CAPITAL BUDGETING

The most important function of financial management is not only the procurement of external funds for the business but also to make efficient and wise allocation of these funds. The allocation of funds means the investment of funds in various assets and other activities. It is also known as investment decision, because a choice is to be made regarding the assets in which the funds will be invested. The assets which can be acquired fall into two broad categories; i) Short term or current assets ii) Long term or fixed assets Accordingly, two types of investment decisions are to be taken. First type of investment decision related to short term assets are called short term investment decisions or current assets management. This is termed as working capital management. Second type of investment decision related to long term assets are called long term investment decisions. These are known as Capital budgeting or Capital expenditure decisions.

Meaning:
Capital budgeting is the technique of making decisions for investment in long term assets. It is a process of deciding whether or not to invest the funds in a particular asset, the benefit of which will be available over a period of time longer than one year.Capital budgeting consists in planning the deployment of available capital for the purpose of maximizing the long term profitability of the firm.Thus, a capital budgeting decision is a firms decision to invest its funds in long term assets in anticipation of an expected flow of benefits over the lifetime of the asset. These benefits may be either in the form of increased sales or reduced costs. Capital expenditure decisions generally include decisions regarding expansion, acquisition, modernization and replacement of long term assets.

Features of Capital Budgeting:

1. Funds are invested in long term assets. 2. Funds are invested in present times in anticipation of future profits. 3. The future profits will occur to the firms over a series of years.

4. Capital budgeting decisions involve a high degree of risk because future benefits are not certain.

Importance of Capital budgeting:

1. Such decisions affect the profitability of a firm: capital budgeting decisions affect the

long term profitability of a firm because of the fact that they relate to fixed assets. The fixed assets, in a sense, reflect the true earning capacity of a firm. They enable a firm to produce finished goods which is ultimately sold for profit. Hence a correct investment decision can yield spectacular profits, whereas, an ill-advised and incorrect decision can endanger the very survival of the firm. 2. Long time periods: the effect of capital budgeting decision will be felt by the firm over a

long time span, and thus, affects the future cost structure of the firm. To illustrate, if a company purchases a new plant to manufacture a new product, the company will have to incur a sizable amount of fixed costs, in terms of labor, supervisors salary, insurance, rent of building etc. If in future, the product turns out to be unsuccessful or if it yields less profit than anticipated, the company will have to bear the burden of heavy fixed costs. Hence, the future costs, sales and profits will be determined by the capital budgeting decisions. 3. Irreversible decisions: Capital budgeting decisions once taken are not easily reversible

without heavy financial loss to the form. This is because it is very difficult to second hand plant. 4. Involvement of Large Amount of Funds: Capital budgeting decisions require large amount

of funds and most of the firms have limited financial resources. Hence, it is absolutely necessary to take thoughtful and correct investment decisions because an incorrect decision will not only result in losses but also prevent the firm from earning profits from the alternative investments which had to be dropped because of the paucity of funds. 5. Risk: Investment in fixed assets may change the risk complexion of the firm. This is because

different capital investment proposals have different degrees of risk. If the adoption of an investment proposal increases average gain, but causes frequent fluctuations in the profits of the firm, the firm will become more risky. As such, investment decisions shape the basic character of a firm. 6. Most difficult to make: these decisions are among the most difficult decisions o be taken by

a firm. This is, because they require an assessment of future events which are uncertain and difficult to

predict. For example, estimating the future cash inflows and life of the project is really a complex problem.

Kinds of Capital Budgeting Decisions:

A firm may have various investment proposals for its consideration. It may select all of them, one of them, or some of them depending upon the various types of proposals. i. Accept-reject decisions: this is a fundamental decision in capital budgeting. If a proposal (or project) is accepted, the firm would invest in it and if the proposal is rejected, the firm would not invest in it. In general, all those proposals, or projects which yield a rate of return higher than a certain required rate of return are accepted and the rest are rejected. By applying this criterion, all independent proposals are either accepted or rejected. Independent proposals are those which do not compete with other proposals and all proposals can be accepted simultaneously. Hence, all the proposals which satisfy the minimum investment criterion should be implemented. ii. Mutually competitive decisions: these are related to the proposals which compete with other projects in such a way that the acceptance of one will automatically result in the rejection of others. For example, a company is considering two sites X and Y for the construction its plant. If site X is selected, site Y will be automatically rejected. iii. Priority order Decisions: In case a firm has unlimited funds, all those independent projects are accepted
which yield a higher rate of return as against some predetermined rate. However, in actual practice most of the firms have limited funds. The firm, therefore, must fix a priority order for investing these funds. The firm allocates funds to various projects in a manner that the long term profits are maximized. The priority of the projects will be determined in the basis of predetermined criterion such as the rate of return. In this way, the projects yielding maximum return will be selected and all other projects will be rejected.

Techniques of Capital Budgeting

expenditure decisions 1. Accounting profit criteria 2. Cash flow criteria

: There are two criterias for capital

Under accounting profit criteria there is only one method for making capital expenditure decision. This method is known as Average Rate of Return method. Under cash flow criteria, several methods are included. These are as under: I. Pay back method

II. Methods based on discounted cash flows (i) Discounted pay back method (ii) Net present value method (iii)Internal rate of return method (iv) Profitability index method In case of cash flow criteria cash inflows and cash outflows of the proposal are considered for making the capital expenditure decisions. Cash inflows include cash coming in from a project and cash outflows include cash invested in a project. Cash flow criteria are preferred as compared to accounting profit criteria for the following reasons: 1. In case of cash flow criteria it is possible to consider the time value of money. 2. Cash flow criteria are based in cash flows rather than accounting profit, therefore, it avoids accounting
uncertainties.

Techniques of capital budgeting

Accounting profit criteria

Cash flow criteria

Accounting Rate of Return

NON-DISCOUNTING TECHNIQUE 1. PAY BACK PERIOD

DISCOUNTING TECHNIQUES 1. DISCOUNTED PAYBACK PERIOD NET PRESENT VALUE PROFITABLITITY

2. 3.

Average rate of return method (ARR): This method is also known as accounting rate of return method. It is based upon accounting information rather than cash flows. It is calculated as follows: ARR = Average annual profit after taxes * 100/ investment Average annual profits after taxes = Total of after tax profits of all the years/number of years Here profit after tax means profit after depreciation and taxes. The average rate of return calculated is compared with a predetermined rate of return. A project is accepted if the actual ARR is higher than the predetermined rate. Otherwise, it is liable to be rejected. Pay back method: The payback method is the simplest and most widely applied traditional method for appraising capital investment decisions. This method calculates the number of years required to pay back the original investment in a project. In other words, payback period is the period which is required to recover original investment in a project.
Actual payback period calculated according to this method is compared with the predetermined payback period fixed by the management in terms of maximum period during which the original investment must be recouped. If the actual payback period is less than the pre determined payback period, the project will be accepted, if not, it will be rejected. Alternatively, when many projects are under consideration, they should be ranked according to the length of the payback period.

Payback period (PB) = investment/constant annual cash flow When the project generates unequal cash inflows every year, the payback period is calculated by adding up the cash inflows till the time they become equal to the original investment. Discounted payback method:

An investment decision rule in which cash flows are discounted at an interest rate and then one determines how long it takes for the sum of the discounted cash flows to equal the initial investment. In investment decisions, the number of years it takes for an investment to recover its initial cost after accounting for inflation, interest, and other matters affected by the time value of money, in order to be worthwhile to the investor. It differs slightly from the payback rule, which only accounts for cash flows resulting from an investment and does not take into account the time value of money. Each investor determines his own discounted payback period rule, and as such, it is a highly subjective rule. In general, however, short term investors use a short number of years for their discounted payback period rules, while long term investors measure their rules in years, or even decades. Net present value method: Under this method, present value of cash outflows and cash inflows is calculated and the present value of cash outflow is subtracted from the present value of cash inflows. This difference is called net present value or NPV. Thus, NPV = PV of Inflow PV of outflow NPV can thus be calculated using the following formulae: NPV = [ cash inflow in 1st year*1/(1+r)1] + [ cash inflow in 2nd year*1/(1+r)2] + [ cash inflow In 3rd year*1/(1+r)3] + . + [ cash inflow in nth year*1/(1+r)n] [initial cost outflow * 1/(1+r)0] Here r= rate of interest (i.e., cost of capital) n= expected life of the proposal If there is some salvage value of the project, it is added in cash inflows in last year. Similarly, if some working capital is needed, it will be added to the initial cost of project. Similarly, if some working capital is needed, it will be added to the initial cost of the project and also to the cash inflows in last year.

If NPV is positive, the project may be accepted. If NPV is negative, the project may not be accepted. If NPV is zero, the project may be accepted only if non-financial benefits are there. To choose one out of various investment proposals, the project with highest NPV is preferred.

Internal rate of return method: The internal rate of return on an investment or potential investment is the annualized effective compounded return rate that can be earned on the invested capital. In more familiar terms, the IRR of an investment is the interest rate at which the costs of the investment lead to the benefits of the investment. This means that all gains from the investment are inherent to the time value of money and that the investment has a zero net present value at this interest rate. Because the internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or yield of an investment. This is in contrast with the net present value, which is an indicator of the value or magnitude of an investment. Given, (n, Cn) where n is a positive integer, the total number of periods N, and the net present value NPV, the internal rate of return is given by r in:

An investment is considered acceptable if its internal rate of return is greater than an established minimum acceptable rate of return or cost of capital. In a scenario where an investment is considered by a firm that has equity holders, this minimum rate is the cost of capital of the investment (which may be determined by the risk-adjusted cost of capital of alternative investments). This ensures that the investment is supported by equity holders since, in general, an investment for which IRR exceeds its cost of capital adds value for the company. Profitability index:

Profitability index method is very similar to the NPV approach. It measures the present value of returns per rupee invested. A major drawback of the NPV method is that it does not give satisfactory results while evaluating the projects requiring different initial investment. PI method provides solution to this problem. NPV method is therefore, considered good when the initial investment in various projects is the same, whereas, PI method is adopted when the initial cost of different projects are different. PI can be calculated as follows: PI = present value of cash inflows / present value of cash outlay (or outflows) If PI is more than one, the project is accepted. If PI is less than one, the project will be rejected. If PI is equal to one, the project may be accepted only on the basis of non financial considerations.

International Dimensions of Capital Budgeting The massive multinational corporations (MNCs), whose names are household words around the globe and which have power that is the envy and fear of many governments grew large by making foreign direct investments, FDI. Project evaluations, generally referred to as capital budgeting, are discussed in a domestic context in almost all introductory corporate finance courses. However, in the international arena, capital budgeting involves complex problems that are not shared in a domestic context. These include, for example, the dependence of cash flows on capital structure the amount of debt versus equity used in company financing because of cheap loans from foreign governments. This makes the cost of capital to the corporation different than the opportunity cost of capital of shareholders, where the latter is the correct discount rate. There are also exchange-rate risks, country risks, multiple tiers of taxation, and sometimes restrictions on repatriating income. There are several approaches to capital budgeting for traditional domestic investments, including net present value (NPV), adjusted present value (APV), interest rate of return, and payback period. A question that arises in all capital budgeting applications, whether the investment project being evaluated is foreign or domestic, concerns the choice of the nominal versus the real discount rate. The answer is that the choice does not matter, provided we are consistent. That is, we reach the same conclusion if we discount nominal cash flows (those not

adjusted for inflation) by the nominal discount rate, or real (inflation adjusted) cash flows by the real discount rate. However, if cash flows are easier to forecast in todays prices, as a practical matter it will be easier to use the real cash flows and discount at the real rate. Capital budgeting decisions are very crucial for the success of any organization. They are long term and irreversible in nature. Firms have to invest present cash in anticipation of future returns. As future is always uncertain these decisions are complex in nature. These decisions in international context assume further significance, as the very nature of foreign investment is complex.

Capital budgeting process:

Capital budgeting is a complex process as it involves decisions relating to the investment of current funds for the benefit to be achieved in the future but the future is always uncertain. The following procedure is adopted in process of Capital Budgeting.

The importance of Capital Budgeting:

The importance of Capital Budgeting can be well understood from the fact that an unsound investment decision may prove to be fatal to the very existence of the concern. The need for Capital Budgeting

mainly

arises

due

to

1. Large investments Capital Budgeting decisions usually involve large investments of funds but mostly the there is a shortage of funds at every firm. Hence the funds and the resources need to be controlled by the firm

2. Irreversible nature Once the decision for acquiring a permanent asset is taken, it becomes very difficult to dispose of these assets without incurring heavy loss

3. Long term effect on Profitability Not only the present earnings of the firm is affected but the future growth and profitability also depend upon investment decisions taken today. So a bad decision today can lead to a downfall tomorrow.

CAPITAL BUDGETING AT BHEL

BHARAT HEAVY ELECTRICALS LIMITED (BHEL) is a public sector giant of NAVRATNA status. It is the largest engineering and manufacturing enterprise in India in the energy related infrastructure sector. Today BHEL caters to the core sectors of Indian economy viz. power generation and transmission, industry, transportation, telecommunication, renewable energy, defense, etc. The study reveals that BHEL has a strong system relating to implementation of the Company Policy and procedure. . These techniques followed are well planned and structured and same are reflected in the Company Manuals. Capital budgeting process is the most important tool to evaluate the financial feasibility of a proposal or to select one among various proposals. As such different organizations may follow different capital budgeting procedures to evaluate their projects. To understand the capital budgeting procedure followed at BHEL an insight of the following is essential: 1. How are the proposals identified? 2. How are the proposals screened? 3. How are the proposals short listed for further consideration? 4. What information is collected for the purpose of evaluating proposals? 5. What methods of evaluation are used? 6. How are the decisions reviewed?

BHEL units come up with proposals for investment with an objective that is in line with the company objectives and policies. As such, an investment scheme is formulated with a holistic approach considering the overall requirement. For instance BHEL has a current capacity of 15000 MW of power equipment and is going for a capacity augmentation to 20000 MW. As such considering this capacity BHEL units formulate proposals as per unit requirements.

Objective of the investment proposal:

The proposals by various units for investment have one of the following objectives: y Capacity expansion y Modernization and rationalization y Investment for new product y Science and technology y Quality

y Township and staff welfare y Enabling works/tools and plant (power sector) However, according to the nature of the project and amount involved, different guidelines have been laid for approval of capital expenditure proposals. The information on processing and competent approval authorities category wise is described below: Financial limits y Major capital items

Major capital investments mainly of more than Rs. 5 crore rupees are are approved by the concerned authorities and all these proposals are supported by a feasibility report. y Minor capital items

For minor capital items, an annual lump sum provision of Rs 20 lakhs to Rs 5 crores is made for various units/divisions. For such expenditures a brief justification is given to the divisional head

and approval is obtained from the same. However this provision is to be obtained subject to the following conditions viz: 1. Provision is to be utilized for production related/ technology development/emergency requirement etc. 2. The provision should not be utilized for vehicles, welfare related items. 3. Rs 5 lakhs to Rs 20 lakhs is the limit for cost of the individual item that can be procured under minor capital.

Excess over sanctioned cost

The cumulative expenditure on the capital projects is periodically reviewed with reference to the total sanctioned cost; taking into account expenditure already incurred and anticipated expenditure. If it is found during the review that the sanctioned cost is likely to exceed, the anticipated excess is worked out and such excess is regularized by obtaining sanction of the competent authority prior to expenditure. The proposal for cost revision explicitly brings out all the changes made with respect to the original proposal. The cost difference between the revised and original (approved) estimates is explained in detail especially whether they are due to fiscal or other reasons. Fiscal and non fiscal reasons are defined as: Fiscal i. ii. iii. Price escalation (inflation or increase by supplier) Statutory reasons (customs duty & excise)
Exchange rate variation

Non-fiscal i. ii. iii. Change of scope Change of technical design, specification of main equipment
Under estimation

Capital investment in Rs. crore

BEGINNING OF THE CAPITAL BUDGETING PROCEDURE

Five year plan
BHEL formulates a five year plan that should be in line with the government policies and objectives which is followed by the formation of an annual plan.

Funding:
The present trend indicates an emphasis on utilization of more internal resources for capital funding. This necessitates a rigorous and critical budget formulation exercise.

Annual plan:
The capital budget process begins with the formulation of Annual plan in the month of September / October every year. The annual plan comprises yearly capital investment funds budget of the company. It reviews capital budget for the current year and consolidates proposals for the next.

Annual plan exercise enables consolidation of all capital items with cash flows during a particular year. However expenditure on capital equipment like cranes, material handling equipment etc, which are required at project sites for erection and commissioning are considered as non plan capital expenditure and is, classified under three categories: I. II. III. Tools and plants which are used for more than one project. Tools and plants unlikely to be available for more than one project. Tools and plants supplied by subcontractor.

All such equipments are required to execute the erection and commissioning commitments under various types of contracts of the company with customer and such expenditures are charged off to the customer contracts for which these equipments are used as per the accounting policies of the company. Such expenditures are normally required to be made primarily by the services divisions like ISG, TPG projects etc. for erection and commissioning. The budget for all such non plan capital expenditures is submitted by the concerned divisions along with the capital budget. Although approval in principle is obtained for the total non plan budget from the board of directors along with the capital funds budget, it is still necessary for the division to obtain separate approval for each individual item from the director (Finance) and chairman of the company. Complete details of all the items are submitted by the division to corporate office through proper channel for making the necessary budgetary provision. The unit that comes up with a proposal needs to present it to the Directors and the corporate team comprising the CMT&IP, Finance, HR, Quality, Business sectors etc. The presentation must also include details of the cash flow of the ongoing schemes and about schemes to be formulated. In short, the unit heads need to give a synopsis of the proposal/scheme to the concerned authority. After the proposal obtains approval from the Directors and the corporate team, the units formulate individual investment proposals on the basis of which the proposals are screened and short listed.

Annual plan process

DISCOUNTED CASH FLOWS Financial analysis Investment = 47495 year 201112 201213 201314 201415 201516 201617 201718 201819 201920 202021 202122 202223 cash inflow capital expenditure 4018 40885 28680 51715 63567 63784 52689 34500 34500 34500 34500 31050 Pay Back period is 5.81 years. ROI is 22.68% 2593 0 0 0 0 0 0 0 0 0 19796 26403 24819 23906 13065 11542 12225 12225 12225 12225 888 949 1044 1148 1263 1389 1528 1681 1849 2034 4278 5897 6053 7105 5506 5888 6308 6771 7279 7839 4000 9525 8659 12031 3555 4116 4054 3955 3821 3651 material direct labor overheads income tax total outflows 4018 40885 31555 42773 40574 44190 23389 22935 24115 24632 25174 25749 cash net cash inflow -4018 -40885 -2875 8942 22993 19594 29300 11565 10385 9868 9326 5301 23.65% IRR

EVALUATION OF AN EXISTING PROJECT

The above given table gives the cash flow analysis of a project with an initial investment of Rs. 47495. The ROI and IRR as calculated are 23.65% and 22.68% respectively. The profit after tax is taken to be equal to 107738. The payback period for the project is 5.81 years. Now the calculations for the discounted payback period are as follows.

Discounted pay back period year 201112 201213 201314 201415 201516 201617 201718 201819 201920 202021 202122 202223 net cash inflow -4018 -40885 -2875 8942 22993 19594 29300 11565 10385 9868 9326 5301 Discounted payback period = 8.006 years 0.877 0.769 0.674 0.592 0.519 0.455 0.399 0.351 0.308 0.27 0.237 6027 13612 10169 13332 4614 3645 2987 2518 1256 6027 19639 29808 43140 47754 51399 54386 56904 58160 PVF 14% @ Discounted inflows cash Cumulative DCF

The discounting factor is taken to be 14% which is BHELs cost of capital. The discounted payback period comes out to be 8.006 years which is 2.15 years more than the payback period of the project. This can give a better picture of the years taken to get the investment back. The calculations of NPV and the profitability index are given as follows. The PV factor is 14% .
Net present value Year 2011-12 2012-13 2013-14 2014-15 net cash inflow -4018 -40885 -2875 8942 0.877 0.769 0.674 PVF 14% @ Discounted flows -4018 -35856 -2211 6027 cash

2015-16 2016-17 2017-18 2018-19 2019-20 2020-21 2021-22 2022-23 Net present value = present value of cash inflows-present value of cash outflow 58160-42085 = 16075

22993 19594 29300 11565 10385 9868 9326 5301

0.592 0.519 0.455 0.399 0.351 0.308 0.27 0.237

13612 10169 13332 4614 3645 2987 2518 1256

The net present value of the project is Rs 16075 which is positive. Therefore the project is feasible.

year 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 2020-21 2021-22 2022-23

Profitability Index net cash inflow PVF @ 14% -4018 -40885 0.877 -2875 0.769 8942 0.674 22993 0.592 19594 0.519 29300 0.455 11565 0.399 10385 0.351 9868 0.308 9326 0.27 5301 0.237

Discounted cash flows -4018 -35856 -2211 6027 13612 10169 13332 4614 3645 2987 2518 1256

Profitability index = PV of cash inflow/PV of cash outflow 58160/42085 P.I. = 1.38, which is Positive