure.

Evaluation of performance.

LEASE FINANCING:-

Lease finance is an agreement for the use of an asset for a specified rental. The owner of

the asset is called the lesser and the user the lesser

1) Operating leases

2) Financial leases

Operating leases are short-term no-cancel able leases where the risk of

obsolescence in borne by the lesser

Financial leases are long-term non-cancelable leases where any risk in the use of

asset is borne by the lessee and he enjoys the return too.

Preliminary budget estimates for the year following the budget year.

GENERAL GUIDELINES:-

The capital funds budget is to be prepared under six major heads.

1) Continuing schemes

2) New schemes

3) Modernization and rationalization

4) Township

5) Science and technology

6) EDP schemes

SCIENCE AND TECHNOLOGY

CONTINUING SCHEMES:-

CAPITAL BUDGETING

These schemes include all such schemes which are under implementation of

which funds prevision has been made in the current year /prevision is required in the

budget year.

NEW SCHEMES:-

This scheme includes all such schemes, which are proposed to be initiated in the

budget year and for which under provisions is required in the budget year. Normally, such

schemes are included in the five-year plan of the company approved by the planning

commission.

MODERNIZATION AND RATIONALIZATION (M&R):-

This includes item of plant and machinery etc for which funds required in the

budget year and the following year. All item included in M&R should result in cost

reduction/quality improvement/rebottle necking/replacement/productivity, improvement

and welfare. The M&R items are to be submitted in the following main characteristics

accompanied with full justification on the agenda of facilities increased output and

production, quality requirements bottlenecks.

Replacement/modernization.

Balancing facilities (essentially to increase production).

Operational requirements including material handling

Quality/testing facilities.

Welfare

Minor works.

These requirements should be protested term wise. A separate proposal is required for

M&R items costing more than Rs 10, 00,000.

TOWNSHIP:-

CAPITAL BUDGETING

Township budget is divided into two parts.

Continuing township schemes

New townships schemes.

Funds required under each schemes should be backed up with full data on number

on quarter/scope of work to be completed against the funds requirements phasing of

budgeted funds for current year, budget year and following year etc, should be given

similar information on number of quarter/scope of work already completed, expenditure

incurred till last year, satisfaction level it is to be added in the above back up information

for each scheme.

SCIENCE AND TECHNOLOGY:-

This budget can be divided into two categories

Continuing schemes.

New schemes to be taken up in the budget year.

The schemes should fall in any of the above cartages giving details on physical and

financial progress etc.

EDP SCHEMES:-

All funds requirements for computer are information system should be grouped

under EDP schemes and projects accordingly.

BUYING OR PROCURING:

Buying or procurement involves purchasing an asset permanently in the form of cash or

credit.

LEASING VS BUYING:

Leasing equipment has the tax advantage of depreciation, which can mutually

benefit the lesser and lessee, other advantage of leasing, include convenience and

CAPITAL BUDGETING

flexibility as well as specialized services to the lessee. Lease privies handy to those

linens, which cannot obtain loan capital form normal sources.

The pros and cons of leasing and buying are to be examined thoroughly before

deciding the method of procurement i.e. leasing or buying.

CAPITAL BUDGETING

CHAPTER – III

INDUSTRY PROFILE

COMPANY PROFILE

MACHINE TOOLS INDUSTRY – AN OVERVIEW

CAPITAL BUDGETING

India ranks nineteenth in production and sixteenth in consumption of machine

tools in the world. The Indian machine tool industry averaged more than 35 percent

growth in 2004-05. Imports exceeded production in the year 2004 with us$356 million

worth machine tools being imported while the production was only us$225 million.

Machine tools from percent of Indies engineering industry and contributes 0.3 Percent of

total machinery exports.

The Indian machine tool industry currently consists about 450 manufacturing units

of which approximately 33 percent (150 units) Fall under the organized category. Further

ten Major Indian companies constitute also most 70 percent of the total production. The

government Owned Hindustan Machine tools Limited (HMT) alone accounts for Nearly

32% of Machine tools Manufactured in India Approximately 75% of the Indian Machine

tool producers have received the coveted. Certification while the large organized players

cater to Indian’s Heavy and Medium industries, the small scale sectors meets the demand

of ancillary and other units

World wide the total modify locations are 3,336. First highest modify location

country is United States in 1333 lowest Modify location countries are Belarus, Bosnia and

Merzegovina, Bulgaria, Croatia, Malta, Russian Federation in only one Modify Location.

51 modify location are located in India. Modern Machine Tool in India’s leading

Industrial Magazine on machine tools and Ancillary industries. Published in affectation

with the country’s apex Body for the machine tools industry. Indian machine tool

Manufacture’s association (IMMA)

With a healthy readership base of over 2 lakhs, this Premium quarterly magazine

is regularly referred to by the key decision makers in the machine tool, cutting and other

manufacturing Industries that include CEOs. Directors, senior managers, as well as

engineers and shop. Floor technical personal apart from students. It serves as the bench

mark and with word it this ever growing sector of Indian industry.

CAPITAL BUDGETING

In addition to manufactures, this publication also reaches out to exporters, dealers,

distributors, R&D personnel Educational institution, consultants, industry associations

and trade commission’s almost every entry in the industry.

Modern machine tools provide an intelligent balanced and cohesive insight into

the machine tools and ancillary industries in India in terms of the death editorial content.

It includes the latest trends and technologies highly useful technical articles and case

studies. Business strategies views and vision of industry leaders and one of the largest

ranges of machines tools/cuttings tools. This apart, there is exhaustive coverage of the

current national and international news, upcoming projects, tenders, events and much

more that help the readers to effectively manage their business in a facilitator and guide

for this burgeoning industry.

Modern machine tools strives to facilitate effective interaction among several

fatuities of the machine tool, cutting and user industries by enabling them in reaching out

to their prospects buyers and sellers through better trade contacts and more business

opportunities.

Machine tool industry has undergone a radical shift in its paradigm thinking, the

Indian machine tool industry is now recognized as a provider of low-cost high quality

learn manufacturing solutions. The industry resiliently supports all its users to enhance

productivity as well as improve competitiveness, for the betterment of the final customer.

Being an integral sector, growth of the machine tool industry has an immense

bearing on the entire economy, especially India’s manufacturing industry. Even more

crucial for development of the country’s strategic segments such as defense, railways,

space and atomic energy.

World over too, industrialized-advanced countries have created market inches on

the back of a well- developed and supportive machine tool sector.

CAPITAL BUDGETING

In India as well, indigenous machine tools have the highest impact on capital

output ratios. Machine tool consumption of Rs. 1,000 crore truly supports the

advancement of the country’s engineering sector, output of which is estimated to be worth

over Rs. 1, 50,000 crore.

Manufacturing range:

The Indian machine tool industry manufactures almost the complete range of

metal cutting and metal forming machine tools complete range of metal-cutting and

metal-forming machine tools.

Customized in nature, the products from the Indian basket comprise and

conventional machine tools as well as computer numerically controlled (CNC) machines.

There are other variants offered by Indian manufactures too, including special purpose

machines, robots, robotics, handling systems and TPM friendly machines.

Efforts within the industry, are now on to better the features of CNC machines,

and provide further value additions at lower costs, to meet specific requirements of users.

Based on the perception of the current trends, and emerging demands, CNC segment

could be the driver of growth for the machine tool industry in India.

Current trends:

A slowdown in the Indian economy since mid-1999 had its fallout on prospects of

Indian machine tool manufactures. The Indian machine tool industry is besieged by lack

of adequate business opportunities that has stemmed from sluggish demand in the home

market of all user industries.

Output by domestic metal working machine tool manufacturers in 2001 calendar

year declined by 14 percent to Rs.5137 million marking the fourth yeast of decline since

1997, for the Indian machine tool industry. Much of this fall was due to subdued

investment by all the major users segments of machine tools, except the Defense industry,

primarily because of a higher capital expenditure outlay.

CAPITAL BUDGETING

While decrease in domestic production was dormant in case of conventional

metalworking machine tools computer numerically conventional metalworking machine

tools, computer numerically controlled (CNC) machine tool manufacturers too suffered,

although marginally. Lathes, machining centers, special purpose machines, and grinding

machines were among the machine tools that sustained much of the order inflow during

2001.even though these segments registered decline, in comparison with the previous

corresponding year.

Export Performance:

In view of an imminent slowdown in the Indian economy, most Indian machine

tool manufactures focused on potential overseas markets for business opportunities.

Sustenance on Indian market alone did not look feasible enough.

Further, there has off late been a perceptible change in the image of the made in

India brand in overseas markets particularly true for Indian-built machine tools. Enhanced

features, competitive pricing, and marketing focus has increased demand for Indian –

made machine tools in overseas markets, particularly in Europe, United States, and East-

Asian regions.

And this is what Indian machine tool manufactures are hoping to leverage so as to

post an optimistic export turnover in the next few years.

Indian-made machine tools are currently exported to over 50 countries: major

ones being United States, Italy, and Brazil. Germany and the Middle East. Lathes and

automats, presses, elector-discharge machines, and machining centers formed the bulk of

export orders for Indian manufactures. These machines from the Indian basket are

generally favored in overseas markets primarily due to their cost-competitiveness, as

compared to that available elsewhere compared to those available elsewhere.

CAPITAL BUDGETING

This vision of the Indian machine tool industry is now to step out and establish a

relative presence in, other potential markets. World-over, market leaders have been those

who have looked to increase their market presence beyond their national frontiers

Industry Structure

Machine tool industry in India comprises about 450 manufactures with 150 units

in the organized sector. Almost 70 percent of production in India is contributed by ten

major companies of this industry. And over three-quarters of total machine tool

production in the country comes out of ISO certified companies. Many machine tool

manufacturers have also obtained CE marking certification, in keeping with requirements

of the European markets. The industry has an installed capacity of over Rs. 10,000

million and employs a workforce totaling 65,000 skilled and unskilled personnel.

Machine tool industry in India is scatted all over the country. The hub of

manufacturing activities, however, is concentrated in places like Mumbai and Pune in

Maharashtra; Batala, Jullundur and Ludhiana in Punjab; Ahmadabad, Baroda, Jamnagar,

Rajkot and Surendranagar in Gujarat, Coimbatore and Chennai (Madras) in Tamilnadu:

some parts in East India; and Bangalore in Karnataka.

Bangalore is considered as the hub for the Indian machine tool industry. The city,

for instance, house HMT machines Tools limited, a company that manufactures nearly 32

percent of the total machine tool industry’s output.

2.6 User Industries Services

The industry’s prospects mainly depend on growth of engineering industries. The

user sectors of machine tools are the automotive, automobile and ancillaries, Railways,

Defense, Agriculture, steel, Fertilizers, Electrical, Electronics, Telecommunication,

textile machinery, ball & roller bearings, industrial values, power-driven pumps, multi-

product engineering companies, earth moving machinery, compressors and consumer

durable like washing machines, refrigerators, television sets, watches, dish-washers,

vacuum cleaners, air conditioners, etc.

CAPITAL BUDGETING

COMPANY PROFILE

INTRODUCTION

Praga is one of the leading machine tool manufacturing units in India established

in the year 1943, Praga’s production are well known in the field of machine tools the

company in organized in four divisions via the machine tools forge foundry and CNC

division which pulsated with the activities of 697 employees turning out a wide range of

production the four divisions equipped with the modern facilities for design development

of manufacture of machine tools, are manned by qualified personnel with proven record

of technical knowledge and exquisite craft smashup acquitted over a period of year.

Praga is proud of its diverse of machine tools the cutler& tools venders milling

machines copy lathes thread rolling machines & Praga CNC machines which keep pace

with the ever changing technology in addition the company also manufactures a wide of

industrial forgings for railway automotive & ordnance applications.

Praga’s wriest investment has been in its excellent collaboration with world

famous names like Jones & shipman of UK for surface grinding and cutter of tool

vendors gamin of France for milling machines scoffers of grace for thread rolling

machines George finisher of Switzerland for coping lather Mitsubishi Heavy industries of

Japan for machining centers of Kayo spiky of Japan for CNC lather the collaboration

have culminated in Praga producing machine tools of the highest quality conforming to

international standards by virtue of their dependability prevision engineering & proven.

CAPITAL BUDGETING

PROFILE OF PRAGA

The Praga Tools is one of the oldest, machine Tools industries in India and has

entire its golden jubilee year in 1993-94. The company has incorporated has the joint

stock company is 1943 has a private company with objective of manufacturing,

instruments with the Technical assistance of a few Czechoslovakia Engineers. The

company was incorporated in Many 1943 as a public limited company in private sector.

The name PRAGA symbolizes the technical co-operation extended in the initial phase by

some Czechoslovakian engineers who suggested the naming of the company as PRAGA

after their capital city PRAGUE (PRAGA).

In March 1995, the Government of India acquired the controlling interest in the

company by acquiring majority shares and placed the administrative control under the

ministry of commerce and industry from May 1995 to December 1963. The managing

agents M/S united industrial corporation limited initially managed the company.

Administrative control of the company has been transferred from the defense minister to

the department of public enterprise under ministry of industry on the 25 th of April 1986.

Presently the company enjoys the status of being a subsidiary of HMT LTD. Bangalore

when a paid up capital of the company was transferred in its name from the government.

The company has four manufacturing units located within the twin cities of

Hyderabad at Kavadiguda at Secunderabad it manufactures a wide range of machine

Tools, accessories and defiance items. A unit of forge and foundry divisions is located at

Kukatpally Hyderabad where manufactures castings and forgings are.

A CNC project was established with advance technology like numerical control

machines like automobiles CNC lathes, VNC mailing machines etc are manufactures with

the qualified personnel’s in the fields of engineering of technology.

The company has manpower of 2000 employees turning out wide range of

products.

The company has organized into four divisions viz., the machine Tools division

(MT-I), machine Tools II (MT-II), forge and foundry division, and the CNC division.

Performance Praga machine tools ate penetrating large segments of foreign

markets including UK CIC Canada, Bulgaria, Indonesia, Germany, Japan.

CAPITAL BUDGETING

PRAGA is even more proud of the fact that it has contributed to the development

of thee machine tools industry in the development of the machine tools industry in the

country and the creation of a vast band of skilled technicians thus Praga today in name of

techno, within the machine tool industry.

CORPORATE VISION OF PRAGA TOOL

VISION STATEMENT:

Praga tools to be the provider of choice for total machine tools solution to

customers and a significant provider of service in Indian industry of oversees too the

strong market position in to be sustained by the provision of integrated products and

services and the aggressive marketing of machine tool knowledge expensive and support

services.

COMPANY STATRATEGY:

1. To maintain good customer relation

2. Providing after seller service

3. Increasing the book order position

4. To maintain good quality and loyalty of the customers on their products

5. Maintain better research and development activities

6. Relation to company and other customer services through conducting the product

exhibition within the company preview

QUALITY VALUE:

Commitment of the management of the quality at all stagers.

To create quality culture among all employees to maintain quality leadership in all

products.

To maintain quality leadership in all products and services.

Total customer satisfaction through quality goods and services.

Total quality through performance leadership.

CAPITAL BUDGETING

MANUFACTURING FACILITIES

The company has two manufacturing units the order manufacturing unit is located

at Kavadiguda in Secunderabad, the heart of the city these unit houses the machine toils

division and the corporate head office and accompanies and area of slightly over 1 acres

the company.

Has its second manufacturing has is at balanagar in Hyderabad, about 5 to 6

kilometers from Hyderabad, airport the CNC division forge shop of foundry division are

located in the balanagar unit the total and available with the currently utilized by the CNC

division forge shop and foundry division leaving a surplus of nearly 100 acres.

PRODUCT RANGE:

The company has three manufacturing division viz., can pavilion forge shop and

foundry division.

MACHINE TOOLS DIVISION:

The major products manufactured by the company in its machine toll division are

cutler of fool grinders, milling machines, thread rotting machine, lather chucking etc.

There products were developed with the technical assistance of the world-renowned

machine tool manufacture by entering into collaboration agreements with M/s. Escoffier,

SA, France, M/s. F. Pratt and Co. and U.K. There machines enjoy good reputation in the

market.

FORCE DIVISION:

Railway Duplication

Auto dialer pants

Tractors links

Other carting

BOUNDARY DIVISION:

Carting for companies machine tools:

The sophisticated machines like CNC machining center sideway, grinding

machines, universal grinding machines, jigs boring machine with coordinated system

been added at a cost of Rs. 1,107.05 lacks.

CAPITAL BUDGETING

PRAGAS VALUES:

Underlying our minion in a set of core corporate valued which deliver praga

priorities. This set of values creates an overall framework for determining our derived

future and developing plans to achieve it.

Praga take advantage of existing synergies and foreseeing higher level of

competitiveness. Safety in the priority value for all aspects of our business.

SWOT Analysis:

STRENGTHS:

Proven products and brand image.

High brand loyalty of customer.

High market shares in few of the products categories.

Skilled work force.

ISO 9001 accredited company.

WEAKNESS:

Limited product gage.

Low volume production.

Out dead technology.

Inadequacy of working capital.

Aberrance of MIS.

Board needs to be board bared and must include.

Financial expensive.

Obralete machinery.

High man power cost.

Poor marketing plants.

CAPITAL BUDGETING

OPPORTUNITIES:

Prospects of improved in auto and automotive sector.

Export potential for exports of machines.

Foreign and components(with up gradation)

Opportunity to from joint venture update technology. And use technical manicuring

experience for globalization through venture partnership.

Diversification into related areas where ever synergy exists.

Threats:

Dwindling market for some of the products server.

Competition from imports of latest technology machines.

A threat from second hand machine imparts.

Shrinking resources of traditional customers, defense and railways.

The above analysis indicates ample scope and prospects for the company subject to

corrective steps being taken early.

CAPITAL BUDGETING

CHAPTER IV

DATA ANALYSIS

&

INTERPRETATION

CAPITAL BUDGETING

PROJECT -1

This project 1 is with a capital investment is about Rs. 220.00 lakhs.

CASH FLOW AFTER TAX FOR PROJECT- 1

PROJECT – 2

This project 2 is with a capital investment is about Rs.160 lakhs.

Year Qty

Sale

Value

Total

Cost

Gross

Earnings

Total

Dep

Net

Earnings

Tax

31% PAT

Add.

Dep. CFAT

1 2 3 4 5=3-4 6 7=5-6 8 9=7-8 10 11=9+10

1 8 566.56 509.9 56.66 0.85 55.81 17.3 38.51 0.85 39.36

2 25 1770.5 1593.45 177.05 0.85 176.2 54.62 121.58 0.85 122.43

3 27 1912.14 1720.93 191.21 0.85 190.36 59.01 131.35 0.85 132.2

TOTAL 60 291.44 293.99

CAPITAL BUDGETING

CASH FLOW AFTER TAX FOR PROJECT – 2

Year Qty

Sale

Value

Total

Cost

Gross

Earnings

Total

Dep

Net

Earnings

Tax

31% PAT

Add.

Dep. CFAT

1 2 3 4 5=3-4 6 7=5-6 8 9=7-8 10 11=9+10

1 5 5546.3 5379.91 166.39 24 142.39 44.14 98.25 24 122.25

2 4 4437.04 4215.19 221.85 24 197.85 61.33 136.52 24 160.52

3 4 4437.04 4320.57 116.47 24 92.47 28.67 63.8 24 87.8

4 4 4437.04 4406.98 30.06 24 6.06 1.88 4.18 24 28.18

TOTAL 17 302.75 398.75

CAPITAL BUDGETING

Payback Period

THE PAYBACK PERIOD OF PROJECT-1

(Rs in lakhs)

Year Annual cash inflows Cumulative cash inflows

1 39.36 39.36

2 122.43 161.79

3 132.2 293.99

.

Investment is Rs 220.00 lakhs.

Payback period =Lower year + Original cost of product – AACIF of lower year /

AACIF of upper year – AACIF of lower year

Payback period = 2 + (220 – 161.79) / (293.99 – 161.79)

= 2 + (58.21 / 132.2)

=2 + 0.44

= 2.4 years

Interpretation: In this project the initial investment is Rs 220.00lakhs are recovered in

the 2nd year of 4th Month

CAPITAL BUDGETING

THE PAYBACK PERIOD OF PROJECT-2

(Rs in lakhs)

Year Annual cash inflows Cumulative cash inflows

1 122.25 122.25

2 160.52 287.77

3 87.8 370.57

4 28.18 398.75

Investment is Rs 160 lakhs.

Payback period =Lower year + Original cost of product – AACIF of lower year /

AACIF of upper year – AACIF of lower year

Payback period = 1+ (160-122.25) / (287.77-122.25)

= 1.2years.

Interpretation:

In this project the initial investment is Rs 160.00 lakhs are recovered in the 1 st

year of 2nd month.

CAPITAL BUDGETING

Figure 1:

Accounting Rate of Return

THE ARR OF PROJECT-1

(Rs in lakhs)

Year NPAT

1 38.51

2 121.6

3 131.4

Total 291.4

Accounting rate of return = average income / Average investment.

Average investment = (Original investment – Scrap value)/2

Average income = Total income / Number of years.

CAPITAL BUDGETING

Investment is Rs220.00 lakhs.

Average investment = 220/2

= 110

Average income = 291.44/3

= 97.14

ARR = (97.14/110) 100

ARR = 88%

THE ARR OF PROJECT-2

(Rs in lakhs)

Year NPAT

1 98.25

2 136.5

3 63.8

4 4.18

Total 302.8

Accounting rate of return = average income / Average investment.

Average investment = (Original investment – Scrap value)/2

Average income = Total income / Number of years.

Investment is Rs.160 lakhs.

Average investment = 160/2

CAPITAL BUDGETING

= 80

Average income = 302.75/4

= 75.68

ARR = (75.68/80) 100

=94.6%

Figure 2

CAPITAL BUDGETING

Net Present Value

NET PRESENT VALUE OF THE PROJECT-1

(Rs in lakhs)

Year Cash flow P.V.factor@10% Cash flows of P.V

1 39.36 0.909 35.77

2 122.43 0.826 101.12

3 132.2 0.751 99.28

4 Total 236.17

Total CF of PV = 236.17

(-) Investment = 220.00

NPV = 16.17

Interpretation:

NPV of project-1 is positive (+) i.e. Rs 16.17 lakhs, so project is acceptable for

company.

CAPITAL BUDGETING

NET PRESENT VALUE OF THE PROJECT-2

(Rs in lakhs)

Year Cash flow P.V.factor@10% Cash flows of P.V

1 122.25 0.909 111.12

2 160.52 0.826 132.58

3 87.8 0.751 65.93

4 28.18 0.683 19.24

5 Total 328.87

Total CV of PV = 328.87

(-) Investment = 160.00

NPV = 168.87

Interpretation:

NPV of project-2 is positive (+) i.e. Rs 168.87 lakhs, so project is acceptable for

company.

CAPITAL BUDGETING

Figure 3

Profitability Index

PROFITABILITY INDEX OF PROJECT-1:

(Rs in lakhs)

Year Cash flow P.V.factor@10% Cash flows of P.V

1 39.36 0.909 35.77

2 122.43 0.826 101.12

3 132.2 0.751 99.28

4 Total 236.17

Total CF of PV = 236.17

(-) Investment = 220.00

NPV = 16.17

CAPITAL BUDGETING

PI = PV of cash inflows / initial cash outlay

PI = 236.17/220= 1.07

Interpretation:

The profitability index value is 1.07, which is more than the value ‘0’, and also the

NPV is positive hence the project is viable to company.

PROFITABILITY INDEX OF PROJECT-2:

(Rs in lakhs)

Year Cash flow P.V.factor@10% Cash flows of P.V

1 122.25 0.909 111.12

2 160.52 0.826 132.58

3 87.8 0.751 65.93

4 28.18 0.683 19.24

5 Total 328.87

Total CV of PV = 328.87

(-) Investment = 160.00

NPV = 168.87

PI = PV of cash inflows / initial cash outlay

CAPITAL BUDGETING

PI = 328.87/160 =2.05

Interpretation:

The profitability index value is 2.05, which is more than the value ‘0’, and also the

NPV is positive hence the project is viable to company.

Figure 4

Internal Rate of return

IRR OF PROJECT – 1

Pay Back Period = 2.4 years

Present value of annuity for PBP lies between 12% and 13%

12% ------------------------- 2.402

13% ------------------------- 2.361

IRR = 13 – (2.4 –2.361) / (2.402 –2.361)

IRR = 11.88%

Interpretation:

The minimum expected rate of return of company is 10%. Since the IRR of

project-1 i.e. 11.88% is greater than expected rate of return, it is observed that project is

viable to company.

CAPITAL BUDGETING

IRR OF PROJECT – 2

Invest of Project-2 is Rs.160 Lakhs.

NPV= 0

(Cash inflow - Investment) = 0

The IRR is the value of ‘r’, which satisfies the following equation.

160 = 122.25 + 160.52 + 87.80 + 28.18

(1+r) (1+r) 2 (1+r) 3 (1+r) 4

The calculation of ’r’ involves a process of trail and error. We try different values

of ‘r’ till we find that the RHS of the above equation is equal to Rs.160Lakhs. Let us, to

began with, try r=62%. This makes the RHS equal to:

39.36 + 122.43 + 132.20 = 161.37

(1+0.62) (1+0.62) 2 (1+0.62) 3

The value is slightly higher than our target valueRs.160lakhs. So we

increase the value of ‘r’ from 62% to 63%.

39.36 + 122.43 + 132.20 = 159.68

(1+0.63) (1+0.63) 2 (1+0.63) 3

Since this value is now less than 160, we conclude that value of ‘r’lies between

62% to 63%. From most of the purposes this indication sufficient. If a move-refined

estimate of ‘r’ is needed, use the following procedure.

CAPITAL BUDGETING

(1) Determine the NPV of Two closest rates of return.

(NPV/62%) 1.37

(NPV/63%) 0.32

(2) Find sum of the absolute values of the NPV obtained in step 1:

1.37 + 0.32 = 1.69

(3) Calculate the ratio of the NPV of the smaller discount rate identified in step 1: to the

sum obtained in step2:

0.32/1.69 = 0.18

(4) Add the number obtained in step3: to the smaller discount rate:

62+0.18 = 62.18%

Interpretation:

The minimum expected rate of return of company is 10%. Since the IRR of

project-2 i.e. 62.18% is greater than expected rate of return, it is observed that project is

viable to company.

Figure5

CAPITAL BUDGETING

CHAPTER V

FINDINGS, CONCLUSION

SUGGESTIONS

CAPITAL BUDGETING

FINDINGS / CONCLUSIONS

The study concerned with the capital budgeting with reference to company

the data is collected, organized, analyzed and interpreted.

The following findings are obtained from the analysis of data:

1 The project 1 is with a capital investment is about Rs.8.12lakhs.

The non-discounted payback period is 2.4 years. The investment will

recover in 2 year and 4th month only.

The ARR is 88% more than the required rate of return. Therefore,

accept the project on ARR basis.

NPV is positive (+) i.e.Rs16.17 lakhs, so accept the project.

The profitability index is 1.07 times > 1.

The IRR is 11.88% more than the required rate of return.

2. The project 2 is with a capital investment is about Rs.160lakhs.

The non-discounted payback period is 1.2 years. The investment will

recover in 1year and 2 month.

The ARR is 94.6% more than the required rate of return. Therefore,

accept the project on ARR basis.

NPV is positive (+) i.e.Rs168.87 lakhs, so accept the project.

The profitability index is 2.05 times > 1.

The IRR is 62.18% more than the required rate of return

CAPITAL BUDGETING

SUGGESTIONS

The project 1 is having a PBP of 6.1yrs, NPV, IRR; ARR & PI are

indicating a positive sign. Therefore accept the project.

The project 2 of is having a PBP of 1.2yrs, NPV, IRR; ARR & PI

are indicating a positive sign. Therefore accept the project.

CAPITAL BUDGETING

BIBLIOGRAPHY:

BOOKS:

1) A Murthy, S Gurusamy, “Management Accounting”, Vijay Nicole, 2006.

2) I M Pandey, “Financial Management”, 9/e, Vikas publishing, 2004.

3) M Y Khan and P K Jain, “Financial Management”, Tata Mc Graw-Hill,

New Delhi- 2003.

WEB-SITES:

www.wikipedia.com

www.google.com