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INTRODUCTION
INTRODUCTION
Meaning:
Capital Budgeting decisions pertaining to fixed /long term assets which by definition
refer to assets which are in operation, and yield a return, over a period of time, usually
exceeding one year. They, therefore involve a series of outlays of cash resources in return for
anticipated flow of future benefits.
Importance:
Capital budgeting also has a bearing on the competitive position of the enterprise
mainly because of the fact that they relate to fixed asset. The fixed asset represents a true
earning asset of the firm. They enable the firm to generate finished goods that can be
ultimately being sold for profits.
The Capital Expenditure decision has its effects over a long time span and inevitable
affects the companys future cost structure.
The Capital investment decision once made are not easily reversible without much
financial loss to the firm because there may be no market for second-of hand plant and
equipment and their conversion to other uses may most financially viable.
Capital investment involves cost and the majority of the firms have search capital
resources.
Capital Budgeting means planning for capital assets. Capital Budgeting decisions are
vital to an organization as to include the decision as to:
Whether or not funds should be invested in long term projects such as settings of
an industry, purchase of plant and machinery etc.,
METHODOLOGY:
At each point of time a business firm has a number of proposals regarding various projects
in which, it can invest funds. But the funds available with the firm are always limited and
are not possible to invest trend in the entire proposal at a time. Hence it is very essential to
select from amongst the various competing proposals, those that gives the highest benefits.
The crux of capital budgeting is the allocation of available resources to various proposals.
There are many considerations, economic as well as non-economic, which influence the
capital budgeting decision in the profitability of the prospective investment.
Yet the right involved in the proposals cannot be ignored, profitability and risk are directly
related, i.e. higher profitability the greater the risk and vice versa there are several methods
for evaluating and ranking the capital investment proposals.
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LITERATURE REVIEW
Factors Affecting Capital Budgeting:
While making capital budgeting investment decision the following factors or aspects
should be considered.
Urgency:
Sometimes an investment is to be made due to urgency for the survival of the firm or
to avoid heavy losses. In such circumstances, the proper evaluation of the proposal cannot be
made through profitability tests. The examples of such urgency are breakdown of some plant
and machinery, fire accident etc.
Degree of Certainty:
Profitability directly related to risk, higher the profits, Greater is the risk or
uncertainty. Sometimes, a project with some lower profitability may be selected due to
constant flow of income.
Intangible Factors:
some times a capital expenditure has to be made due to certain emotional and
intangible factors such as safety and welfare of workers, prestigious project, social welfare,
goodwill of the firm, etc.,
Legal Factors.
Any investment, which is required by the provisions of the law, is solely influenced
by this factor and although the project may not be profitable yet the investment has to be
made.
Availability of Funds.
As the capital expenditure generally requires large funds, the availability of funds is
an important factor that influences the capital budgeting decisions. A project, how so ever
profitable, may not be taken for want of funds and a project with a lesser profitability may
be some times preferred due to lesser pay-back periodfor want of liquidity.
Future Earnings
A project may not be profitable as compared to another today but it may promise
better future earnings. In such cases it may be preferred to increase earnings.
Obsolescence.
There are certain projects, which have greater risk of obsolescence than others. In
case of projects with high rate of obsolescence, the
may be preferred other than one this may have higher profitability but still longer pay-back
period.
Cost Consideration.
Cost of the capital project, cost of production, opportunity cost of capital, etc. Are
other considerations involved in the capital budgeting decisions?
Certainty Equivalent
Method
Suggestions
Co-Efficient of
Accounting risk
Variation Method
In Capital Budgeting
Sensitivity Technique
Standard Deviation
Method
Profitability Technique
Sensitivity Technique:
Where cash inflows are very sensitive under different circumstances, more than one forecast
of the future cash inflows may be made. These inflows may be regards as Optimistic,
Most Likely, and Pessimistic. Further cash inflows may be discounted to find out the
Net present values under these three different situations. If the net present values under the
three situations differ widely it implies that there is a great risk in the project and the
investors decision to accept or reject a project will depend upon his risk bearing abilities.
Probability Technique:
A probability is the relative frequency with which an event may occur in the future.
When future estimates of cash inflows have different probabilities the expected monetary
values may be computed by multiplying cash inflow with the probability assigned. The
monetary values of the inflows may further be discounted to find out the present vales. The
project that gives higher net present vale may be accepted.
Exhibiting the decision tree indicating the decision points, chance events, and other
relevant date;
All the techniques of capital budgeting presume the various investment proposals
under consideration are mutually exclusive which may not practically be true in
some particular circumstances.
1. The techniques of capital budgeting require estimation of future cash inflows and
outflows. The future is always uncertain and the data collected for future may not be
exact. Obviously the results based upon wrong data may not be good.
2. There are certain factors like morale of the employees, goodwill of the firm, etc.,
which cannot be correctly quantified but which otherwise substantially influence the
capital decision.
3. Urgency is another limitation in the evaluation of capital investment decisions.
4. Uncertainty and risk pose the biggest limitation to the techniques of capital
budgeting.
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ensure that these are accordance with the corporate strategies or selection criterion of the
firm and also do not lead to departmental imbalances.
Evaluation of Various Proposals:
The next step in the capital budgeting process is to evaluate the profitability of
proposals. There are many methods that may be used for this purpose such as Pay Back
Period methods, Rate of Return method, Net Present Value method, Internal Rate of Return
method etc. All these methods of evaluating profitability of capital investment proposals
have been discussed.
Fixing Priorities:
After evaluating various proposals, the unprofitable or uneconomic proposals may be
rejected straight away. But it may not be possible for the firm to invest immediately in all the
acceptable proposals due to limitation of funds. Hence it is very essential to rank the various
proposals and to establish priorities after considering urgency, risk and profitability involved
therein.
Implementing Proposal:
Preparation of capital budgeting expenditure budgeting and incorporationof a
particular proposal in the budget does not itself authorized to go ahead with the
implementation of the project. A request for the authority to spend the amount should further
to be made to the capital expenditure committee, which may like to revive the profitability
of the project in the changed circumstances.
Further, while implementing the project, it is better to assign the responsibility for
completing the project within given time frame and cost limit so as to avoid unnecessary
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delays and cost over runs. Network techniques used in the project management such as Pert
and CPM can also be applied to control and monitor the implementation of the project.
Performance Review.
The last stage in the process of capital budgeting is the evaluation of the performance
of the project. The evaluation is made through post completion audit by way of
comparison of actual expenditure on the project with the budgeted one, and also by
comparing the actual return from the investment with the anticipated return. The
unfavorable variances, if any should be looked into and the causes of the same be
identified so that corrective action may be taken in future.
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Further, in view of the investment proposal under consideration, capital budgeting decisions
may be classified as:
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ii)
ii)
iii)
iv)
Profitability Index.
CAPITAL BUDGETING METHODS
TRADITIONAL
METHOD
METHOD
OF RETURN
INTERNAL RATE
OF RETURN
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PROFITABILITY INDEX
TRADITIONAL METHODS
Average Rate of Return:
The average rate of return (ARR) method of evaluating proposed capital expenditure
is also know as the accounting rate of return method. It is based upon accounting
information rather than cash flows. There is no unanimity recording the definition of the
rate of return.
ARR =
____
X 100
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amount of working capital should be taking determining relevant investment for the purpose
of calculating ARR. Thus,
Average investment = Net Working Capital + Salvage Value + (initial cost of machine
value)
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PB = ---------------- 5 years.
The second method is used when project cash flows are not uniform (mixed stream)
but vary form year to year. In such a situation, PB is calculated by the process of cumulating
cash flows till the time when cumulative cash flow become equal to the original investment
outlay.
1) First of all determined an appropriate rate of interest that should be selected as minimum
required rate of return called cut off rate of interest in the market and the market- on
long term loans or it should reflect the opportunity cost of capital of the investor.
2) Compute the present value of total investment outlay, I,e., cash outflows at the determined
discount rate. If the total investment is to be made in the initial year, the present value shall
be as the cost of investment.
3) Compute the present value of total investment proceeds I,e., inflows (profit before
depreciation and after tax) at the above determined discount rate.
4) Calculate the Net present value of each project by subtracting the present value of cash
inflows from the value of cash outflows for each project.
5)If the Net present value is positive or zero, I.e., when present value of cash inflows either
exceeds or is equal to the present values of cash outflows, the proposal may be accepted. But
in case the present value of inflows is less than the present value of cash outflows, the
proposal should be rejected.
6) To select between mutually exclusive projects, projects should be ranked in order of net
present values, i.e., the first preferences to be given to the project having the maximum net
present value.
The present value of re.1 due in any number of years may be found with the use of
the following the mathematical formula:
PV= 1/(1+r) n
Where,
PV = present value
R
N = number of years
Like the present value method the IRR method also considers the time value of money by
case of the net present value method, the discount rate is the required rate of return and
being a predetermined rate, usually the cost of capital, its determinants are external to the
proposal under consideration. The IRR, on the other hand it is based on facts, which are
internal to the proposals. In other words while arriving at the required rate of return for
finding out present values the cash inflows as well as outflows are not considered. But the
IRR depends entirely on the initial outlay and the cash proceeds of the projects, which is
been evaluated of acceptance or rejection. It is therefore appropriately referred to as internal
rate of return.
The internal rate of return is usually the rate of return that a project earns. It is defined as the
discount rate ( r ) which equates the aggregate present value of the Net cash inflows
( CFAT ) with the aggregate present value of cash outflows of a project. In other words it is
that rate which gives the project of Net present value is zero.
The firm would be indifferent if both the values are equal. A variation of the terminal
value method (TV) is the net terminal value (NTV). Symbolically it can be represented as
NTV = (PVTS PVO). If the NTV is the positive accept the project, if the negative reject
the project.
Profitability Index:
The time adjusted capital budgeting is Profitability Index (P1) or Benefit Cost Ratio
(B / C). It is similar to the approach of NPV. The profitability index approach measures the
present value of returns per rupee invested, while the NPV is based on the differences
between the present value of future cash inflows and the present value of cash outflows. A
major shortcoming of the NPV method is that, being an absolute measure; it is not reliable
method to evaluate project inquiring different initial investments. The PI method proves a
solution to this kind of problem. It is, in other words, a relative measure. It may be defined
as the ratio, which is obtained by dividing the present value of future cash inflows by the
present value of cash inflows.
PI
This method is also known as B / C ratio because the numerator measures benefits
and the denominator costs.
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Data collection:
Primary data: - The primary data is the data which is collected, by interviewing directly
with the organizations concerned executives. This is the direct information gathered from the
organization.
Secondary data: - The secondary data is the data which is gathered from
publications and websites.
CAPITAL BUDGETING:
A capital expenditure is an outlay of cash for a project that is expected to
produce a cash inflow over a period of time exceeding one year. Examples of projects
include investments in property, plant, and equipment, research and development projects,
large advertising campaigns, or any other project that requires a capital expenditure and
generates a future cash flow.
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KINDS OF CB DECISIONS:
Capital Budgeting refers to the total process of generating, evaluating, selecting and
following up on capital expenditure alternatives basically; the firm may be confronted with
three types of capital budgeting decisions
Accept reject decisions
This is a fundamental decision in capital budgeting. If the project is accepted, the firm
invests in it; if the proposal is rejected, the firm does not invest in it. In general, all those
proposals, which yield rate of return greater than a certain required rate of return or cost
of capital, are accreted and rest are rejected. By applying this criterion, all independent
projects all accepted. Independent projects are the projects which do not compete with
one another in such a way that the acceptance of one project under the possibility of
acceptance of another. Under the accept-reject decision, the entire independent project
that satisfies the minimum investment criterion should be implemented.
(i)
(ii)
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period. Selecting or rejecting the projects for this purpose will require the
taking of the following steps:
1) Ranking of projects according to profitability index (PI) or Initial rate of
return (IRR).
2) Selecting of rejects depends upon the profitability subject to the budget
limitations keeping in view the objectives of maximizing the value of
firms.
The future benefits will occur to the firm over a series of year.
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Importance of Investment Decisions:Investment decisions require special attention because of the following reasons.
Growth
The effects of investment decisions extend in to the future and have to be
endured for a long period than the consequences of the current operating expenditure. A
firms decision to invest in long-term assets has a decisive influence on the rate and direction
of its growth. A wrong decision can prove disastrous for the continued survival of the firm;
unwanted or unprofitable expansion of assets will result in heavy operating costs of the firm.
On the other hand, inadequate investment in assets would make it difficult for the firm to
complete successfully and maintain its market share.
Risk
A long-term commitment of funds may also change the risk complexity of the firm. If the
adoption of an investment increases average gain but causes frequent fluctuations in its
earnings, the firm will become more risky. Thus, investment decisions shape the basic
character of a firm.
Funding
Investment decisions generally involve large amount of funds, which make it
imperative for the firm to plan its investment programmers very carefully and make an
advance arrangements for procuring finances internally or externally.
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Irreversibility
Most investment decisions are irreversible. It is difficult to find a market for
such capital items once they have been acquired. The firm will incur heavy losses if such
assets are scrapped.
Complexity
Investment decisions are among the firms most difficult decisions. They are
an assessment of future events, which are difficult to predict. It is really a complex problem
to Economic, political, social and technological forces cause the uncertainty in cash flow
estimation.
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Independent investments
Contingent investments
Independent Investments
Independent investments serve different purposes and do not compete
with each other. For example, a heavy engineering company may be considering
expansion of its plant capacity to manufacture additional excavators and addition of new
production facilities to manufacture a new product - light commercial vehicles.
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Depending on their profitability and availability of funds, the company can undertake
both investments.
Contingent Investments
Contingent investments are dependent projects; the choice of one investment
necessitates undertaking one or more other investments. For example, if a company
decides to build a factory in a remote, backward area, if may have to invest in houses,
roads, hospitals, schools etc. for employees to attract the work force. Thus, building of
factory also requires investments in facilities for employees. The total expenditure will
be treated as one single investment.
It should consider all cash flows to determine the true profitability of the
project.
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It should recognize the fact that bigger cash flows are preferable to smaller
ones and early cash flows are preferable to later ones.
Evaluation criteria
A number of investment criteria (or capital budgeting techniques) are in use in practice.
They may be grouped in the following two categories.
Profitability index(PI)
Payback period(PB)
Net present value (NPV) or net present worth (NPW)[ is defined as the total present value
(PV) of a time series of cash flows. It is a standard method for using the time value of
money to appraise long-term projects. Used for capital budgeting, and widely throughout
economics, it measures the excess or shortfall of cash flows, in present value terms, once
financing charges are met.
The rate used to discount future cash flows to their present values is a key
variable of this process. A firm's weighted average cost of capital (after tax) is often used,
but many people believe that it is appropriate to use higher discount rates to adjust for risk
for riskier projects or other factors. A variable discount rate with higher rates applied to cash
flows occurring further along the time span might be used to reflect the yield curve premium
for long-term debt.
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In general, if the IRR is greater than the project's cost of capital, or hurdle rate, the project
will add value for the company.
In the context of savings and loans the IRR is also called effective interest rate.
In cases where one project has a higher initial investment than a second mutually exclusive
project, the first project may have a lower IRR (expected return), but a higher NPV (increase
in shareholders' wealth) and should thus be accepted over the second project (assuming no
capital constraints).
IRR assumes reinvestment of positive cash flows during the project at the same calculated
IRR. When positive cash flows cannot be reinvested back into the project, IRR overstates
returns. IRR is best used for projects with singular positive cash flows at the end of the
project period.
Profitability index
Yet another time adjusted method of evaluating the investment proposals is the
benefit-cost (B/C) ratio or profitability index. Profitability index is the ratio of the present
value of cash inflows at the required rate of return, to the initial cash out flow of the
investment.
Evaluation of PI method
Like the NPV and IRR rules, PI is a conceptually sound method of arising
investment projects. It is a variation of the NPV method and requires the same
computations as the NPV method.
Relative profitability in the PI method since the present value of cash in flows
is divided by the initial cash out flow , it is a relative measure of projects
profitability.
Like NPV method PI criterion also requires calculation of cash flows and estimate
of the discount rate.
Payback period
The payback period is one of the most popular and widely recognized traditional methods of
evaluating investment proposals. Payback is the number of years required to cover the
original cash outlay invested in a project. If the project generates constant annual cash
inflows, the payback period can be computed by dividing cash outlay by the annual cash
inflow.
Evolution of payback:
Many firms use the payback period as an investment evaluation criterion and a method of
ranking projects. They compare the projects payback with pre-determined standard pay
back. The would be accepted if its payback period is less than the maximum or standard pay
back period set by management as a ranking method. It gives highest ranking to the project,
which has the shortest payback period and lowest ranking to the project with highest
payback period. Thus if the firm has to choose between two mutually exclusive projects, the
project with shorter pay back period will be selected.
Simpl
The significant merit of payback is that it is simple to understand and easy to calculate. The
business executives consider the simplicity of method as a virtue. This is evident from their
heavy reliance on it for appraising investment proposals in practice.
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Cost effective
Payback method costs less than most of the sophisticated techniques that require a lot of the
analysts time and the use of computers.
Short-term
Effects a company can have more favorable short-run effects on earnings per share by
setting up a shorter standard payback period. It should, however, be remembered that this
may not be a wise long-term policy as the company may have to sacrifice its future growth
for current earnings.
Liquidity
The emphasis in payback is on the early recovery of the investment. Thus, it gives an insight
into the liquidity of the project. The funds so released can be put to other uses.
In spite of its simplicity and the so, called virtues, the payback may not be a desirable
investment criterion since it suffers from a number of serious limitations.
Risk shield
The risk of the project can be tackled by having a shorter standard payback period. As it may
be in a ensured guaranty against its loss. A company has to invest in many projects where the
cash inflows and life expectancies are highly uncertain. Under such circumstances, pay back
may become important, not so much as a measure of profitability but, as a means of
establishing an upper bound on the acceptable degree of risk.
Simplicity
The ARR method is simple to understand and use. It does not involve complicated
computations.
ACCOUNTING DATA
The ARR can be readily calculated from the accounting data, unlike in the NPV and IRR
methods, no adjustments are required to arrive at cash flows of the project.
ACCOUNTING PROFITABILITY
The ARR rule incorporates the entire stream of income in calculating the projects
profitability.
The ARR is a method commonly understood by accountants and frequently used as a
performance measure. As decision criterion, how ever it has serious short comings.
CASH FLOWS IGNORED
The ARR method uses accounting profits, not cash flows, in appraising the projects.
Accounting profits are based on arbitrary assumptions and choices and also include non-cash
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items. It is, there fore in appropriate to relay on them for measuring the acceptability of the
investment projects.
The averaging income ignores the time value of money. In fact, this procedure gives more
weight age to the distant receipts.
ARBITRARY CUT-OFF
The firm employing the ARR rule uses an arbitrary cut-off yardstick. Generally, the
yardstick is the firms current return on its assets (book -value). Because of this, the growth
companies earning very high rates on their existing assets may project profitable projects
and the less profitable companies may accepts bad projects.
PROJECT CLASSIFICATION
Project classification entails time and effort the costs incurred in this exercise must
be justified by the benefits from it. Certain projects, given their complexity and magnitude,
may warrant a detailed analysis; others may call for a relatively simple analysis. Hence firms
normally classify projects into different categories. Each category is then analyzed
somewhat differently.
While the system of classification may vary from one firm to another, the following
categories are found in cost classification.
Mandatory investments
These are expenditures required to comply with statutory requirements. Examples
of such investments are pollution control equipment, medical dispensary, fire fitting
equipment, crche in factory premises and so on. These are often non-revenue producing
investments. In analyzing such investments the focus is mainly on finding the most costeffective way of fulfilling a given statutory need.
Replacement projects
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Expansion projects
These investments are meant to increase capacity and/or widen the distribution
network. Such investments call for an expansion projects normally warrant more careful
analysis than replacement projects. Decisions relating to such projects are taken by the top
management.
Diversification projects
These investments are aimed at producing new products or services or entering
into entirely new geographical areas. Often diversification projects entail substantial risks,
involve large outlays, and require considerable managerial effort and attention. Given their
strategic importance, such projects call for a very through evaluation, both quantitative and
qualitative. Further they require a significant involvement of the board of directors.
Miscellaneous projects
This is a catch-all category that includes items like interior decoration,
recreational facilities, executive aircrafts, landscaped gardens, and so on. There is no
standard approach for evaluating these projects and decisions regarding them are based on
personal preferences of top management.
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Introduction
Until now, this web site has broken one of the cardinal rules of financial management. This
page corrects for that problem and presents now, the first part of the subject of Capital
Budgeting.
Many books and chapters and web pages purport to discuss capital budgeting when in reality
all they do is discuss CAPITAL INVESTMENT APPRAISAL. There's nothing wrong with a
discussion of the CIA methods except that authors have a duty to point out that CIA methods
are only one part of a multi stage process: the capital budgeting process.
A discussion of CIA and nothing else means that capital budgeting decisions are being
discussed out of context. That is, by ignoring the earlier and later parts of capital budgeting,
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we are never assess where capital budgeting project come from, how alternatives are found
and evaluated, how we really choose which project to choose and then we never review
the projects and how they have been implemented.
Definition
Capital budgeting relates to the investment in assets or an organization that is relatively
large. That is, a new asset or project will amount in value to a significant proportion of the
total assets of the organization.
The International Federation of Accountants, IFAC, defines capital expenditures as
Investments to acquire fixed or long lived assets from which a stream of benefits is
expected. Such expenditures represent an organization's commitment to produce and sell
future products and engage in other activities. Capital expenditure decisions, therefore, form
a foundation for the future profitability of a company.
Projects don't just fall out of thin air: someone has to have them. The main point here is that
successful, dynamic and growing companies are constantly on the lookout for new projects
to consider. In the largest organizations there are entire departments looking for alternatives
and opportunities.
Look for suitable projects
Once someone has had the idea to invest, the next step is to look at suitable projects: projects
that complement current business, projects that are completely different to current business
and so on. Initially, all possibilities will be considered: along the lines of a brainstorming
exercise.
As time goes by, and as corporate objectives allow, the initial list of potential projects will be
whittled down to a more manageable number.
Identify and consider alternatives
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Having found a few projects to consider, the organization will investigate any number of
different ways of carrying them out. After all, the first idea probably won't either be the last
or the best. Creativity is the order of the day here, as organizations attempt to start off on the
best footing.
As the diagram suggests, at each of these first three stages, we need to consider whether
what we are proposing fits in with corporate objectives. There is no point in thinking of a
project that conflicts with, say, the growth objective or the profitability objective or even an
environmental objective.
A lot of data will be generated in this stage and this data will be fed into stage four: Capital
Investment Appraisal.
4 Capital Investment Appraisal
This is the number crunching stage in which we use some or all of the following methods
Payback (PB)
accounting rate of return (ARR)
Net present value (NPV)
Internal rate of return (IRR)
Profitability Index (PI)
There are other techniques of course; but the technique to be used will depend on a range of
things, including the knowledge and sophistication of the management of the organization,
the availability of computers and the size and complexity of the project under review.
For more information here, go to my page on CIA once you have finished this page.
Analysis of feasibility
Stage four is the number crunching stage. This stage is where the decision is made as to
which project is to be assessed as acceptable. That is, which project is feasible?
In order to choose the project, management needs some hurdles:
What must the payback be
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and so on.
Some projects will be discarded as a result of this stage. For example, if the PB cut off is,
say, 2 years, and a project has a PB of 3 years, it will be rejected. The same is true of the
ARR, NPV, IRR and PI.
Capital rationing might be a problem here, too, if the organization has general cash flow
problems.
Capital Budgeting Policy Manual
Let's pause at this point to make the point that what we have just said about cut off rates and
so on come from formal procedures and documents. One such formal document is the
Capital Budgeting Policy Manual, in which formal procedures and rules are established to
assure that all proposals are reviewed fairly and consistently. The manual helps to ensure
that managers and supervisors who make proposals need to know what the organization
expects the proposals to contain, and on what basis their proposed projects will be judged.
The managers who have the authority to approve specific projects need to exercise that
responsibility in the context of an overall organizational capital expenditure policy.
In outline, the policy manual should include specifications for:
1. an annually updated forecast of capital expenditures
2. the appropriation steps
3. the appraisal method(s) to be used to evaluate proposals
4. the minimum acceptable rate(s) of return on projects of various risk
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start to finish: stages 1 - 7 and looks at how it was thought of, analyzed, chosen,
implemented, and monitored and so on.
The purpose of the post audit is to test whether capital budgeting procedures have been fully
and fairly applied to the project under review.
Of course, any weaknesses that might be found during the post audit might be specific to
one project or they might relate to capital budgeting systems for the organization as a whole.
In the latter case, the auditor will report back to his superiors and to management that
systems need to be overhauled as a result of what has been found.
Similarly, the
invention of the motorcycle created the self propelling bicycle. The first commercial
design was three-wheeler built by Edward Butler in Great Britain in 1884. This employed a
horizontal single-cylinder gasoline engine mounted between two steer able front wheels and
connected by a drive chain to the rear wheel. The 1900s saw the conversion of many
bicycles or pedal cycles by adding small, centrally mounted spark ignition engine engines.
There was then felt the need for reliable constructions. This led to road trial tests and
competition between manufacturers. Tourist Trophy (TT) races were held on the Isle of
main in 1907 as reliability or endurance races. Such were the proving ground for many new
ideas from early two-stroke-cycle designs to supercharged multivalent engines mounted on
aerodynamic, bikebon fiber reinforced bodywork.
motorcycle? May seem like a simple question, safety, bicycle, i.e., bicycle with front
and rear wheels of the same size, with a pedal crank mechanism to drive the rear wheel.
Those bicycles in turn described from high-wheel bicycles. The high wheelers descended
from an early type of pushbike, without pedals, propelled by the riders feet pushing against
the ground. These appeared around 1800, used iron banded wagon wheels, and were called
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bone-crushers, both for their jarring ride, and their tendency to toss their riders. Gottiieb
Daimler (who credited with the building the first motorcycle in 1885, one wheel in the front
and one in the back, although it had a smaller spring-loaded outrigger wheel on each side. It
was constructed mostly of wood, the wheels were of the iron-banded wooden-spooked
wagon-type and it definitely had a bone-crusher chassis!
FURTHER DEVELOPMENTS:
Most of the developments during the early phase concentrated on three and four-wheeled
design since it was complex enough to get the machines running with out having to worry
about them falling over. The next notable two-wheeler though was the Hildebrand & Wolf
Mueller, patented in Munich in 1894. In 1895, the French firm of DeDion-button built and
engine that was to make the mass production and common use of motorcycle possible. The
first motorcycle with electric start and a fully modem electrical system; the Hence special
from the Indian Motorcycle Company astounded the industry in 1931. Before World War 1,
IMC was the largest motorcycle manufacturer in the world producing over 20000 bikes per
year.
INCREASING POPULARITY:
The popularity of the vehicle grew especially after 1910, in 1916; the Indian motorcycle
company introduced the model H racer, and placed it on sale. During World War 1, all
branches of the armed forces in Europe used motorcycles principally for dispatching. After
the war, it enjoyed a sport vogue until the Great Depression began in motorcycles lasted into
the late 20th century; weight the vehicle beingused for high-speed touring and sport
competitions. The more sophisticated of a 125cc model. Since then, an increasing number
of powerful bikes have blazed the roads.
Indian is the second largest manufacturer and producer to two wheelers in the World. It
stands next only to Japan and China in terms of the number of V produced and domestic
sales respectively. This destination was achieved due to variety of reason like restrictive
policy followed by the government of India towards the passenger bike industry, rising
demand for personal transport, inefficiency in the public transportation system etc. The
Indian two-wheelers industry made a small beginning in the early 50s when Automobile
products of India (API) started manufacturing scooters in the country. Until 1958, API and
Enfield were the sole producers.
The two wheelers market was opened were opened to foreign competition in the mid-80s.
And the then market leaders-Escorts and Enfield were caught unaware by the onslaught of
the 100cc bikes of the four Indo- Japanese joint ventures. With the availability of fuelefficiency low power bikes, demand swelled, resulting in Hero Honda then the only
producer of four stroke bikes (100cc category), gaining a top slot.
The first Japanese motorcycles were introduced in the early eighties. TVS Suzuki and Hero
Honda brought in the first two-stroke and four-stroke engine motorcycles respectively.
These two players initially started with assembly of CKD Kits, and later on progressed to
indigenous manufacturing.
The industry had a smooth ride in the 50s, 60s and 70s when government prohibited new
entries and strictly controlled capacity expansion. The industry saw a sudden growth in the
80s. The industry witnessed a steady of 14% leading to a peak volume of 1.9 mn vehicles in
1990.
In 1990 the entire automobile industry saw a drastic fall in demand. This resulted in a
decline of 15% in 1991 and 8% in 1992, resulting in a production loss of 0.4mn vehicles.
Barring Hero Honda, all the major producers suffered from recession in FY93 and FY94.
Hero Honda showed a marginal decline in 1992.
The reason for recession in the sector were the incessant rise in fuel prices, high input costs
and reduced purchasing power due to significant like increased production in 1992, due to
new entrants coupled with recession in the industry resulted in companies either reporting
losses or a fall in profits.
CONCLUSION:
46
The two-wheelers market has hada perceptible shift from a buyers market to a sellers
market with a variety of choice, players will have compete on various fronts viz. pricing,
technology product design, productivity after sale service, marketing and distribution. In the
short term, market shares of individual manufacturers are going to be sensitive to capacity,
product acceptance, pricing and competitive pressures from other manufacturers.
As incomes grow and people grow and people feel the need to own a private means of
transport, sales of two-wheelers will rise.
47
COMPANY PROFILE
CORPORATE PROFILE
Hero Moto Corp Ltd. (Formerly Hero Honda Motors Ltd.) is the world's largest
manufacturer of two - wheelers, based in India.
In 2001, the company achieved the coveted position of being the largest two-wheeler
manufacturing company in India and also, the 'World No.1' two-wheeler company in terms
of unit volume sales in a calendar year. Hero MotoCorp Ltd. continues to maintain this
position till date.
Today, every second motorcycle sold in the country is a Hero Honda bike. Every 30 seconds,
someone in India buys Hero Honda's top-selling motorcycle Splendor.
Vision
The Hero Honda story began with a simple vision the vision of a mobile and an
empowered India, powered by Hero Honda. This vision was driven by Hero Hondas
commitment to customer, quality and excellence, and while doing so, maintaining the
highest standards of ethics and societal responsibilities. Hero Honda believes that the fastest
way to turn that dream into a reality is by remaining focused on that vision.
Strategy
Hero Hondas key strategy has been driven by innovation in every sphere of activity
building a robust product portfolio across categories, exploring new markets, aggressively
48
Manufacturing
Hero Honda bikes are manufactured across three globally benchmarked manufacturing
facilities. Two of these are based at Gurgaon and Dharuhera which are located in the state of
Haryana in northern India. The third and the latest manufacturing plant is based at Haridwar,
in the hill state of Uttrakhand.
Technology
In the 1980s Hero Honda pioneered the introduction of fuel-efficient, environment friendly
four-stroke motorcycles in the country. Today, Hero Honda continues to be technology
pioneer. It became the first company to launch the Fuel Injection (FI) technology in Indian
motorcycles, with the launch of the Glamour FI in June 2006.
Products
Hero Honda's product range includes variety of motorcycles that have set the industry
standards across all the market segments. The company also started manufacturing scooter in
2006. Hero Honda offers large no. of products and caters to wide variety of requirements
across all the segments.
Distribution
The company's growth in the two wheeler market in India is the result of an intrinsic ability
to increase reach in new geographies and growth markets. Hero Honda's extensive sales and
service network now spans close to 4500 customer touch points. These comprise a mix of
authorized dealerships, Service & Spare Parts outlets, and dealer-appointed outlets across the
country.
Brand
The company has been continuously investing in brand building utilizing not only the new
product launch and new campaign launch opportunities but also through innovative
marketing initiatives revolving around cricket, entertainment and ground- level activation.
49
Hero Honda has been actively promoting various sports such as hockey, cricket and golf.
Hero Honda was the title sponsor of the Hero Honda FIH Hockey World Cup that was
played in Delhi during Feb-March 2010. Hero Honda also partners the Commonwealth
Games Delhi 2010.
2015-16 Performance
Total unit sales of 54,02,444 two-wheelers, growth of 17.44 per cent
Total net operating income of Rs. 19401.15 Crores, growth of 22.32 per cent
Net profit after tax at Rs. 1927.90 Crores
Total dividend of 5250% or Rs. 105 per share including Interin Dividend of Rs. 70 per share
on face value of each share of Rs. 2 each
EBIDTA margin for the year 13.49 per cent
EPS of Rs. 96.54
2014-15 Performance
Total unit sales of 46,00,130 two-wheelers, growth of 23.6 per cent
Total net operating income of Rs. 15860.51 Crores, growth of 28.1 per cent
Net profit after tax at Rs. 2231.83 Crores, growth of 74.1 per cent
Final dividend of 1500% or Rs. 30 per share on face value of each share of Rs. 2
EBIDTA margin for the year 17.4 per cent
EPS of Rs. 111.77, growth of 74.1 per cent
responsibilities.
50
This mission is what drives Hero Honda to new heights in excellence and helps the
organization forge a unique and mutually beneficial relationship with all its stake holders.
Designation
Mr. PawanMunjall
Technical Director
Non-Executive Director
Non-Executive Director
Non-Executive Director
Non-Executive Director
Mr. PradeepDinodia
10
11
12
Ms. ShobhanaBhartia
13.
Mr. M. Damodaran
14.
15.
51
52
Mr. Suman
Kant Munjal
Non Executive Director
Mr. Munjal was appointed as an Additional Director on the Board of the Company on July
29, 2010. Mr. Munjal is the Managing Director of Rockman Industries Ltd., one of the
leading suppliers of Aluminum Die Casting, Machined and Painted Assemblies to Hero
MotoCorp Ltd. Mr. Munjal, a graduate in Commerce, possesses rich experience and
expertise in business management and thus has been instrumental in elevating Rockman
Industries Ltd. to its current status.
Nature of Office
Director
Director
ShivamAutotech Limited
Director
53
Event
1983 Joint Collaboration Agreement with Honda Motor Co. Ltd. Japan signed
Shareholders Agreement signed
1984
Hero Honda Motors Ltd. incorporated
1985 First motorcycle "CD 100" rolled out
1987 100,000th motorcycle produced
1989 New motorcycle model - "Sleek" introduced
1991 New motorcycle model - "CD 100 SS" introduced
500,000th motorcycle produced
1992 Raman MunjalVidyaMandir inaugurated - A School in the memory of founder
Managing Director, Mr. Raman Kant Munjal
1994 New motorcycle model - "Splendor" introduced
1,000,000th motorcycle produced
1997 New motorcycle model - "Street" introduced
Hero Honda's 2nd manufacturing plant at Gurgaon inaugurated
1998 2,000,000th motorcycle produced
1999 New motorcycle model - "CBZ" introduced
Environment Management System of Dharuhera Plant certified with ISO-14001 by
DNV Holland
Raman Munjal Memorial Hospital inaugurated - A Hospital in the memory of
founder Managing Director, Mr. Raman Kant Munjal
2000 4,000,000th motorcycle produced
Environment Management System of Gurgaon Plant certified ISO-14001 by DNV
Holland
Splendor declared 'World No. 1' - largest selling single two-wheeler model
"Hero Honda Passport Programme" - CRM Programme launched
2001 New motorcycle model - "Passion" introduced
One million production in one single year
New motorcycle model - "Joy" introduced
5,000,000th motorcycle produced
2002 New motorcycle model - "Dawn" introduced
New motorcycle model - "Ambition" introduced
54
55
2011
2012
2013
2014
Stone laid
50 Million cumulative 2 wheelers production
2015
Bike Maker of the Year by ET-ZigWheels Car & Bike of the Year Awards 2009
200 'Two-wheeler Manufacturer of the Year' by NDTV Profit Car & Bike Awards 2009
9
57
200 NDTV Profit Business Leadership Award 2008 - Hero Honda Wins the Coveted
8
200 The NDTV Profit Car India & Bike India Awards 2007 in the following category:
7
Wheeler Company).
One of the 8 Indian companies to enter the Forbes top 200 list of worlds most
58
reputed companies.
No. 1 in automobile industry by TNS Corporate Social Responsibility Award.
Best in its class awards for each category by TNS Total Customer Satisfaction
Awards 2006:
CD Deluxe (Entry)
201
Awards 2009 and Passion Pro adjudged as Car and Bike Viewers'
Choice two-wheeler
Rated as Top Indian Company in Automobile - Two Wheelers sector
2011
3
Motorbeam - Bike Manufacturer of the year, Zigwheels - Entry-Level
201
4
Overdrive - Scooter of the Year - Hero Maestro Edge,
201 .
6
The NDTV Profit Car India & Bike India Awards 2006 in the following category:
Constructing metalled roads and connecting these villages to the National Highway
(NH -8).
Renovating primary school buildings and providing hygienic water and toilet
facilities.
The Raman MunjalVidyaMandirbegan with three classes (up to class II) and 55 students
from nearby areas. It has now grown into a modern Senior Secondary, CBSE affiliated coeducational school with over 1200 students and 61 teachers. The school has a spacious
playground, an ultra-modern laboratory, a well-equipped audio visual room, an activity
room, a well-stocked library and a computer centre.
The Raman Munjal Sports Complex has basketball courts, volleyball courts, and hockey and
football grounds are used by the local villagers. In the near future, sports academies are
planned for volley ball and basket ball, in collaboration with National Sports Authority of
India.
KEY POLICIES
COMPANY
61
At Hero Honda, our goal is not only to sell you a bike, but also to help you every step of the
way in making your world a better place to live in. Besides its will to provide a high-quality
service to all of its customers, Hero Honda takes a stand as a socially responsible enterprise
respectful of its environment and respectful of the important issues.
Hero Honda has been strongly committed not only to environmental conservation
programmers but also expresses the increasingly inseparable balance between the economic
concerns and the environmental and social issues faced by a business. A business must not
grow at the expense of mankind and man's future but rather must serve mankind.
"We must do something for the community from whose land we generate our wealth."
A famous quote from our Worthy Chairman Mr.BrijmohanLallMunjal.
Environment Policy
We at Hero Honda are committed to demonstrate excellence in our environmental
performance on a continual basis, as an intrinsic element of our corporate philosophy.
To achieve this we commit ourselves to:
Comply with all applicable environmental legislation and also controlling our
environmental discharges through the principles of "alara" (as low as reasonably
achievable).
Quality Policy
62
Safety Policy
Hero Honda is committed to safety and health of its employees and other persons who may
be affected by its operations. We believe that the safe work practices lead to better business
performance, motivated workforce and higher productivity.
We shall create a safety culture in the organization by:
Generally the sale will be either on cash basis or on institutional basis. Bank like ICICI,
HDFC and CENTURION are providing loans to customers.
Advertising strategy of phoenix motors:
They are giving the ads through newspapers, wall paintings, hoardings and field staff. They
are upgrading sales by introducing the schemes, group bookings, institutional sales and
customer door-to-door activities.
Customer relationship:
They entertain the showroom providing a customers huge having pool game, internet
facility and television with home there system. They provide bile maintenance programs on
every week.
According to other dealers PHOENIX motors in first in sales and best in service. They treat
customer, is the very important person at PHOENIX motors customer satisfaction is their
motto, why because, they will satisfied customer is the best advertisement. They provide
better value for the customers and as well as employees also. At PHOENIX motors the
customer is the boss.
rim
misalignment or bend.
65
If there is any damage due o modification or fittings of accessories other than ones
recommended by HERO HONDA. If the motor has been used in any competitive events like
tracking races or rallies. If there is any damage to the painted surface due to industrial
pollution or other extraneous factors. For clams made for any consequential damage due to
any previous malfunction. For normal phenomenon like noise, vibration, oil seepage, which
do not affect the performance of the motorcycles.
66
KARIZMA
IMPULSE
67
MAESTRO EDGE
68
XTREME SPORTS
IGNITOR
69
CUSTOMER RELATIONSHIP:
To entertain the customers the showroom providing a customers huge having pool game,
Internet facility and television with home theatre system. They provide bike maintenance
programs on every week. According to other dealers PHOENIX motors in first in sales and
best in service. They treat customer, is the very important person at PHOENIX motors
customer satisfaction is their motto, why because, the well satisfied customer is the best
advertisement. They provide better value for the customers and as well as employees also.
At PHONIX motors the customer is the boss.
70
Total
Fixed
Net
Capital
sales
assets
assets
Profit
Employed
2011-
3002.7
2074.2
2012
2012-
1
3897.9
7
3300.5
865.6
1719.8
2013
2013-
8
4750.6
2
4666.4
2
2461.8
2014
2014-
2
5397.8
5
5299.5
6
3041.3
2015
2015-
8
5918.2
2
5020.3
9
2126.8
2016
Years
383.35
378.74
237.34
-210.21
-379.74
1173.21
2289.36
3232.23
4145.56
2812.99
Long
Share
term
holders
funds
Funds
1,13,161
45.45
1,27,090
1,49,415
1,66,719
2,14,254
45.45
45.45
45.45
45.45
TABLE 2
Years
2011-2012
2012-2013
2013-2014
2014-2015
2015-2016
1.447598
1.18102
1.018037
1.01856
1.178842
Change
0.266578
0.162983
-0.00052
-0.16028
71
72
TABLE - 3
Years
2011-2012
2012-2013
2013-2014
2014-2015
2015-2016
Over Ratio
Change
3.468935
2.266505
1.20243
1.929687
0.336817
1.774807
0.15488
2.7826
-1.00779
c) The fixed assets turnover ratio has showing a fluctuating trend and increase from
1.04 times to -1.01 times (2014-2015). This fluctuation any be due to fixed assets
investment.
TABLE - 4
Years
2011-2012
2012-2013
2013-2014
2014-2015
2015-2016
Return on Investment
Ratio%
Change%
0.326753
0.165435
0.161318
0.073429
0.092006
-0.05071
0.124136
-0.135
0.084288
Return on Investment.
Formula:
Return on Investment =
Net Profit
_____________________ X 100
Capital Employed
74
TABLE 5
Years
2011-2012
2012-2013
2013-2014
2014-2015
2015-2016
TABLE-6
Years
2011-2012
2012-2013
2013-2014
2014-2015
2015-2016
Calculation of each cash flows after taxes of three years, which is arrived at by
deducting depreciation, interest and tax from earning before tax and interest
(EBIT). This residue is profit after tax to arrive at cash flow after tax.
2) This cash flow after tax are multiplied with the values obtained from the
Table (the present value annuity table against the 8% actuary discount
Rate i.e. in the case of project.
3) NPV is derived by deducting the sum of present values from the initial
Investment.
4) Initial investments are the sum of cash flows of three years shown in
Capital expenditure table
Let us assume the discount rate be 10%:
TABLE:7
YEARS
2011-2012
2012-2013
2013-2014
CFATS
PVIF @ 10%
PVS
0.909
4036.94
5657.83
0.826
3669.578
8014.59
0.751
4673.368
6018.957
77
2014-2015
2015-2016
7188.91
0.683
4910.026
6959.35
0.620
TOTAL:
4314.797
23586.73
6636.97
16949.76
ACCEPT-REJECT CRITERION:
The accept -reject decision of NPV is very simple. If the NPV is positive then the project
should be accepted and if NPV is negative then the project should be rejected
i.e .If
and
NPV > 0
NPV < 0
(ACCEPT)
(REJECT)
Hence in the case of Hero Moto Corp Ltd project it is visible that the positive NPV shows
the acceptance and importance of the project.
In this method discount rate is not known, but the cash inflows and
cash out flows are known. It is the rate of return, which equates the present value of
cash inflows to out flows or it, is the rate of return, which renders NPV TO ZERO.
STEPS INVOLVED IN THE CALCULATION OF IRR:
1) Calculation of NPV with given discount rate
2) Calculation of NPV with assumed discount rate
3) Select the higher NPV of both
4) Let R be the higher discount rate
5) Let R1 be the difference of discount rates
6) Calculation of difference of P Vs (Always higher NPV-lower NPV)
IRR= R +
Higher NP
---------------------------- XR1
Difference of P V s.
FORMULATION OF STEPS:
STATEMENT OF SHOWING CALCULATION NPV @88%,89%,90% UNDER
IRR
METHOD
(R s corers)
TABLE:8
YEARS Annua Discount
Discount
Discount
l CFA Rate-88%
Rate-89%
Rate-90%
Ts
PVF
PV
PVF
PV
PVF
PV
20114036.9 0.531 2143.6151
0.529 2135.5413
0.526 2123.4304
79
2012
2012-
4
5657.8
2013
2013-
3
8014.5
2014
2014-
9
7188.9
2015
2015-
1
6959.3
2016
0.292
1
0.157
9
0.085
8
0.046
1
1652.6521
0.2799
1583.6266
0.277
1567.2189
4
1265.5037
0.1481
1186.9608
0.145
1162.1156
6
616.80847
0.0783
562.89165
0.076
546.35716
8
320.82603
0.0414
288.11709
0.04
278.374
5
5999.4055
5757.1374
5677.4961
ACCEPT-REJECT CRITERION:
IRR is the maximum rate of interest, which an organization can afford to pay on capital,
invested in, is accepted if IRR exceeds the cutoff rates and rejected if it is below the cutoff
rate.
80
The cutoff rate of Hero Moto Corp Ltd is 10%, which is less than the IRR i.e 88.5% hence
the acceptance of Hero Moto Corp Ltd is quiet a good investment decision taken by
management.
PROFITABILITY INDEX: (BCR OR PI)
Profitability index method is also known as time adjusted method of evaluating the
investment proposals. Profitability also called as benefit cost ratio (B\C) in relationship
between present value of cash inflows and the present value of cash out flows. Thus
Present value of cash inflows
Profitability index =
Profitability index
CALCULATIONS OF BCR:
STEP1: Calculations of cash flows after taxes
STEP2: Calculations of Present values of cash inflows @10%.
STEP3: Application of the formula.
Statement for calculating of benefit cost ratio
TABLE:9
YEARS
CFATS
PVIF @
PVS
10%
2011-2012
0.909
4036.94
3669.578
81
5657.83
2012-2013
0.826
4673.368
8014.59
2013-2014
0.751
6018.957
7188.91
2014-2015
0.683
4910.026
6959.35
2015-2016
0.620
4314.797
23586.73
TOTAL:
TABLE:10
YEARS
2011-2012
2012-2013
2013-2014
2014-2015
2015-2016
CFATS
PVIF @ 10%
0.909
4036.94
5657.83
0.826
8014.59
0.751
7188.91
0.683
6959.35
0.620
3669.578
4673.368
6018.957
4910.026
4314.797
16505.98
TOTAL:
Profitability index
PVS
16505.98
= -----------------6636.97
= 2.58
Hence PI = 3years.
ACCEPT-REJECT CRITERION:
82
> 1 (ACCEPT).
< 1
(REJECT).
83
The budgeting exercise in Hero Moto Corp Ltd also covers the long term capital
budgets, including annual planning and provides long term plan for application of
internal resources and debt servicing translated in to the corporate plan.
The scope of capital budgeting also includes expenditure on plant betterment, and
renovation, balancing equipment, capital additions and commissioning expenses on
trial runs generating units.
To establish a close link between physical progress and monitory outlay and to
provide the basis for plan allocation and budgetary support by the government.
The manual recommends the computation of NPV at a cost of capital / discount rate
specified from time to time.
A single discount rate should not be used for all the capacity budgeting projects.
The analysis of relevant facts and quantifications of anticipated results and benefits,
risk factors if any, must be clearly brought out.
Inducting at least three non -official directors the mechanism of the Search
Committee should restructure the Boards of these PSUs.
Feasibility report of the project is prepared on the cost estimates and the cost of
generation.
Unapproved schemes
SUGGESTIONS
The capital budgeting decision for Hero Moto Corp Ltd is governed by a manual
issued by the planning Commission. It contains the following important provisions in
84
the regard: (1) It suggest the use of various project evaluation techniques, such as
return on investment (ROD, payback period, discounted cash flow (DCF) Evaluation
and Review Technique (PERT), Critical path method (CPM), and strengths,
weaknesses, opportunities and Threats (SWOT) Analysis.
The total assets turnover ratio of Hero Moto Corp Ltd recorded consistent
fluctuations from 0.41 (2011-2012) to 01.04 (2015-2016). The lowest recorded as
0.38 (2014-2015). This decline is an account of lower growth rates sales in those
years.
The fixed assets turnover ratio of Hero Moto Corp Ltd showing a fluctuating trend
and increased from 1.04 times (2011-2012) to 1.25 times (2014-2015). These
fluctuations any be due to fixed assets investment.
The ROI Of Hero Moto Corp Ltd did not record any consistent trend. It varied from
0.32% (2011-2012) to -0.12% (2015-2016).
The fixed assets ratio shows the fluctuating trends form 0.76 (2011-2012) to (20142015) as 1.15 and the funds were required then continuously declined.
The fixed assets ratio of Hero Moto Corp Ltd as shown continuously increasing from
0.76 (2011-2012) to (2015-2016) as 0.99.There fluctuations observed.
BIBLIOGRAPHY
85
Books:
-Financial Management
- Prasanna Chandra
-Management Accounting
- R.K.Sharma&ShashiK.Gupta
-Management Accounting
-S.N.Maheshwary
-Financial Management
-Research Methodology
-K.R.Kothari
Internet Sites:
http\\:www.google.com
http\\:www.Hero Moto Corp Ltd.co.in
http\\:www.googlefinance.com
86