A STUDY ON CAPITAL BUDGETING TECHNIQUES USED AT ANDHRA PRADESH STATE FINANCIAL CORPORATION

MASTER OF BUSINESS ADMINISTRATION

Submitted by G. RAKESH KUMAR H.T.NO: 003070119

O. U. P. G. COLLEGE, VIKARABAD. (2007-2009) DECLARATION

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I HERE BY DECLARE THAT THE PROJECT WORK ENTITLED CAPITAL BUDGETING TECHNIQUES USED AT ANDHRA PRADESH STATE FINANCIAL CORPORATION IS AN ORIGINAL AND CONAFIDE WORK DONE BY ME IN PARTIAL FULFILMENT FOR THE AWARD OF THE DEGREE OF MASTER OF BUSINESS ADMINISTRATION.

THE

RESULTS

EMBODIES

IN

THIS

DISSERATION

HAVE

NOT

BEEN

REPRODUCED OR SUBMITTTED TO ANY OTHER UNIVERSITY OR INSTITUTE FOR AWARD OF ANY DEGREE OR DIPLOMA. THE CONTENTS OF THIS REPORT ARE BASED ON THE INFORMATION COLLECTED BY ME DURING MY TENURE AT ANDHRA PRADESH STATE FINANCIAL CORPORATION.

PLACE : HYDERABAD

(G. RAKESH KUMAR )

ABSTRACT
CAPITAL BUDGETING IN APSFC

In anticipation of an expected flow of future benefits over a series of years. The long-term activities are those activities, which affect firms operations beyond the one year period. Generally, the firms capital budgeting decisions will include addition, disposition, modification and replacement of long term, or fixed assets.

Greater emphasis on the capital budgeting decision : 1) They have long term implication for the firm and influence its risk complexion. 2) They involve commitment of large amounts of fund. 3) They are irreversible decisions. 4) They are among the most difficult decision to make.

Andhra Pradesh State Financial Corporation (APSFC) is a term lending institution established in 1956 for promoting small and medium scale industries in Andhra Pradesh under the provisions of the state financial corporations act, 1951. The corporation came into existence on 1-11-1956 by merger of Andhra Financial Corporation and Hyderabad State Financial Corporation.

ACKNOWLEDGEMENT

The presentation of the project report in the way required has been made possible by the way of contributions of various people. The complete of this project report brings to the time to express one thanks to all those helped along the way.

I am very thankful to Mr. B Krishnaiah for providing me and for providing me an opportunity to conduct my project work in APSFC.

I am also thankful to our Mr. V. Chinna Animi Reddy the project guide for their support and encouraging in submitting this dissertation.

Last but not least, I would like to thankful to our principal Mr. C. Praveen Kumar Reddy and all other faculty of the department, O.U. Post Graduation College, Vikarabad for giving me this opportunity.

CONTENTS

CHAPTER

Pg No.

1) INTRODUCTION

6-17

2) CORPORATION PROFILE OF APSFC

18-33

3) INTRODUCTION OF CAPITAL BUDGETING

34-58

4) TECHNIQUES OF CAPITAL BUDGETING

59-72

5) DATA ANALYSIS AND PRESENTATION

73-86

6) FINDINGS AND SUGGESTIONS

87-92

7) BIBLIOGRAPHY

93-94

CHAPTER - 1

INTRODUCTION

INTRODUCTION TO FINANCIAL MANAGEMENT MONEY MAKES MANY THINGS is the good olden proverb, which explains the importance of money in the life of human being and also organizations. Money is necessary to acquire and utilize the resources in the organization. A business enterprise, which doesnt have proper financial planning and control loses it resources and doesnt exist.

Financial management is an organizational activity that is concerned with man managing financial resources. In common finance provides monetary resources at the time required.

Financial management is a business activity which concerned with capital funds in meeting financial needs and overall objectives of business enterprise.

EVOLUTION OF CORPORATE FINANCE : Financial management has become very important in all private and public corporate sectors and emerged as a corporate finance, which is divided into 3 broad categories. They are

1. TRADITIONAL PHASE 2. TRANSITIONAL PHASE 3. MODERN PHASE

1. Traditional phase mainly focuses on formation, issue of capital, merger, major expansion and liquidation. It lasted for four decades. 2. Transitional phase is similar to the traditional phase. It mainly on day to day problems faced by financial manager in fund analysis, planning and control. It began around early forties and continued to early fifties. 3. The modern phase in mid-fifties and financial management has become more annalistic and quantitative.

SCOPE OF FINANCIAL MANAGEMENT: The scope of financial management is vast and determined by financial requirements of the business enterprise, which have to be identified before any plan is to be formulated. Business need are costly and changes from time to time depending upon environment factors, since investment opportunities which give rise to financial needs are available from environment.

The financial manager must have through understanding over the environment and its changes. So that financial manager should look after the funds are preceded in proper manner, so that risk and cost are balanced.

The financial manager should take proper decision to attain organization goals. It is also referred as corporate finance or managerial finance.

FINANCIAL MANAGEMENT

Capital Structure and Formation

Capital Budgeting FINANCIAL MANAGEMENT Working Capital Management

Financial Analysis and Planning

Performance and Operational Analysis

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CAPITAL STRUCTURE AND FORMATION: After the requirement of funds is certain through capital budgeting decision, the capital is to be acquired through various long-term sources of finance can be divided into two groups.

Equity capital consists of share capital and retained earning. Debt capital consists of debentures, preference share and longterm loans etc.

The financial manager has to establish an optimum capital structure and ensure the maximum rate of return on investment the ration between equity and other liabilities carrying fixed charges has to be decided.

In the process, he has to consider the operating and financial leverage of his enterprise; the operating leverage exist because of operating expenses, while financial leverage exists because of the amount of debt involved in a firms capital structure. The financial manager should have an adequate knowledge about the optimum capital structure.

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CAPITAL BUDGETING:

Capital budgeting decision deals with allocation of capital to acquire fixed assets for the enterprise. These assets need to spend at present and in future. Future is uncertain and difficult to measure. It is the oldest area of modern approach. The decision can be taken during promoting, expansion, reorganization and replacement. Modern approach capital budgeting

decisions are very crucial as they relate to judicious allocation of capital. Capital budgeting forecast on proposed long-term investment and compares profitability of different investments and their cost of capital.

WORKING CAPITAL MANAGEMENT: Any organization contains two types of assets, namely fixed and current assets. Besides managing fixed asset, the financial manager must also look after current assets to safeguard the profitability, liquidity and solvency of the company. Current assets are not profitable but if they are not maintained at the required level, liquidity suffers and solvency is threaten. Working capital is an of fixed capital investment. It is a financial lubricant, which keeps business operations going. Cash, accounts receivables, and inventory are the important components of working capital management. Cash is a central reserve of a firm and ensure liquidity. Account receivables and inventory form the principal factor for production and sales.

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The financial manager should evaluate the advantage of customer trade credits, like increase in volume of sales against cost and risk, which are related to inventory management. The risks are those when inventory is inadequate. FINANCIAL ANALYSIS AND PLANNING: After the decisions regarding the fixed assets and current assets are taken, implemented result can be secured. So, the next job of the financial manager is to analyze the financial position of the enterprise and plan according. It involves evaluation and interpretation of companys financial position.

PERFORMANCE AND OPERATIONS ANALYSIS: After planning the financial manager need to analyze the performance. To analyze the performance of various activities, breakeven analytical tools like ratio analysis, funds flow analysis, cash flow analysis, breakeven analysis & CPV analysis are to be used to measure the profitability and overall performance of various assets. It reveals the facts and details about the financial position of a firm very clearly. The business enterprise financial decisions are interrelated and influence the market value of shares through affecting its return & risk. So, proper balance between return and risks to be operate well to minimize the share value of firm so that the financial should manage efficiently by making financial decisions. He should inventory trends with levels of sales. There are several cost and risks which are related to inventory management when inventory is inadequate or in excess in requirement.

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CHANGING ROLE OF FINANCIAL MANAGEMENT: According to the change in role of financial management the manager should cope up the change in activities the operation of financial management is different from the public sector to private sector and competition between two.

The change in environment calls for the phenomenal changes in public sector to the challenges of competition and change in economic setup the corporate management need major skill and strategies to take care of changes in technologies, human resource management and source of financial investment.

After 1991 the policy of government companies incurred due to the deli censes system by the government and foreign companies which entered into our country. So many public units have been privatized. But some government companies should maintain for the country. So that, some matter should not travel to privatize companies.

So the financial manager needs to cope up with this change by his skills and need to manage finance according to the requirements of the company. According to the government policies, budgets play key role in the financial management, which changes from period to period.

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NEED FOR THE STUDY

The project study is undertaken to analyze and understand the Capital Budgeting process in power sector, which gives mean exposure to practical implication of theory knowledge.

To know about the companys operations of using various Capital budgeting techniques.

To know how the company gets funds from various resources.

OBJECTIVES OF THE STUDY

To study the relevance of capital budgeting in evaluating the project

To study the techniques of capital budgeting for decision-making

To measure the present value of rupee invested.

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

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 To make suggestions if any for improving the financial positions of the company

METHODOLOGY OF THE STUDY

To achieve a fore said objective the following methodology has been adopted. The information for this report has been collected through the primary and secondary sources.

Primary Sources It is also called as first handed information the data is collected through the observation in the organization and interviews with officials. By asking questions with the accounts and other persons in the financial department. A part from these some information is collected through the Prospectus, Internet, seminars and discussions.

Secondary Sources These secondary data is existing data which is collected data which is collected by others that is sources are financial journals, annual reports of the APSFC and APSFC website, and other publications of APSFC.

PERIOD OF THE STUDY

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The period of the study is provided by the Andhra Pradesh State Financial Corporation is 8 weeks. The period for the study of Capital Budgeting is not enough for the brief.

LIMITATIONS OF THE STUDY:

Lack of time is another limiting factor the schedule period 8 weeks are not sufficient to make the study independently regarding Capital Budgeting in APSFC. The busy schedule of the officials in the APSFC is another limiting factor. Due to the busy schedule of officials restricted me to collect the complete information on about organization. Non-availability of confidential financial data of case studied data i.e. company profile of M/s. Paramount Rice Mill, Zahirabad. The study is conducted in a short period, which was not detailed in all aspects.

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CHAPTER - 2

CORPORATION OF

PROFILE

APSFC

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A P S F C PROFILE
ARTICLES
ANDHRA PRADESH A STATE OF BOUNDLESS OPPORTUNITIES Andhra Pradesh is a microcosm of India, combining the best of the north, east, west and south. No wonder, it is in the News as an investor friendly State. Andhra Pradesh, with its wide and diversified industrial base and progressive policies is the preferred and favorite destination for industrial investment. It has excellent infrastructural facilities, rich agricultural and mineral resource base and growing market. It has, therefore, attracted knowledge based, resource based and skill based industries.

Some of the worlds most reputed companies like General Electric (GE), Microsoft, Oracle, HSBC, Deloitte Consulting, Baan and Nokia have chosen Andhra Pradesh for their investment and operations.

It is the world class infrastructure, the supportive regulatory environment and the speed with which industries can be set up that makes Andhra Pradesh so attractive. It has a low cost sustainable pool of highly skilled, flexible and motivated
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man power. No wonder that Hyderabad, the capital of Andhra Pradesh is considered as Cyber bad or the new silicon valley of India. The State is a favored Investment destination, preferred location for industry and place where things happen in a fast forward mode. In short, a happening State.
ANDHRA PRADESH STATE FINANCIAL CORPORATION: Merging Andhra SFC and Hyderabad SFC on 01.11.1956 formed the Andhra Pradesh State Financial Corporation. The Corporation has made significant contribution to the industrial development of the State during the last five decades by selfless service to the Small and Medium Sector in Andhra Pradesh. The Corporation is in lead position amongst all other SFC in the country for the fourth year in succession in all the Key Result Areas i.e. Sanctions, Disbursements and Percentage of Recoveries. It has an enviable history of innovative industrial promotion and imaginative entrepreneurship development.

Andhra Pradesh State Financial Corporation is an investor friendly organization and is fondly called as the friendly financier. It not only lends, it cares and tends. Most of the prominent industrialists in Andhra Pradesh were nurtured and assisted by it as part of its first generation entrepreneurship drive. They have all graduated to good senior and special category entrepreneurs, which is its greatest satisfaction. The corporation believes that if preparation meets opportunity, success follows. It is a profit earning corporation and professionally run organization. Its unique selling proposition is its objective appraisal of proposals, provision of escort services, handholding attitude and speed in decision making. 20

PROACTIVE GOVERNMENT: Andhra Pradesh government is investor friendly, proactive and supportive. It has already formulated and announced an investment friendly and progressive industrial investment promotion policy (2005-2010) that welcomes investment from all over India and globally as well. Apart from liberal concessions and incentives, it provides a single window clearance system to accelerate industrial clearances and pave the way for a fast and smooth start up and thereby promote High investment and rapid growth. With the initiatives taken by Government, a congenial environment exists for entrepreneurs to avail industrial opportunities. AP has attracted both foreign and domestic investment and is among the leading industrial States of India.

INFRASTRCTURE: The Andhra Pradesh government believes that infrastructure must be ahead of the needs of the economy and has been creating world class infrastructure. It facilitates public / private partnerships and has chalked out realistic plans to develop roads, ports, air and transport services and telecom facilities on par with international standards. An International Airport at Hyderabad is constructed. Linkages between production, consumption and exports of goods and services are being further strengthened.

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POWER Andhra Pradesh is among the top five States in the country in installed capacity for power generation and production in the private sector is way ahead of other states in India.

PORTS Andhra Pradesh has a 1000 Kilo meter coastline, the longest of all the Indian States. Visakhapatnam, Port is the leading port of India in tonnage and Visakhapatnam has been hailed as the city of destiny. The State has two intermediate ports at Kakinada and Machilipatnam while new ports are coming up at Gangavaram and Krishnapatnam.

RICH NATURAL RESOURCES: Andhra Pradesh is rich in natural resources. Three large rivers, Godavari, Krishna and Pennar and their tributaries course through three fourths are of the State. Endowed with fertile land, abundant water and good agro climatic conditions, A.P. is an agriculturally prosperous State. There is enormous scope for setting up of agro processing and food based industries. And global giants would like to source the products.

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FOOD PRODUCTION & PROCESSING: The State is a large producer of rice, and cash crops like tobacco, groundnut, chilies, turmeric, oilseeds, cotton, sugar and jute, among others. It produces some of the finest varieties of mangoes, grapes, guavas, papayas and bananas. Agro and food processing sector offers. Immense scope. The State Government expects an annual growth rate of 15 percent driven by exports and growing domestic demand. The State is the largest producer of eggs in the state. The State is also a major producer of hides and skins in India and has 34 large and medium tanneries.

TEXTILE INDUSTRY: Andhra Pradesh is one of the leading producers of cotton. There is over 80 spinning mills, most of which are 100 percent export oriented units with state of the art machinery. These units produce cotton, synthetic and blended yarns. Amble opportunities are available for setting up modern weaving units in the State. Huge demand exists for good quality fabrics from the apparel manufacturing industry. An Apparel Park is being developed near Hyderabad.

OTHER INDUSTRIES:

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Opportunities exist for mineral exploration projects of some of the most lucrative fields like diamonds, gold, base metals, granite etc.

STATE GOVERNMENTS INITIATIVES TO PROMOTE INDUSTRY IN THE STATE: Andhra Pradesh has developed many a industry specific industrial estates in the state to promote industrial development. There are over 272 industrial estates in the State. It is also promoting special Economic Zones, Industrial Corridors and Industrial Cluster Development. The Government has also announced a Genome Valley and Knowledge Corridor near Hyderabad. In addition, textile parks and leather parks are being set up in the State.

INDUSTRIAL INVESTMENT PROMOTION POLICY 2005-2010: Government of Andhra Pradesh have provided many incentives to entrepreneurs in the tiny, SSI, SME and Mega Projects, existing units have also been provided some incentives. Women and SC/ST entrepreneurs are eligible for additional concessions. Emphasis is on quality certification, power tariff concessions, tax relief and lowered costs of transacting business:

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SOME MAJOR INCENTIVES UNDER THE A.P. INDUSTRIAL INVESTMENT PROMOTION POLICY 2005-2010: 15 PER CENT INVESTMENT SUBSIDY ON FIXED CAPITAL INVESTMENT TO Small Scale (SSI) and Tiny industrial units subject to a limit of Rs.15.00 lakhs. Provision of a corpus fund matching the contribution made by consortium industries in Industrial estates subject to a limit of Rs.25.00 lakhs. Infrastructure assistance to stand-alone units by contribution of 50 per cent of the cost of infrastructure from Industrial Infrastructure Development Fund with a ceiling of Rs.1 crore. 25 per cent of the tax paid during one financial year will be ploughed back to all eligible industries as a grant by the Government towards the payment of tax during the next year. 3 per cent interest rebate on the prime-lending rate (PLR) on term loans taken by new tiny/SSI units subject to a limit of Rs.5.00 lakhs per year. This will be 5 per cent if SC and ST entrepreneurs promote the units. Power cost will be reimbursed @ Rs.0.75 per unit during the first year of the Policy and thereafter for the remaining four years of the rate of

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reimbursement would be so regulated on yearly basis keeping in view of the changes in the tariff structures to ensure that power cost to the industry is pegged down to the first year level. Reimbursement of 25 per cent of the cost of land purchased in the industrial development areas of A.P. Industrial Infrastructure

Corporation Ltd. Subject to a limit of Rs.5.00 lakhs. An additional investment subsidy of 5 per cent subject to a maximum of Rs.5.00 lakhs will be provided to women entrepreneurs. They will be also given a 5 per cent interest rebate on PLR. Projects with an investment of Rs.100 crores and above are eligible for all the incentives available to large and medium scale industries. The Government will also extend tailor-made benefits to suit to particular investment requirements on case-to-case basis. 100 per cent reimbursement of stamp duty and transfer duty paid by the industry. 100 per cent reimbursement of stamp duty for release of land, shed or buildings. 100 per cent reimbursement of stamp duty and transfer duty paid by the industry on financial deeds and mortgages etc.

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SCHEMES IN OPERATION FOR FINANCIAL ASSISTANCE: The Corporation is operating about 34 different schemes of financial assistance. Some of the important schemes are:

Good Entrepreneurs Scheme o Assistance to Tourism Related Activities o Assistance to Hotels/Motels/Restaurants o Assistance to Hospitals/Nursing Homes/Electro-medical Equipment o Assistance for setting up Industrial Estates o Scheme for Qualified Professionals o Single Window Scheme of Assistance o Scheme for Construction of Commercial / Residential Complexes /Group Housing o Scheme for Textile Industry under Technology Up-gradation

Fund for SSI Units o Making Assistance Scheme o Seed Capital Assistance under Mahila Udyam Nidhi Scheme o Seed Capital Assistance under National Equity Fund Scheme

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o SEMFEX Scheme for Ex-Servicemen o Working Capital Term Loan Scheme for Good

Entrepreneurs/Enterprises o Assistance to Civil Contractors o Assistance to Practicing Doctors o Line of Credit Scheme for Good Entrepreneurs o Credit Linked Capital Subsidy Scheme for Technology Up-gradation of SSI units o Financial assistance to Export Oriented Industries / Service Enterprises o Financial assistance to set up Super Bazaars / Retail outlets o Financial assistance to meet seasonal Working Capital requirements o Financial assistance to Food Processing Industries o Financial assistance to private market yards o Financial assistance for purchase of Existing Assets

INTEREST RATES: APSFC provides competitive rates of interest on its loans and the rate of interest ranges from 13.50 to 14.75% depending upon quantum of loan, sector and the scheme. Full particulars may be noted from the printed interest rates sheet.

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ANDHRA PRADESH STATE FINANCIAL CORPORATION HYDERABAD BALANCE SHEET AS AT 31ST MARCH 2004 TO 2008
Rs. in lakhs
CAPITAL AND LIABILITIES : SHARE CAPITAL LOAN PENDING CONVERSION TO SHARE CAPITAL RESERVE FUND AND OTHER RESERVES TERM BORROWINGS CURRENT LIABILITIES & PROVISIONS 2003-04 8771.99 1334.00 2014.75 103975.10 9232.22 2004-05 8971.99 1334.00 2014.75 99795.64 7956.91 2005-06 9221.99 1334.00 2014.75 96452.52 10258.25 2006-07 9221.99 6334.00 2157.50 107900.96 16329.90 2007-08 20600.99 5834.00 2676.40 136587.69 18319.21

TOTAL PROPERTY AND ASSETS : CASH & BANK BALANCE INVESTMENTS LOANS & ADVANCES FIXED ASSETS CURRENT ASSETS PROFIT & LOSS ACCOUNT

125328.06

120073.29

119281.51

141944.35

184018.29

7312.25 4.25 94175.23 2116.85 5200.02 15794.82

7133.89 4.25 91028.93 2028.54 5093.17 14784.50

5485.30 54.25 93235.09 1990.95 5046.33 13469.59

10138.26 114.25 115928.33 2077.71 5253.39 8432.41

15817.34 4106.14 144148.34 13055.04 6891.43 0.00

TOTAL

124603.42

120073.28

119281.51

141944.35

184018.29

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APSFC PERFORMANCE REVIEW FOR THE LAST 5 YEARS

Rs. in lakhs
YEAR ENDED 31st MARCH 2004 2005 2006 2007 2008

SANCTIONS DISBURSEMENTS RECOVERIES (PRINCIPAL + INTEREST)

43058.46 28324.87 45021.74

46469.60 34887.45 45139.40

58596.93 42172.45 48214.04

70475.23 52313.69 51595.25

100665.80 66269.91 62193.76

CUMULATIVE NET EFFECTIVE SANCTIONS: NUMBER AMOUNT 66288 360409.45 67243 391421.62 68246 43273.10 69323 491638.25 70513 579660.42

A. OPERATIVE INCOME B. OPERATIONAL COSTS C. OPERATING PROFIT

14309.21 13707.77 601.44

13004.80 12313.84 690.96

13851.53 13067.90 783.63

15861.16 15045.91 815.25

22686.85 21186.64 1500.21

OUTSTANDING AMOUNT NUMBER OF ACCOUNTS NUMBER OF EMPLOYEES

127149.40 20802 534

120955.88 19623 523

122839.27 17878 519

133450.01 15796 514

157864.31 14409 502

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APSFC PERFORMANCE IN KEY RESULT AREAS FROM LAST 5 YEARS

YEAR SANCTIONS DISBURSEMENTS RECOVERIES

2003-04

2004-05

2005-06

2006-07

2007-08 100665.80 66269.91 62193.76

43058.46 46469.60 58596.93 70475.23 28324.87 34887.45 42172.45 52313.69 45021.74 45139.40 48214.04 51595.25

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APSFC OPERATING PROFIT FROM LAST 5 YEARS

(Rs. in lakhs)

YEAR 2003-04 2004-05 2005-06 2006-07 2007-08

PROFITS 601.44 690.96 783.63 815.25 1500.21

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APSFC RECOVERY PERFORMANCE FROM LAST 5 YEARS

YEAR PRINCIPAL INTEREST TOTAL 2003-04 31960.03 13061.71 45021.74 2004-05 33110.55 12028.85 45139.4 2005-06 35218.91 12995.13 48214.04 2006-07 37117.83 14477.42 51595.25 2007-08 42171.82 20021.95 62193.77

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CHAPTER - 3 INTRODUCTION OF

CAPITAL BUDGE TIN G

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INTRODUCTION TO CAPITAL BUDGETING

Capital budgeting is the decision process relating to long-term capital investment programmes. Capital budgeting decisions involve costly long-term investments with profound impacts upon organizations and their long-term performance. Success or failure can hinge on one such decision. Given this, managers must understand investment appraisal techniques. This chapter introduces the capital budgeting process of organizations. Hence, the Capital Budgeting defines as it is long term planning for making and financing proposed capital outlays. Capital budgeting is vital in marketing decisions. Decisions on investment, which take, time to mature, have to be based on the returns which that investment will make. Unless the project is for social reasons only, if the investment is unprofitable in the long run, it is unwise to invest in it now. Often, it would be good to know what the present value of the future investment is, or how long it will take to mature (give returns). It could be much more profitable putting the planned investment money in the bank and earning interest, or investing in an alternative project. Typical investment decisions include the decision to build another grain silo, cotton gin or cold store or invest in a new distribution depot. At a lower level,

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marketers may wish to evaluate whether to spend more on advertising or increase the sales force, although it is difficult to measure the sales to advertising ratio. Capital investments can commit companies to major courses of action. They can be risky as outlays tend to be large, benefits uncertain and slow to materialize, and they are difficult to reverse. Typical investment decisions include introducing electronic commerce, new product lines, and computerized production processes; acquiring or merging with another company; substantially increasing production capacity; and major research and development plans. These decisions have common characteristics: they lay the basis for future success, commit a substantial proportion of resources to possibly irreversible actions, involve substantial costs and benefits, are permeated with uncertainty, and profoundly impact long-term performance.

Capital budgeting is one of the most important areas of financial management. There are several techniques commonly used to evaluate capital budgeting projects namely the payback period, accounting rate of return, present value and internal rate of return and profitability index. Recent studies highlight that financial managers worldwide favor methods such as the internal rate of return (IRR) or non-discounted payback period (PP) models over the net present value (NPV), which is the model academics consider superior. In particular this research focused on small, medium and large businesses and investigated a number of variables and associations relating to capital budgeting practices in businesses in the Western Cape province of South Africa.

The results revealed that payback period, followed by net present value, appears to be the most used method across the different sizes and sectors of business. It was 36

also found that 64% of businesses surveyed used only one technique, while 32% of the respondents used between two to three different types of techniques to evaluate capital budgeting decisions. The findings show that the more complicated methods such as IRR and NPV are most favored by the large businesses as compared to the small businesses. The majority of the respondents believed that project definition was the most important stage in the capital budgeting process. Implementation stage appeared to be the most difficult stage for the manufacturing sector whereas Project definition, Analysis and selection and Implementation were generally rated as being the difficult stages by the retail sector. Project definition and Analysis and selection were found to be the most difficult stages by the service sector. Most businesses used the cost of bank loan as a basis in capital budgeting and more than two thirds of respondents used non-quantitative techniques to consider risk when making a decision on investing in fixed assets.

Management accountants should direct managerial attention to significant information (Weetman, 1999), and provide analysis and advice but investment decisions also require expertise ranging from, inter alia, production and marketing managers, engineers, and the board of directors (Northcott, 1998).

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AN OVERVIEW OF CAPITAL BUDGETING DECISION

Capital Budgeting Decision

Project Generation

Project Evaluation

Project Selection

Project Execution

Payback Period Accounting Rate of Return Net Present Value Internal Rate of Return Risk Return Profitability Index

Cash Flow Estimates

Selection of Appraisal

Trade Off

Market Value per Share

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After studying this chapter, you should be able to:

1. Appreciate the significance of capital budgeting 2. Recognize the nature and importance of capital investment decisions 3. Identify the four stages of capital budgeting 4. Understand the opportunity cost of an investment, the time value of money, and the difference between compounding and discounting 5. Evaluate capital investment proposals using net present value (NPV), internal rate of return (IRR), payback (PB), and accounting rate of return (ARR) methods and understand their strengths and weaknesses 6. Use profitability indices to allocate limited funds between projects 7. Identify the impact of tax and inflation on investment cash flows 8. Understand risk and uncertainty and how to deal with risk in investment appraisal 9. Appreciate the importance of non-financial and qualitative factors, and new approaches such as real options

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Features of Capital Budgeting:

The important features, which distinguish capital budgeting decisions in other day-to-day decisions, are

Capital budgeting decisions involve the exchange of current funds for the benefits to be achieved in future

The futures benefits are expected and are to be realized over a series of years

The funds are invested in non-flexible long-term funds They have a long terms are significant effect on the profitability of the concern

They involve huge funds They are irreversible decisions. They are strategic decisions associated with high degree of risk

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Significance of Capital Budgeting

The key function of the financial management is the selection of the most profitable assortment of capital investment and it is the most important area of decision-making of the financial manger because any action taken by the manger in this area affects the working and the profitability of the firm for many years to come. The need of capital budgeting can be emphasized taking into consideration the very nature of the capital expenditure such as heavy investment in capital projects, longterm implications for the firm, irreversible decisions and complicates of the decision making. Its importance can be illustrated well on the following other grounds:-

(1) Indirect Forecast of Sales. The investment in fixed assets is related to future sales of the firm during the life time of the assets purchased. It shows the possibility of expanding the production facilities to cover additional sales shown in the sales budget. Any failure to make the sales forecast accurately would result in over investment or under investment in fixed assets and any erroneous forecast of asset needs may lead the firm to serious economic results. 41

(2) Comparative Study of Alternative Projects. Capital budgeting makes a comparative study of the alternative projects for the replacement of assets which are wearing out or are in danger of becoming obsolete so as to make the best possible investment in the replacement of assets. For this purpose, the profitability of each project is estimated.

(3) Timing of Assets-Acquisition. Proper capital budgeting leads to proper timing of assets-acquisition and improvement in quality of assets purchased. It is due to ht nature of demand and supply of capital goods. The demand of capital goods does not arise until sales impinge on productive capacity and such situation occurs only intermittently. On the other hand, supply of capital goods with their availability is one of the functions of capital budgeting.

(4) Cash Forecast. Capital investment requires substantial funds which can only be arranged by making determined efforts to ensure their availability at the right time. Thus it facilitates cash forecast.

(5) Worth-Maximization of Shareholders. The impact of long-term capital investment decisions is far reaching. It protects the interests of the shareholders and of the enterprise because it avoids over-investment and under-investment in fixed assets. By selecting the most profitable projects, the management facilitates the wealth maximization of equity share-holders.

(6) Other Factors. The following other factors can also be considered for its

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significance:(a) It assist in formulating a sound depreciation and assets replacement policy. (b) It may be useful n considering methods of coast reduction. A reduction campaign may necessitate the consideration of purchasing most up-to-date and modern equipment.

(c) The feasibility of replacing manual work by machinery may be seen from the capital forecast be comparing the manual cost the capital cost.

(d) The capital cost of improving working conditions or safety can be obtained through capital expenditure forecasting.

(e) It facilitates the management in making of the long-term plans assists in the formulation of general policy.

(f) It studies the impact of capital investment on the revenue expenditure of the firm such as depreciation, insures and there fixed assets.

Among the various business decisions Capital Budgeting decisions are most critical and crucial decisions. Therefore, special care must be taken while taking these decisions. This can be mainly attributed to the following reasons:

Involvement of Heavy Funds

43

The capital budgeting decisions involve large capital outlays. In such cases the firm should carefully plan its investment programmes. It is necessary that the firm plans its investment carefully so that it may yield the finance at right time and it can be used profitably. Incorrect decisions can be harmful to the survival of the firm as huge funds get locked up for long periods.

Long term Implication The firm will feel the effect of capital budgeting decisions over a long period; they have a decision influence on the rate and direction of the growth of the firm. The short term decisions will have long run implications.

Irreversible Decision Once the decisions are made the company has to abide by the decisions. These decisions cannot be reversed without incurring substantial losses.

Most Difficult to Make These decisions require an assessment of future events which are uncertain. It is really a difficult task to estimate the probable future events, probable benefits and costs accurately in quantitative terms. The term capital budgeting includes both planning for proposed capital out lays as well as financing them.

44

Rationale of Capital Expenditure Capital budgeting decisions are based on the objective of efficient utilization of resources. The overall objective of capital expenditure is to maximize the firms profits and thus optimising the return on investment. This objective can be achieved either by increased revenue or by reduced cost. Therefore, capital expenditure decisions can be of two types.

a. Expenditure which increases revenue (more uncertain) b. Expenditure which reduces cost (less uncertain)

Factors of Capital Budgeting

Amount of Investment When a firm has unlimited funds for investment, it can accept all the capital investment proposals which give a rate of return higher than the minimum acceptable or cut-off rate. However most firms have limited funds and therefore capital rationing has to be imposed. In such a situation the firm can accept only those proposals which are within its means. For this purpose all 45

the projects are arranged in an ascending order according to the capital investment required and accept only those projects which are within its capital constraints. Capital investment required is also known as Net Cash Outflow. Net cash outflow is the sum of all outflows and inflows occurring at zero time periods.

Minimum Rate of Return on Investment The management expects a minimum rate of return on the capital investment. The minimum rate of return is usually decided on the basis of the cost of capital. The minimum rate of return may also be called as cut-off point. The cut-off point refers to the point below which a project would not be accepted. For example, if the desired rate of return is 15% then the cut-off rate is 15%.

Return Expected from the Investment Capital investment decisions are made in anticipation of increased return in the future. Therefore, it is necessary to estimate the future return or benefits accruing from the investment proposals. There are two criteria available for quantifying benefits from capital investment decisions. They are (i) Accounting Profits (ii) Cash flows. The term accounting profit is identical with income concept used in accounting. While estimating cash flows, depreciation charges and other amortization charge of fixed assets are not subtracted from the gross revenue because no cash expenditure or cash outflow is involved.

46

The cash flow approach of determination of benefits from a capital investment project is better as compared to accounting profit approach because of the following reasons: 1. Determination of Economic Value: A firm is more interested in determining the economic value which can be done more conveniently by comparing cash flows.

2. Accounting ambiguity:

Accounting profit approach is full of

ambiguities and account of different accounting policies and practices. Regarding the valuation of inventories, allocation of costs, calculation of depreciation etc. as compared with this there will be only one set of cash flows, associated with the project.

3. Time Value of Money: Under usual accounting practices revenue is considered to be realized not at the time when the cash is received but at the time the sale is made.

Risk of Investment Proposals

47

When a number of project appear to be acceptable on the basis of their profitability the projects will be ranked in order of their profitability is order to determine the most profitable project.

Risk and Uncertainty Different capital investment proposals have different degrees of risk and uncertainty. There is a slight difference between risk and uncertainty. Risk involves situations in which the probabilities of a particular event occurring are known whereas in uncertainty these probabilities are unknown. In many cases these two terms are used inter changeably. Risk in capital investments may be due to the general economic conditions, competition, technological developments, consumer preferences etc.

Capital Budgeting Process

The allocation of invest able funds to different long term assets is known as Capital Budgeting Decisions. Capital budgeting is a complex process which may be divided into five broad phases.

Project Generation:

The planning phase of a firms capital budgeting process is concerned with the circulation of its broad investment strategy and the general and 48

preliminary screening project proposals. The investment strategy of the firm delineates the broad areas or types of investments the firm plans to undertake. This provides the frame work which shapes, guides and circumscribes the identification of individual project opportunities.

Once a project proposal is identified, it needs to be examined. To begin with a preliminary project analysis is done. A prelude to the full blown feasibility study, this exercise is meant to assess.

I. Whether the project is worth while to justify a feasibility study? And II. What aspects of the project are critical to its viability?

Project Evaluation: If the preliminary screening suggests that the project is prima-facie worth while, a detailed analysis of the marketing technical, financial, economic and ecological aspects is undertaken. The questions and issued raised in such a detailed analysis are described in the following section. The focus of this phase of capital budgeting is on gathering, preparing and summarizing relevant preformation about various project proposals which are being considered for inclusion in the capital budget. Based on the information developed in this analysis, the stream of costs and benefits associated with the project can be defined.

Project Selection:

49

Selection follows an often overlaps, analysis. If addresses the questions. Is the project worth while? A wide range of appraisal criteria have been suggested to judge to worth while ness of a project. They are divided into two broad categories, viz. non-discounting criterion and discounting criterion. The principle in-discounting criteria are the pay back period and the accounting rate of return. The key discounting criteria are the net present value, the internal rate of return and the benefit cost ratio.

The selection rules associated with these criteria are as follows: Pay Criterion Accept Back Period PBP < Target period Reject PBP > Target period ARR < Target Rate NPV < 0 IRR < Cost of

(PBP) Accounting Rate of ARR > Target rate Return (ARR) Net Present Value NPV > 0 (NPV) Internal Rate of IRR > Cost of capital

Return (IRR) Benefit Cost Ratio BCR > 1 (BCR)

capital BCR < 1

To apply the various appraisal criteria suitable cut-off values (hurdle rate, target rate, and cost of capital) have to be specified. These are essentially a function for the fix of financing and the level of project risk while the former can be defined with relative case, the latter truly tests the liability of the project evaluation. In deed, despite a wide range of tools and techniques for the risk analysis (sensitivity analysis, scenario analysis, Monte Carlo simulation, decision tree analysis, portfolio theory, capital asset pricing model and so on), risk analysis remains the most intractable part of project evaluation exercise.

50

Project Implementation: The implementation phase for industrial projects which involves setting up of manufacturing facilities consists of several stages. Stage Project and engineering designs Concerned with probing and prospecting,

Site

preparation of blue prints and plant designs, plant engineering selection of Negotiations and contracting specification machines and equipment. Negotiating and drawing up of legal contracts with respect to project financing, acquisition of technology, construction of building and civil works, provision of utilities, supply of machinery and equipment, marketing Construction arrangements etc. Site preparation, installation Training of construction machinery of and

building and civil work, erection and equipment. Training of engineers, technicians and workers (this can along precede with the simultaneously Plant commissioning

construction work). Start up of the plant (this is a brief but commissioning cycle). 51 technically crucial stage in the project development

Translating an investment proposal into a concrete project is a complex, timeconsuming and risk-fraught task. Delays in implementation, which are common, can lead to substantial cost over runs. For expenditions implementation at a reasonable cost, the following are helpful.

Adequate formulation of projects. A major reason for the delay is an adequate formulation of projects. Put differentially, if necessary home work in terms of preliminary studies and comprehensive and detailed formulation of the project is not done, many surprises and shocks are likely to spring on the way. Hence, the need for adequate formulation of the project cannot be overemphasised.

Use

of

the

principle

of

responsibility

accounting

assigns

specific

responsibilities to project managers for completing the project within the defined time frame and cost limits. It is helpful in expeditions execulation and cost control.

Use of the techniques for project planning and control two basic techniques are available PERT (Programme Evaluation Review Techniques) and CPM (Critical Path Method). These techniques have, of lane, merged and are being referred to by a common terminology that is network techniques. With the help of these techniques, monitoring becomes easier.

52

Project Review:

Once the project is commissioned the review phase has to be set in motion. Performance review should be done periodically to compare actual performance with projected performance. A feedback device, it is useful in several ways.

I. It throws light on how realistic were the assumptions underlying the project.

II. It provides a documented long of experience that is highly valuable in future decision-making.

III. It suggests corrective action to be taken in the light of the actual performance.

IV. It helps in uncovering judgemental biases.

V. It induces a desired caution among project sponsors.

53

Capital budgeting versus current expenditures

A capital investment project can be distinguished from current expenditures by two features: a) Such projects are relatively large. b) A significant period of time (more than one year) elapses between the investment outlay and the receipt of the benefits.

As a result, most medium-sized and large organizations have developed special procedures and methods for dealing with these decisions. A systematic approach to capital budgeting implies: a) the formulation of long-term goals b) The creative search for and identification of new investment opportunities c) Classification of projects and recognition of economically and/or statistically dependent proposals d) The estimation and forecasting of current and future cash flows e) A suitable administrative framework capable of transferring the required information to the decision level f) The controlling of expenditures and careful monitoring of crucial aspects of project execution g) A set of decision rules, which can differentiate acceptable from unacceptable alternatives, is required. 54

The classification of investment projects

a) By project size Departmental managers may approve small projects. More careful analysis and Board of Directors' approval is needed for large projects of, say, half a million dollars or more. b) By type of benefit to the firm An increase in cash flow A decrease in risk An indirect benefit (showers for workers, etc).

c) By degree of dependence Mutually exclusive projects (can execute project A or B, but not both) Complementary projects: taking project A increases the cash flow of project B. Substitute projects: taking project A decreases the cash flow of project B. d) By degree of statistical dependence Positive dependence Negative dependence Statistical independence.

e) By type of cash flow

55

Conventional cash flow: only one change in the cash flow sign E.g. -/++++ or +/----, etc

Non-conventional cash flows: more than one change in the cash flow sign, E.g. +/-/+++ or -/+/-/++++, etc.

The economic evaluation of investment proposals

The analysis stipulates a decision rule for: I) Accepting or II) Rejecting Investment projects

56

PROBLEMS AND DIFFICULTIES IN CAPITAL BUDGETING:

The problems in capital budgeting decisions may be as follows: a. Future uncertainty: Capital budgeting decisions involve long-term commitments. However there is lot of uncertainty in the long-term. The uncertainty may be with reference to cost of the project, future expected returns, future competition, legal provisions, political situation etc. b. Time Element: The implications of a Capital budgeting decision are scattered over a long period. The cost and benefits of a decision may occur at different points of time. The cost of a project is incurred immediately. However, the investment is recovered over a number of years. The future benefits have to be adjusted to make them comparable with the cost. Longer the time period involved, greater would be the uncertainty. c. Difficulty in Quantification of impact. The finance manager may face difficulties in measuring the cost and benefits of projects in quantitative terms. For example, the new products proposed to be launched by a firm may result in increase or decrease in sales of other product proposed to be launched by a firm may result in increase or decrease in sales of other products already being sold by the same firm. It is very

57

difficult to ascertain the extent of impact as the sales of other products may also be influenced by factors other than the launch of the new products.

ASSUMPTIONS IN CAPITAL BUDGETING:

The capital budgeting decision process is a multi-faceted and analytical process. A number of assumptions are required to be made. These assumptions constitute a general set of conditions within which the financial aspects of different proposals are to be evaluated. Some of these assumptions are:

A. Certainty with respect to cost and benefits: It is very difficult to estimate the cost and benefits of a proposal beyond 2-3 years in future. However, for a capital budgeting decision, it is assumed that the estimates of cost and benefits are reasonably accurate and certain. B. Profit motive: Another assumption is that the capital budgeting decisions are taken with a primary motive of increasing the profit of the firm. No other motive or goal influences the decision of the finance manager. C. No Capital Rationing: The Capital budgeting decisions in the present chapter assume that there is no scarcity of capital. It assumes that a proposal will be accepted or rejected on the strength of its merits alone. The proposal will not be considered in combination with other proposals to consider the maximum utilization of available funds.

58

CHAPTER - 4 TECHNIQUES OF

CAPITAL BUDGE TIN G

59

Methods or Techniques of Capital Budgeting :

There are many methods for evaluating the profitability of investment proposals. The various commonly used methods are:

Traditional Methods: I. Payback Period (PBP) II. Accounting Rate of Return (ARR)

Time adjusted or discounting techniques: I. Net Present Value (NPV) II. Internal Rate of Return (IRR) III. Profitability Index (PI)

60

Payback - The payback period (PP): The CIMA defines payback as 'the time it takes the cash inflows from a capital investment project to equal the cash outflows, usually expressed in years'. When deciding between two or more competing projects, the usual decision is to accept the one with the shortest payback. Payback is often used as a "first screening method". By this, we mean that when a capital investment project is being considered, the first question to ask is: 'How long will it take to pay back its cost?' The company might have a target payback, and so it would reject a capital project unless its payback period was less than a certain number of years.

Decision rule: A project is accepted if its payback period is less than the period specific decision rule. A project is accepted if its payback period is less than the period specified by the management and vice-versa. Initial Cash Outflow Pay Back Period = ----------------------------Annual Cash Inflow Or Reqd. CFAT Pay Back Period = Base Yr. + -----------------------Next Yr. CFAT 61

Reqd. CFAT = Cash outflow Base Yr. Cumulative CFAT

Advantages: Simple to understand and easy to calculate. It saves in cost; it requires lesser time and labour as compared to other methods capital budgeting. In this method, as a project with a shorter pay back period is preferred to the one having a longer pay back period, it reduces the loss through obsolescence. Due to its short-term approach, this method is particularly suited to a firm which has shortage of cash or whose liquidity position is not good.

Disadvantages: It ignores the timing of cash flows within the payback period, the cash flows after the end of payback period and therefore the total project return. It ignores the time value of money. This means that it does not take into account the fact that $1 today is worth more than $1 in one year's time. An investor who has $1 today can either consume it immediately or alternatively can invest it at the prevailing interest rate, say 30%, to get a return of $1.30 in a year's time.

62

 It is unable to distinguish between projects with the same payback period. It may lead to excessive investment in short-term projects. The accounting rate of return - (ARR) : The ARR method (also called the return on capital employed (ROCE) or the return on investment (ROI) method) of appraising a capital project is to estimate the accounting rate of return that the project should yield. If it exceeds a target rate of return, the project will be undertaken.

Decision rule: The project with higher rate of return is selected and vice-versa. The return on investment method can be used in several ways, as Average Annual Profits (after dep. & tax) Average Rate of Return = ---------------------------------------------------------- X 100 Net Investment

Note: Net annual profit excludes depreciation.

Advantages It is very simple to understand and easy to calculate

63

 It uses the entire earnings of a project in calculating rate of return and hence gives a true view of profitability As this method is based upon accounting profit, it can be readily calculated from the financial data

Disadvantages

It does not take account of the timing of the profits from an investment. It implicitly assumes stable cash receipts over time. It is based on accounting profits and not cash flows. Accounting profits are subject to a number of different accounting treatments. It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment. It takes no account of the length of the project. It ignores the time value of money.

64

The payback and ARR methods in practice Despite the limitations of the payback method, it is the method most widely used in practice. There are a number of reasons for this: It is a particularly useful approach for ranking projects where a firm faces liquidity constraints and requires fast repayment of investments. It is appropriate in situations where risky investments are made in uncertain markets that are subject to fast design and product changes or where future cash flows are particularly difficult to predict. The method is often used in conjunction with NPV or IRR method and acts as a first screening device to identify projects which are worthy of further investigation. It is easily understood by all levels of management. It provides an important summary method: how quickly will the initial investment be recouped?

65

Net Present Value (NPV) The NPV method is a modern method of evaluating investment proposals. This method takes in to consideration the time value of money and attempts to calculate the return on investments by introducing time element. The net present values of all inflows and outflows of cash during the entire life of the project is determined separately for each year by discounting these flows with firms cost of capital or predetermined rate. It shows that you are making more money on the investment than you are spending on your cost of capital. If NPV is negative, then do not approve the project because you are paying more in interest on the borrowed money than you are making from the project. The steps in this method are 1. Determine an appropriate rate of interest known as cut off rate. 2. Compute the present value of cash outflows at the above-determined discount rate. 3. Compute the present value of cash inflows at the predetermined rate. 4. Calculate the NPV of the project by subtracting the present value of cash outflows. From present value of cash flows

Decision Rule

66

Accept the project if the NPV of the project is 0 or +ve that is present value of cash inflows should be equal to or greater than the present value of cash outflows.

Advantages: It recognizes the time value of money and is suitable to apply in a situation with uniform cash outflows and uneven cash inflows. It takes in to account the earnings over the entire life of the project and gives the true view of the profitability of the investment Takes in to consideration the objective of maximum profitability.

Disadvantages:

More difficult to understand and operate It may not give good results while comparing projects with unequal investment of funds. It is not easy to determine an appropriate discount rate.

67

Internal Rate of Return (IRR) The internal rate of return method is also
a modern technique of capital budgeting that takes in to account the time value of money. It is also known as time-adjusted rate of return or trial and error yield method. Under this method the cash flows of a project are discounted at a suitable rate by hit and trial method, which equates the net present value so calculated to the amount of the investment. The internal rate of return can be defined as that rate of discount at which the present value of cash inflows is equal to the present value of cash outflows.

Decision Rule: Accept the proposal having the higher rate of return and vice versa. If IRR>K, accept project, K= cost of capital. If IRR<K, reject project. Determination of IRR:

a) When annual cash flows are equal over the life of the asset. Initial Outlay Factor = ----------------------------- X 100 Annual Cash Inflow

68

b) When the annual cash flows are unequal over the life of the asset PV of cash inflows at lower rate - PV of cash outflows IRR = Lower rate + ------------------------------------------------------------------------(hr-lr) PV of cash inflows at lower rate PV of cash inflows at higher rate

The steps are involved here are: 1. Prepare the cash flow table using assumed discount rate to discount the net cash. Flows to the present value. 2. Find out the NPV, and if the NPV is positive, apply higher rate of discount 3. If the higher discount rate still gives a positive NPV, increase the discount rate further. Until the NPV becomes zero. 4. If the NPV is negative, at a higher rate, NPV lies between these two rates.

Advantages: It takes into account, the time value of money and can be applied in situations with even and even cash flows. It considers the profitability of the projects for its entire economic life. The determination of cost of capital is not a pre-requisite for the use of this method.

69

 It provides for uniform ranking of various proposals due to the percentage rate of return. This method is also compatible with the objective of maximum profitability.

Disadvantages: It is difficult to understand and operate. The results of NPV and IRR methods may differ when the projects under evaluation differ in their size, life and timings of cash flows. This method is based on the assumption that the earnings are reinvested at the IRR for the remaining life of the project, which is not a justified assumption.

70

Profitability Index or Benefit Cost Ratio:

It is also a time-adjusted method of evaluating the investment proposals. PI also called benefit cost ratio or desirability factor is the relationship between present value of cash inflows and the present values of cash outflows. Thus

PV of cash inflows Profitability Index = -----------------------------PV of cash outflows (Or) NPV Profitability Index = -----------------

Initial Outlay

Advantages:

Unlike net present value, the profitability index method is used to rank the projects even when the cost of the projects differs significantly. It recognizes the time value of money and is suitable to applied in a situation with uniform cash outflows and uneven cash inflows.

71

 It takes into an account the earnings over the entire life of the project and gives the true view of the profitability of the investment. Takes into consideration the objective of maximum profitability.

Disadvantages:

More difficult to understand and operate. It may not give good results while comparing projects with unequal investment funds It is not easy to determine and appropriate discount rate It may not give good results while comparing projects with unequal lives as the project having higher NPV but have a longer life span may not be as desirable as a project having some what lesser NPV achieved in a much shorter span of life of the asset.

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CHAPTER 5

DATA ANALYSIS AND PRESENTATION

73

CASE STUDY

74

The proposed project M/s. Paramount Rice Mill, Zahirabad, has taken as the case study, which need the term-loan from APSFC for further growth. In this regard, APSFC evaluate the capability of the company by using these methods IRR, DCR & BEP.

Total Investment
(Rs. in lakhs) LAND BUILDINGS PLANT & MACHINERY CONTINGENCIES @10% ERECTION DEPOSITS PRELIMINARY & PRE OPERATIVE EXP. MARGIN MONEY FOR WORKING CAPITAL TOTAL : 17.10 81.00 147.00 14.70 3.00 3.70 16.70 39.80 323.00

MEANS OF FINANCE (Rs. in lakhs) 113.00 50.00

PARTNERS' CAPITAL INVESTMENT SUBSIDY

75

TERM LOAN TOTAL :

160.00 323.00

Assumptions:
Life of the project is 8 years At the cost of Land & Buildings, Plant & Machinery Rate of interest is (K) = 12% Depreciation method is Written Down Value method Rate of Depreciation on Buildings is @ 10%, and on Plant & Machinery is @ 15% (as per Income Tax rules) Rate of Income Tax = 33.66% Capital = 323.00 lakhs

COST OF SCHEME: The cost of the scheme is calculated on the basis of what actually that company is owned. The below is the notes of cost of scheme calculation. LAND The promoter purchased the land admeasuring Ac.5-22 guntas covered by the following survey numbers at Zahirabad Village, R R District. Document Number 2794/2008 3215/2008 3216/2008 Survey Nos. 1487 1480 1487 76 Extent Ac.5-00 *Ac. 0-05 *Ac. 0-07 Value (Rs. in lakhs) 15.00 0.05 0.53

3217/2008

1481 Total

*Ac. 0-10 Ac.5-22 guntas

0.08 15.66

* Purchased for approach road. The total cost of the land including registration charges is estimated at Rs.17.10 lakhs. The promoter proposes to offer value of the land towards part of the collateral security. Hence, no loan is considered. BUILDINGS: On the aforesaid land, the promoter proposes to construct main factory rice milling section with AC sheet roofing of 1586 sqm; husk room with AC sheet roofing of 33 sqm; husk bin of 24 sqm; Boiler shed of GI sheet roofing of 60 sqm; drying platform of 1167 sqm. The total cost of civil works including machinery foundations, electrification & yard lighting, sanitation and water supply, OH tank, land development & internal roads, compound wall, fencing & gate, architect fee & supervision charge is estimated at Rs.81.00 lakhs.

PLANT & MACHINERY: The promoter proposes to acquire the following machinery: 42 tons capacity paddy parboiling plant comprising of parboiling tank, paddy drier plant, elevators, heat exchanger, blower, motors, dust collection system, ducting, steam lines, insulation, etc. from M/s. HSF Food Protech Pvt Ltd, Sirsa, Haryana. 3000 kg/hr capacity husk fired Boiler with Chimney and other accessories from M/s. Thermax India Ltd, Pune. Fowler Westrup Pre-cleaner for pre-aspiration, final aspiration, waste outlet from M/s.Fowler Westrup (India) Private Limited, Bangalore

77

Vibro destoner, Multi-sifter, Paddy separator, Rice destoner, Length grader from M/s.Ricetec Machinery Private Limited, Hyderabad, Thickness grader from M/s.Sona Foods India, New Delhi.

Water Jet polishing machine, bran discharger, pneumatic sheller, cyclone etc, from M/s.Miltec Machinery Private Limited, Bangalore.

LG Air Compressor, Weighing Scales, Bore well pumps, Electrification etc., from standard suppliers.

Husk fired steam boiler of 3000 kg/hr capacity is proposed from M/s. Thermax India Ltd, Pune, who is reputed supplier in this line.

The total cost of the machinery is estimated at Rs.147.00 lakhs.

A provision of Rs.3.00 lakhs is made towards erection expenses. An amount of Rs.14.70 lakhs is provided towards contingencies.

The unit is proposing to purchase the machinery from reputed manufacturers and suppliers, who have supplied similar machinery to many units in Andhra Pradesh and other states. The prices of the machinery proposed have been reckoned at 90% of the quoted prices for finalising the list of proposed machinery.

A condition is stipulated that funds on fabricated machinery items like Mechanical Dust Collector, ducting, together with funds on elevators, separator shall be released as per valuation .

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DEPOSITS: Particulars Consumption Deposit to APNPDCL Telephone VAT/CST Miscellaneous PRELIMINARY & PREOPERATIVE EXPENSES: The following are the details of preliminary and pre-operative expenses to be incurred: Eligible for Loan: Interest during construction period Legal expenses Wages during construction period Insurance during construction period Trial run expenses Not Eligible for Loan: Service charges & Upfront fee to APSFC Service line charges to APNPDCL Travelling expenses Conveyance expenses. Office establishment. Miscellaneous expenses. Total (Rs. in lakhs) Amount Amount 7.50 0.50 0.30 0.20 0.20 8.70 1.60 3.50 1.50 0.50 0.40 0.50 (Rs. in lakhs) Amount 3.50 0.05 0.10 0.05 Total 3.70

8.00 16.70

ESTIMATION OF COST OF THE PRODUCT FOR THE 1ST YEAR

No. of working days = 250 days Working on per day = 3 (shift basis)

1. Installed Capacity:
Rice Mill Capacity = 3 tons/hour x 24 hours x 250 days No. of Batches = 2 Batches per day Paramount Rice Mill Capacity 42 tons per batch 42 tons x 2 batches x 250 days 79 = 21000 TPA = 18000 TPA

But, installed capacity is assumed at 18000 TPA only. Production Mix: Levy Production = 75% on 18000 TPA i.e. 13500 Own Production = 25% on 18000 TPA i.e. 4500

2. Operating Capacity:
Assumed @ 50% in the first year (TPA) = 9000 Levy Production 75% i.e. 6750 Own Production 25% i.e. 2250

3. Raw Materials:
Paddy for levy production = 6750 tons Paddy for own production = 2250 tons Rate per Ton (for levy) = Rs. 9300/Rate per Ton (for own) = Rs. 13000/ Total Cost = 6750 x 9300 2250 x 13000 TOTAL = 6,27,75,000.00 = 2,92,50,000.00 = 9, 20,25,000.00 i.e. in lakhs = 920.25

4. Yields
ITEM RICE BROKEN BRAN HUSK WASTAGE YIELD % 68% 2% 8% 20% 2% PRODUCTION QUANTITY LEVY OWN TOTAL 4590 1530 6120 135 45 180 540 180 720 1350 450 1800 135 45 180 80

5. Revenue from Sales:

75% of the rice production is to be supplied on levy basis and the balance 25% rice production is to be sold in open market. ITEM QTY/TONS PRICE/TON TOTAL LEVY RICE 4590 16000 73440000 OPEN MARKET PRICE 1530 20000 30600000 BROKEN 720 6500 4680000 BRAN 540 12000 6480000 TOTAL: 115200000 (in lakhs) 1152.00

6. Packing Materials & Stores:

a) Rice is packed in 50 kg. Capacity Bags No. of Bags required = 6120 x 1000 / 50 = 122400 bags. Cost of each bag = Rs. 22/-. Total Cost = 122400 x 22 b) Rubber rolls consumption is assumed @ Rs. 20 per ton of Paddy milled c) Other store materials like lubricants, spares, etc., = 1,80,000.00 = 26,92,800.00

= 1,00,000.00 ------------------= 29,72,800.00 ------------------(in lakhs) 29.75

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7. Power:
Proposed connected load = 275 Lighting and others a) Energy Charges: 300 x 0.746 x 24 x 250 x 0.5 (o.c) x 0.80(LF) x 3.30 /unit b) Maximum Demand charges: 300 x 0.8776 x Rs.195/KVA x 12 = 4,92,860.00 -----------------22,65,356.00 ------------------(in lakhs) 22.65 = 17,72,496.00 = 25 300

8. Fuel:
HSD fuel consumption = 22.5 ltrs/hour. Price of HSD = Rs.39.50 / ltr. HSD consumed = 22.5 ltrs x 250 days 50% Operating Capacity = 2812.50 ltrs., Cost of HSD Consumed = 1,11,094.00 (in lakhs) 1.10

Total cost of Power & Fuel (Rs. in lakhs)

= 23.75

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PROJECTIONS OF M/S PARAMOUNT RICE MILL, ZAHIRABAD

ESTIMATE OF COST OF PRODUCTION & PROFITABILITY
YEARS-----> 1st 18000.00 9000.00 50.00 0.00 920.25 29.75 23.75 21.95 3.60 3.20 3.60 1006.10 2nd 18000.00 10800.00 60.00 0.00 1104.30 35.70 28.51 28.97 3.96 3.52 4.32 1209.28 3rd 18000.00 12600.00 70.00 0.00 1288.35 41.65 33.26 37.18 4.36 3.87 5.04 1413.71 Rs. in lakhs 4th 5th 18000.00 12600.00 70.00 0.00 1288.35 41.65 33.26 40.90 4.79 4.26 5.04 1418.25 18000.00 12600.00 70.00 0.00 1288.35 41.65 33.26 44.99 5.27 4.69 5.04 1423.25 6th 18000.00 12600.00 70.00 0.00 1288.35 41.65 33.26 49.49 5.80 5.15 5.04 1428.74 7th 18000.00 12600.00 70.00 0.00 1288.35 41.65 33.26 54.44 6.38 5.67 5.04 1434.79 8th 18000.00 12600.00 70.00 0.00 1288.35 41.65 33.26 59.88 7.02 6.24 5.04 1441.44

A B C D

INSTALLED CAPACITY (TPA) PRODUCTION (TPA) CAPCITY UTILISATION (%) MANUFACTURING EXPENSES RAW MATERIALS(IMPORTED) RAW MATERIALS(INDIGENOUS) CONSUMABLES POWER & FUEL WAGES REPAIRS & MAINTENANCE RENT, TAXES & INSURANCE OTHER INPUTS/FACTORY EXP SUB TOTAL "D" ADMINISTRATIVE EXPENSES MANAGEMENT REMUNERATION SALARIES OTHER ADMINISTRATIVE EXP. SUB TOTAL "E"

3.60 4.80 3.60 12.00 36.00 0.00 1054.10 1152.00 97.90 23.60 13.78 0.00 0.00 37.38 35.03 25.49 8.58 16.91 62.87

3.96 5.28 3.96 13.20 43.20 0.00 1265.68 1382.40 116.72 23.60 16.53 0.00 0.00 40.13 30.21 46.38 15.61 30.77 86.51

4.36 5.81 4.36 14.53 50.40 0.00 1478.64 1612.80 134.16 21.78 19.29 0.00 0.00 41.07 26.07 67.02 22.56 44.46 108.09

4.79 6.39 4.79 15.97 50.40 0.00 1484.62 1612.80 128.18 17.25 19.29 0.00 0.00 36.54 22.51 69.13 23.27 45.86 105.67

5.27 7.03 5.27 17.57 50.40 0.00 1491.22 1612.80 121.58 13.62 19.29 0.00 0.00 32.91 19.45 69.22 23.30 45.92 102.13

5.80 7.74 5.80 19.34 50.40 0.00 1498.48 1612.80 114.32 9.98 19.29 0.00 0.00 29.27 16.81 68.24 22.97 45.27 97.51

6.38 8.51 6.38 21.27 50.40 0.00 1506.46 1612.80 106.34 6.35 19.29 0.00 0.00 25.64 14.55 66.15 22.27 43.88 91.79

7.02 9.36 7.02 23.40 50.40 0.00 1515.24 1612.80 97.56 2.72 19.29 0.00 0.00 22.01 12.60 62.95 21.20 41.75 84.96

F G H I J K

SELLING EXPENSES CENVAT & VAT PAYABLE TOTAL COST OF PRODUCTION SALES GROSS PROFIT BEFORE INT AND DEPRECIATION (I-H) FINANCIAL EXPENSES: INTEREST ON TERM LOANS INT. ON BORROWINGS FOR W.C. INT. ON OTHER BORROWINGS INT. ON FUNDED INTEREST SUB TOTAL "K"

L M N O P

DEPRECIATION OPERATING PROFIT(J-K-L) PROVISION FOR TAXATION (@33.66% ON OPERATING PROFIT) PROFIT AFTER TAX (M-N) NET PROFIT BEFORE TAXES INT. ADDED BACK BUT AFTER DEPRECIATION OR EBIT(J-L)

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Cash flow statement can be prepared in order to know that future cash position of a concern so as to enable a firm to plan and coordinate its financial operations properly. It is useful in the evaluation of cash position of a firm. These values are useful in calculating the IRR method.

CASH FLOW STATEMENT

(Rs. in Lakhs)
PARTICULARS GROSS PROFIT BEFORE INTEREST & DEPRECIATION Less : DEPRECIATION PROFIT BEFORE TAX (PBT) : Less : PROVISION FOR TAXATION PROFIT AFTER TAX (PAT) Add : DEPRECIATION CASH FLOW AFTER TAX (CFAT) : 1st Yr. 97.89 35.03 62.86 8.58 54.28 35.03 89.31 2nd Yr. 116.72 30.21 86.51 15.61 70.90 30.21 101.11 3rd Yr. 134.17 26.07 108.10 22.56 85.54 26.07 111.61 4th Yr. 128.18 22.51 105.67 23.27 82.40 22.51 104.91 5th Yr. 121.58 19.45 102.13 23.30 78.83 19.45 98.28 6th Yr. 114.33 16.81 97.52 22.97 74.55 16.81 91.36 7th Yr. 106.35 14.55 91.80 22.27 69.53 14.55 84.08 8th Yr. 97.58 12.60 84.98 21.20 63.78 12.60 76.38

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Computation of Internal Rate of Return:

The internal rate

of return can be defined as that rate of discount at which the present value of cash inflows is equal to the present value of cash outflows. It takes into account, the time value of money and can be applied in situations with even and even cash flows. It considers the profitability of the projects for its entire economic life. It provides for uniform ranking of various proposals due to the percentage rate of return.

YEARS 1 2 3 4 5 6 7 8

CASH FLOWS AFTER TAX (CFAT) 89.31 101.11 111.61 104.91 98.28 91.36 84.08 76.38 757.04

Initial Investment Fake Pay Back Period (FPBP) = -------------------------------------Average Cash Flow After Tax

Total of Cash Flow After Tax Avg. After Cash Flow After Tax = ---------------------------------------Total No. of years 757.04 Avg. After Cash Flow After Tax = ----------- = 94.63 8 yrs. 323.00 85

FPBP = ----------- = 3.41 94.63 The above 3.41rate indicates between 24% and 25% in Net Present worth table. So, let us calculate the CFATs at 24% and 25% Present Values.

YEARS 1 2 3 4 5 6 7 8

CASH FLOWS AFTER TAX (CFAT) 89.31 101.11 111.61 104.91 98.28 91.36 84.08 76.38 757.04

PV @ 25% 0.800 0.640 0.512 0.410 0.328 0.262 0.210 0.168

CFAT @25% PV 71.448 64.710 57.144 42.971 32.206 23.945 17.632 12.817 322.874

At the rate of 25% the CFAT is about 322.874, which is less than initial investment.
YEARS 1 2 3 4 5 6 7 8 CASH FLOWS AFTER TAX (CFAT) 89.31 101.11 111.61 104.91 98.28 91.36 84.08 76.38 757.04 PV @ 24% 0.806 0.650 0.525 0.423 0.341 0.275 0.222 0.179 CFAT @ 24% PV 71.984 65.722 58.539 44.366 33.523 25.133 18.649 13.664 331.581

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The lower rate is 24% the CFAT is about 331.581, which is higher than initial investment. Now, let us calculate the IRR value: PV of lower rate is 24% the value is 331.581 PV of higher rate is 25% the value is 322.874 Initial Investment is 323.00 PV of cash inflows at lower rate - PV of cash outflows IRR = Lower rate + ------------------------------------------------------------------------(hr-lr) PV of cash inflows at lower rate PV of cash inflows at higher rate

331.581 323.000 IRR = 24 + ------------------------- - x ( 25-24) 331.581 322.874 IRR = 24 + 0.986 = 24.986

Interpretation: The IRR is 24.986. It is greater than cost of capital i.e. 12%. So, it is accepted.

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Debt Service Coverage Ratio: The D.S.C.R statement is calculated to know in how many years the invested money will be recouped with the interest.

A B C D E

PARTICULARS COVER NET PROFIT AFTER TAX DEPRECIATION INT. ON LONG TERM LOANS INT. ON SOFT LOANS INT. ON FUNDED INT TOTAL COVER SERVICE REPAYMENT OF L.T.

1st Yr.

2nd Yr.

3rd Yr.

Rs. in lakhs 4th Yr. 5th Yr.

6th Yr.

7th Yr.

8th Yr.

TOTAL 314.88 177.23 118.90 0.00 0.00 611.01

16.91 35.03 23.60 0.00 0.00 75.54

30.77 30.21 23.60 0.00 0.00 84.58

44.47 26.07 21.78 0.00 0.00 92.32

45.86 22.51 17.25 0.00 0.00 85.62

45.93 19.45 13.62 0.00 0.00 79.00

45.27 16.81 9.98 0.00 0.00 72.06

43.89 14.55 6.35 0.00 0.00 64.79

41.78 12.60 2.72 0.00 0.00 57.10

A B C D E

LOANS 0.00 REPAYMENT OF SOFT LOANS INT. ON L.T. LOANS 23.60 INT. ON SOFT LOANS 0.00 INT. ON FUNDED INT 0.00 TOTAL SERVICE 23.60 D.S.C.R. RATIO 3.20

12.31 23.60 0.00 0.00 35.91 2.36

24.62 21.78 0.00 0.00 46.40 1.99

24.62 17.25 0.00 0.00 41.87 2.04

24.62 0.00 13.62 0.00 0.00 38.24 2.07

24.62 0.00 9.98 0.00 0.00 34.60 2.08

24.62 0.00 6.35 0.00 0.00 30.97 2.09

24.62 0.00 2.72 0.00 0.00 27.34 2.09

160.03 0.00 118.90 0.00 0.00 278.93 2.19

D. S. C. R. IS EQUAL TO 1 : 2.19

BREAK EVEN POINT : The unit is expected to breakeven at 35.91% and

cash break even at 22.65% at its installed capacity. The break even

calculations are based on the Unit's working results in the 3 rd year of operation which is the optimum level of operation.
VARIABLE COSTS :

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RAW MATERIALS POWER & FUEL WAGES CONSUMABLES SELLING EXPENSES INT. ON BANK BORROWINGS EXCISE DUTY OTHER FACTORY EXPENSES TOTAL VARIABLE COSTS SEMI VARIABLE & FIXED COSTS MANAGERIAL REM. & SALARIES REPAIRS & MAINTENANCE INT. ON TERM & U/S LOANS DEPRECIATION RENT, TAXES ETC. OTHER ADMN EXP. TOTAL FIXED COSTS CONTRIBUTION = (SALES LESS VARIABLE COSTS) BREAK EVEN POINT (%) = CASH BREAK EVEN POINT (%) =

1288.35 33.26 37.18 41.65 50.40 19.29 0.00 5.04 1475.17

10.17 4.36 21.78 26.07 3.87 4.36 70.61 137.64 35.91 22.65

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CHAPTER 6

FINDINGS AND SUGGESTIONS

SUGGESTIONS:
An accept-reject criterion has been applied for all the Capital Budgeting methods. The result in this case study suggests that the project can be accepted.

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 The corporation may consider using of other Capital Budgeting techniques like Pay Back Period, Average Rate of Return, Net Present Value and Profitability Index in the appraisal of the product, which will enhance the quality of the appraisal.

We deduct BEP from assumed Capacity of utilization i.e. 70% -35.91% the Margin of Safety 34.09%. If we further deduct 5% more expenses, it is till show the project in benefit side.

FINDINGS:
1. The Internal Rate of Return is also more than the cost of capital i.e. 24.986% where as the cost of capital of the project is just 12%. So, it is accepted. 2. The D S C R statement shows the ratio is 2.19 which are for 8 yrs whereas the actual company lies between 1:55 to 2 times for 8 years. Fixes up the project for 7 yrs. the D.S.C.R. is 2.09.
3. The unit is expected to breakeven at 35.91% and cash break even at 22.65% at its installed capacity. The break even calculations are

based on the Unit's working results in the 3 rd year of operation which is the optimum level of operation.

4. If we further increase in Raw material cost or decrease in Revenue, the change will be like this:
FINANCIAL INDICATORS DSCR BREAK EVEN (%) NORMAL 2.19 35.91 2% Increase in Raw material cost 1.72 44.24 2% Decrease in Revenue 1.61 46.8

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CASH B.E. (%) IRR (%)

22.65 24.986

27.91 18.276

29.52 16.706

OBSERVATIONS: In overall observations we can say that the project of M/s. Paramount Rice Mill, Zahirabad, can be accepted, as it is satisfying all the required rates and showing the profits in assumed 8 years of period. For the APSFC to lending their term loan, is not a risk factor to M/s Paramount Rice Mill, Zahirabad, as it is clearly showing in all assumptions that it is capable company which can recover the all the term loans within a period with interest. The Andhra Pradesh State Financial Corporation, can lend the working capital to M/s. Paramount Rice Mill, for their further growth as it is showing that the Margin Money for Working Capital is Rs. 39.80 lakhs only in proposed scheme, by increasing their working capital the companys cost of the scheme will also increase.

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CHAPTER 7

BIBLIOGRAPHY

BIBLIOGRAPHY

FINANCIAL MANAGEMENT TEXT AND PROBLEMS KHAN & JAIN

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 FINANCIAL MANAGEMENT I M PANDEY

FINANCIAL MANAGEMENT PRINCIPLES & PRACTICES S N MAHESHWARI

INTERNET www.google.com (related topics searched & taken) www.apsfc.gov.in

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