Professional Documents
Culture Documents
I would like to express my gratitude to all my loved ones both home and outside,
who have supported and encouraged me through my summer training report
especially through my rough and tough times.
I also owe a special gratitude to GOD for the grace and ability to complete this
project. Finally, I would like to thank my supervisor (Mr. Dilip Kumar, Accounts
Manager), Lecturer Nancy Sahni for her patience, constructive advice and
assistance throughout the duration of my project.
Nivesh Maheshwari
August 05, 2009
TABLE OF CONTENTS
Acknowledgement…………………………………………………
List of Abbreviations………………………………………………………
Abstract……………………………………………………………
List of Tables………………………………………………
Chapter 1
A1.0 Introduction………………………………………………….
1.1 Research, purpose & justification…………………………..
1.2 Research focus & aims……………………………………..
1.3 Research methodology……………………………………...
A2.0 Review………………………………………………………
2.1 Capital budgeting……………………………………………
2.2 capital budgeting process……………………………………
2.2i Strategic planning…………………………………………..
ii Identification of investment opportunities………………….
iii Preliminary screening of project……………………………
iv Financial appraisal………………………………………….
v Qualitative factors in project evaluation…………………….
vi Accept/reject decision………………………………………
vii Implementation of monitoring………………………………
viii Post implementation audit…………………………………..
2.3 Importance of capital budgeting to org………………………
2.4 Theories of method of capital budgeting…………………….
2.5 Capital budgeting techniques…………………………………
2.5i The payback period………………………………………….
i(a Payback period in relation to the goals of the comp………..
(b Discounted payback period method…………………………
(c Advantages of payback period…………………………………
(d Disadvantages of payback period………………………………
2.5ii Net present value………………………………………………
(b Disadvantages of NPV…………………………………………
2.5iii Internal rate of return……………………………………………
(a Advantages of IRR………………………………………………
(b Disadvantages of IRR……………………………………………
Chapter 2
- Overview……………………………………………………….
- Profile…………………………………………………………..
- Growth, landmarks & milestones………………………………
- Product & service………………………………………………
- Operations………………………………………………………
Chapter 3
Chapter 4
- Analysis of data
- Limitation of the data analysis
Chapter 5
Conclusion
List Of Abbreviations
Table 2.1 Price comparison of treatment among Indian & other countries
Table 4.2 Extract from the data on the use of capital budgeting method in Sweden
Table 4.3 Data extracted from the survey conducted by John R. Harvey
Background & problem decision : The capital budgeting decision has been a very typical
issue in the sustenance of a company. Several companies have lost their identity or liquidated
due to wrong capital budgeting decision they made at a particular point of time. Based on these
common problems in industries and the effect of globalization on industries, it is important to use
effective method before making any investment decision.
Capital budgeting is extremely important because the decision made directly affects the
organization future growth. One of the traditional methods commonly used for capital investment
appraisals by some Organizations is the Payback Method, although this method is criticized by
academicians as it does not include the time value or future value of cash flow & do not measure
profitability. The wide acceptance of this method has called for a discussion that why this
method is still popularly used in the organizations. Here we will examine the reasons major
decision makers in organizations still use this method despite it’s critics objections.
PURPOSE : The aim of the research is to investigate the importance of the use of the Payback
method in Capital budgeting decisions in relation to other appraisal techniques used for capital
budgeting decision in organizations.
METHOD : The method used are the theories on the Payback period as it affects decision
making in the organization and past research work methods which companies used in appraising
investment, are used as Secondary Data in order to have a basic insight into the importance of the
Payback method in Capital budgeting. The theories help us to look, the methods that are often
used in the capital budgeting decision showing the advantages and disadvantages that are
associated with each method.
ANALYSIS: The analysis is done on the basis of various research works that have been done
on the payback period, and different data of the survey of the research is being used as secondary
data to obtain the result. From the analysis, the trend showed that the Payback method has been
commonly used in appraising capital budgeting decisions in various organizations.
CONCLUSION: It is clear from the research that the payback method is often majorly used
in the organizations allover the world despite its criticism by academicians, making inference
from the analysis of companies. The importance of the payback method, which includes but not
limited to its simplicity, liquidity and risk assessment have made the method to be gaining more
awareness in appraising investment opportunity by practicing manager.
KEY WORDS: Capital Budgeting, Payback Method, Payback Period, Net Present Value,
Internal Rate of Return.
Chapter 1
(A) 1.INTRODUCTION
The first chapter aims to introduce the reader to the research topic, background problem,
purpose and to the limitations that will be discussed.
1.0 INTRODUCTION
The payback method is commonly used for capital budgeting investments in companies despite
its theoretical deficiencies. The payback method is often used when aspects like Project time-risk
and Liquidity are focused and pure profit is single criterion. In practice, the maximum acceptable
payback period is chosen as fixed, for example, let say 6 years. In some cases, the limit value of
the payback period is chosen in relation to the economic life of the project or investment, for ex:
payback period could be shorter than the economic life of the project. Mostly the payback
method is used as a foremost device to sort out the obvious cases of profitable or unprofitable
investments, leaving the other means which are more advanced and time consuming methods
based on Discounted cash flows, such as the Internal rate of return(IRR) and net present
value(NPV) methods (Statman and Sepe 1984).
However there are various companies of considerable size, where the payback period is used as a
single criterion in investment evaluations. The use of Payback period method as the primary or
only method is often used in small & medium size companies. However it should be noted that
payback method can be developed to handle cases with varying cash flows, though some of its
simplicity is lost in process. This is a fact that the decision situation in the evaluation of capital
budgeting investment is typically uncertain considering the time pattern and the duration of cash
flows, the use of the simple and more robust payback method can be justified even if there will
be time for more advanced analyses methods.
Before, we move into more details of Payback method, lets have a clear understanding of capital
budgeting and its techniques:
One of the traditional methods commonly used for capital investment appraisals by some
Organizations is the Payback Method, although this method is criticized by academicians as it
does not include the time value or future value of cash flow & do not measure profitability. The
wide acceptance of this method has called for a discussion that why this method is still popularly
used in the organizations. Here we will examine the reasons major decision makers in
organizations still use this method despite its critics objections.
Could the reason be traced to the simplicity of this method in capital budgeting than other
investment appraisal method or could it be other reasons? Although modification of the Payback
method to consider the future cash flow which is discounted payback period (DPB) has been able
to reduce to some extent the deficiency of Payback Period, on which the company emphasize.
The objective of the research is to consider the reason for the use of the payback method in
making capital budget decision in organizations. Here we will consider in brief all investment
appraisal technique used for capital budgeting decision in organizations with major emphasize
on payback method. We will investigate the importance of use of payback method in capital
budgeting. We will also examine the importance of payback method in relation to simplicity,
manager incentive compensation and the size of the company.
2.0 Review
The literature review provides background explanations of the elements of the research work
such as Capital budgeting, capital budgeting process, theories of method of capital budgeting,
techniques of capital budgeting with emphasis on the payback method and the payback method
in relation to the goal function of the company. This is also an overview of literature and past
research work in related areas which provide a platform for the research.
Sizable, long term investments in tangible and intangible have long term consequences. An
investment today will determine the firm’s strategic position in coming years. These investments
also have a considerable impact on the future cash flows and risk associated with those cash
flows. Thus capital budgeting has a crucial impact on the firm’s performance and on the firm’s
success & failure. So capital budgeting decisions have a major effect on the value of the firm and
its shareholder wealth as whole. (Don Dayananda et al 2002)
Financial management largely concerns with financing, dividend and investment decisions of the
firm. Corporate finance theory has developed around a goal of maximizing the market value of
the firm to it shareholders, which is also known as shareholder wealth maximization. Financial
decision deal with the firm’s optimal capital structure in terms of debt & equity. Investment
decisions deal with the funds raised in financial market are employed in productive activities to
achieve the firm’s overall goal, or we should say, how much should be invested and what assets
should be invested in. (Don Dayananda et al 2002)
In reality, many firms have limited borrowing resources that should be allocated among the best
investment alternatives. Many people would argue that a company can issue an almost unlimited
amount of capital stock to raise capital. Increasing the number of shares of company stock will
serve only to distribute the same amount of equity among a greater number of shareholders. In
other words, as the number of shares of a company increases, the company ownership of
individual stockholder may proportionally decreases. The argument that capital is a limited
resource is true of any form of capital, whether debt or equity or retained earnings, accounts
payable or notes payable and so on. Even the best-known firm in an industry increase its
borrowings up to a certain limit. Once this point has reached, the firm will either be denied more
credit or be charged a higher interest rate. Faced with limited sources of capital, management
should carefully decide whether a particular project is economically acceptable. In the case of
more than one project, management must identify the projects that will contribute most to profits
and to the value of the firm. This is the basis of Capital Budgeting.
2.2 Capital Budgeting Process
There are different sequential stages in the capital budgeting process. The capital budgeting
process is a multi-faceted activity. The sequential stages of a capital budgeting process can be
depicted in a simple flow chart below –
Corporate Goal
↓
Strategic Planning
↓
Investment Opportunities
↓
Preliminary Screening
↓
Financial appraisal, Quantitative Analysis,
Project evaluation or project analysis
↓
Qualitative factors, judgments and gut feelings
↓ ↓
Accept Reject
↓
Implementation
↓
Facilitation, monitoring, control & review
↓
Continue, expand or abandon project
↓
Post implementation project
discussion and consultation. At times, management may be able to predict the impact of some of
the issues through the estimation of monetary cost or benefits of the project and incorporating
those values in cash flows.
When large amount of funds are raised, organizations must pay close attention to the financial
markets because the cost of capital is directly related to the current rate of interest. The need for
relevant information and analysis of capital budgeting alternatives has inspired in making the
“best” allocation of resources. The earliest models were the payback method, which in simple
terms determine the length of time required to recover its cash outlay, & the return on investment
model, which evaluates the project based on standard historical cost accounting estimates.
The next concept is the time value of money to obtain a superior measure of the cost/benefit
trade-off of potential projects.
Capital budgeting decisions are extremely important and complex and have inspired many
research studies in the past. For example: in an in-depth study of the capital budgeting projects of
12 large manufacturing firms (Ross 1972), that although techniques that incorporated discounted
cash flow were used to some extent, firms relied so much on the simplistic payback model.
Also, when discounted cash flow techniques were used, they were often simplified. Ex: some
firms’ simplifying assumptions include the use of the same economic life for all projects even
though the actual life of individual projects might be different. (Ross 1986)
In 1965, J. William Petty, David P. Scott, and Monroe M. Bird examined responses from 109
controllers of 1971 fortune 500 firms concerning the techniques their companies use to evaluate
new and existing product lines. They found that internal rate of return was the method preferred
for evaluating all the projects. (Petty 1975)
Laurence G. Gitman and John R. Forrester Jr. analyzed the responses from 110 firms who replied
to their 1977 survey of the 6oo companies that Forbes reported as having a greatest stock price
growth over the 1971-1979 period. The survey containing questions related to capital budgeting
techniques, the division of responsibility, the cut-off rate and the methods used to assess risk.
They found that the discounted cash flow techniques were the most popular methods for
evaluating projects. However many firms still used the payback method as a backup. (Gitman
1977)
In 1981, Suk H. Kim and Edward J. Farragher surveyed the 1979 Fortune 100 Chief financial
officers about their usage of techniques for evaluating capital budgeting projects. They found
majority of firms relied on a discounted cash flow method, as the primary and the payback as the
secondary method. (Suk 1981)
It should be noted that the required payback period sets the barrier for the project acceptance. It
often appears that in many cases the determination of the required payback period is based on
subjective assessment, taking into past account experiences and the level of project risk. The
payback period has shown to be an important, popular, primary and traditional method in the
developed nations like the UK and USA (Pike 1985)
Typically, the payback period expected by the managers appears to be in the range of 2 to 4
years. This method by definition, only takes into account project returns upto the payback period.
However, for certain projects which are long term by nature and whose benefits will accrue in
the future and beyond the normal payback may not be accepted based on the calculation used by
the payback method, although such projects may actually be vital for the long term success of the
business. It is important to use the payback method more as a measure of project liquidity rather
than project profitability.
The payback method is commonly used for appraisal of capital investments in companies despite
of its deficiencies and in some it is used as a measure of attractiveness of capital investments.
Although the use of this method as a single criterion has decreased over time, it is used as a
secondary measure increased over time. (Segelod 1995) This method is commonly used in pure
profit evaluations as a single criterion and also sometimes used when focusing on aspects such as
liquidity and project time risk. The obvious case of profitable & unprofitable investments are
sorted out, when the payback method is used as the first screening device, leaving only the
investments that have survived the screening process in the middle group to be scrutinized by
means of advanced and more time consuming calculation methods based on discounted cash
flows (DCF), such as the internal rate of return (IRR) and net present value (NPV) methods.
However, there are many companies where the payback period is used as a single criterion in
investment evaluations. (Blatt 1979) Most importantly the overall conclusion seems to reveal
that the payback method is much in use by companies for investment appraisals and it is
therefore necessary to reduce some of its deficiencies.
The major deficiencies of the payback method are that it ignores cash flows after the payback
period and it does not measure the time value of money in correct manner. To reduce these
deficiencies the maximum acceptable payback period should be chosen as a fixed value, say 3
yrs and in some cases the limit value of the payback period has been related to the economic life
of the investment, for ex: a payback period that is shorter than half the economic life. When these
two rules of thumb are combined, a more theoretically correct evaluation of investments can be
achieved and such a combined payback method is based on assumption of constant yearly cash
flows. The payback time limit has been criticized by theorists because it ignores profits which
may accrue in the subsequent life of the project. The criticism is unjust, the practical men are
completely right. In a riskless world future profits are certain. But in the real world, the
imposition of payback time limit is a necessary protection for the survival of the planning
manager. Infact payback time limit is used by every responsible manager.
2.5(i) a. Payback Method in Relation to the Goals of the Company
In the payback method companies will go ahead with an investment if the return of the
investment is higher or larger than the capital cost. Generally, most companies go ahead with an
investment decision if the following conditions hold true.
1) NPV > 0
This means that for a good investment decision to be made, the net present value must be
greater than zero.
method has been employed because some practicing manager believe that it is the approximation
of internal rate of return and that it also support the goal function of the company. This is also
one of the reasons the payback method is still relevant in industries.
Cost of Project
Payback Period =
Annual Cash Flow
In payback method, the projects with shorter payback periods rank higher than those with longer
paybacks. The reason is that projects with shorter period are more liquid and thereby less risky
i.e. they allow the organizations to recoup the investment sooner, so that the money can be
invested elsewhere. Also in shorter period there is little or no chance that market conditions,
interest rates, the economy, or other factors affecting the proposed project will drastically
change.
Note that higher NPVs are more desirable. The specific decision rule for NPV is as follow:
NPV < 0, reject project
NPV >0, accept project
Overview
Medical industry is actually thousand of years old. India is a recent entrant in this industry. As
per research reports, approx.1,50,000 medical tourists came to India in 2002, according to
McKinsey and the Confederation of Indian Industry. India has number of hospitals offering
world class treatments in nearly every medical sector – Cardiology & cardiothoracic, joint
replacement, orthopedic surgery, transplants and neurology and many more…. India has a large
pool of doctors (approx. 6,00,000).
In India, complicated surgical procedures are being done at 1/10 th the cost as compare to
developed countries like U.K, Canada & Europe.
Price Comparison of India, U.S. & U.K
TREATMENT APPROX. Cost In Cost In Other
INDIA ($) Major Healthcare
Destination ($)
Open Heart Surgery 4,500 >18,000
Neurosurgery with 6,500 >21,000
Hypothermia
Complex Spine surgery with 4,300 >13,000
implants
Simple spine surgery 2,100 6,500
Simple Brain tumor
-Biopsy 1,000 >4,300
-Surgery 4,300 >10,000
PROFILE
Since 1985, BL has been marketing a wide range of Cardiovascular equipment and critical care
devices in India. Over the past 20 years, company has amassed a vast amount of experience. It’s
that experience combined with leading edge technology which has allowed company to develop
such high quality products. The objective of this effort has been, not only superior products but
competitive prices. BL established it’s manufacturing facility in 1999 with a vision to be an
innovative and competitive world class Medical Device Manufacturer emphasing on Quality,
customization and contract manufacturing.
Growth, Landmarks & Milestones
OPERATIONS
• Manufacturing unit covers a total of approx. 30,000sq. ft
• With a certified class 10,000 clean room
• In house ETO sterilizers
• Fully integrated microbiology lab
• ISO 9001/ ISO13485 certified facility
• CE marked products
Chapter 3
they often lack the requirements to be able to source for fund. It cannot be neglected that the
complexities of the other investment appraisal methods always scare the small company
managers. Basically if the small companies were involved in regular capital projects they might
develop familiarity with complex methods.
Research has been conducted on foreign countries companies to see the most used capital
budgeting methods used by managers. So for the purpose of this research, we will limit ourselves
to the published papers in United Kingdom & Sweden, which relate to the survey conducted on
companies in these two countries. The report of the survey of foreign countries is as follow:
The research done by Carsberg & Hope shows that 59.2% of the respondent used traditional
payback method, while 39.8% used the discounted payback period. The survey also shows that
the companies that use only one single method, the payback period was the most important
method used. The survey of Pike and Sharp also shows that the popularity of the payback
period in capital budgeting decision is increasing despite it’s critics objections. It was evidence
that 92% of the firms still used the Payback method. Drury et al showed that PB was the most
used capital budgeting technique. This analysis also reveals that the use of payback method in
United Kingdom is important in capital budgeting decisions. Though many new techniques has
been introduced, but the practicing managers still find it comfortable to use Payback method.
Gert Sandhal and Stefan Sjogren conducted a research on the use of various capital budgeting
techniques and the extracts are as follows:
Capital Budgeting Techniques % using the various budgeting
techniques(%)
Payback 78.1
NPV 52.3
Expenses Calculation 30.5
IRR 22.7
Accounting Rate of Return 21.1
Annuity 10.2
All DCF 64.8
Others 6.3
Table 4.2: Extract from the data on the use of capital budgeting method in Sweden
The conclusion drawn from the analysis is that many companies use the payback method. So we
can say that shareholder maximization policy was not pursued by the company’s management in
Sweden. The major reason for the increase in the use of payback period was focused on the
liquidity rather than profitability, and we can say that companies are risk averse.
American Companies
A research was conducted by some of American companies on the development of payback
method and the companies that used this method. The analysis of Fremgen(1973) shows that
67% of all respondents used the payback method. The analysis done by Petty et al(1975) also
shows that the payback method was ranked first by 12% of the respondents and second by 44%.
So the conclusion of the research is that the payback method is often used than any other method.
Hendricks (1988) shows in his analysis that 29% used the payback method as their primary
evaluation technique when considering factory automation projects, while 48% use it as
secondary technique, but he conclude that the payback method should be used as secondary
evaluation measure.
Basically, all the survey conducted shows that the payback method was commonly used in the
American companies either as primary method or secondary method. It also shows that the trend
of the use of payback period is growing.
One more research survey was conducted by John R. Harvey. The following data was extracted
from the survey of the questionnaire that asks – ‘How does your firm use the following technique
when deciding investment?’
The survey shows that majority of the firms used the internal rate of return, while a noticeable
percentage of the firms used the payback method. But if the two payback period is combined
(Traditional payback and Discounted payback), it will indicate that the number of the firms that
used the payback method is of the highest in the survey. So we can conclude that the trend of the
popularity of the payback method is still high in American firms, either as primary or secondary
tool.
I had asked from the competitors of BL Lifesciences a question through mail that – ‘Which are
the primary capital budgeting methods used in evaluating the investments by your company?’
your company?
Internal rate of return
Net present value
Profitability index
Accounting payback
Present value payback
Adjusted internal rate of return
Other methods
TOTAL
Table 4.4: Report of question asked from the competitors
But the companies are not ready to provide the data.
John Graham (2000) shows in his survey on American firms how the capital budgeting decision
is influenced by the size of the company. The ranking was done by respondents who were asked
to score how frequently they used the different capital budgeting techniques on a scale of 0 to 4,
(0 meaning ‘Never’ and 4 meaning ‘Always’). The data is not available, but the analysis of the
survey showed that small companies used the payback period more than the large companies.
Also the discounted payback period follows the same trend. The reason large companies mostly
use NPV and IRR is because they always require more time to make investment than small
companies and they use complex method through regular use of the method on different capital
investments at different times, while small companies mostly depend on the payback method
because of its simplicity and risk measurement incorporated in it.
Analysis of Data
The research survey was chosen from two different countries – Sweden and United Kingdom.
The data used involve the survey on the use of the payback method for different years, which
shows that the PB method was being used with the highest rate as 92% and lowest as 59%. The
lowest was in the survey conducted in 1976. Evidence from the reports has shown that
manufacturing companies often used the payback period, compared to other sector. The issue of
the relevance of the use of the payback method is motivated by the importance of the payback
method which includes the size of the business, the goal function and basis of using simple
appraisal method. While the simplicity and the size of the company can be traced to the use of
the payback method by financial managers, which is due to the fact that they always want to
avoid the use of complex method and also lack of sufficient funds.
I have been able to find out why payback method is often used in different countries based on
empirical analysis carried out by researchers in that field and also why some particular countries
prefer payback method, which primarily based on such kind of industries that run the economy,
ex: manufacturing industry. It is evident that the manufacturing industries often use the payback
period in analyzing their investment opportunities. The major reason is that manufacturing
company often embark on capital projects and availability of liquidity is highly important in
executing such projects, which have made them to always embark on effective working capital
management. Another thing is that any manufacturing company will not want to hold down the
capital for long, because a cash gained today is certain than expected cash in future. Considering
the secondary data, the attitude of the finance manager can be traced and how they intend to raise
funds to finance their business. They use the payback method because of the availability of the
internal funding. Also the simplicity of the payback period has motivated the use of the method.
Managers normally want to use a very simple formula to make their investment decision.
Although developed countries are now more interested in using complex formulas like real
option approach, NPV, IRR but the conclusion is that the simplicity of the payback method it to
be easily understood and has motivated the general use of the payback method.
The risk taking of the finance manager also indicate why the payback method is often used. The
consciousness of managers has made payback a better tool for investment appraisal. The
manager generally wants to embark on those projects which will generate immediate cash flows.
The major reason for this kind of attitude is that most businesses are run on loan and overdraft.
The analysis shows that size of the company also motivated the use of payback method. Small
companies survive mainly on investment that can generate immediate liquidity and the major
investment method that support this idea is the payback method and to encourage small
companies banks are providing loans at reduce interest rate. Managers are biased on the
investments that generate immediate cash flows, because their bonuses are attached with it. This
can be viewed that despite the awareness of other appraisal methods managers are interested in
using payback method.
In conclusion, putting all these analyses together, it is revealed that companies prefer the use of
the payback method.
Chapter 5
CONCLUSION
The importance of using investment appraisal method in capital budgeting has gained a wide
acceptance in the industries. Different method has been employed, but the significant of using
the payback method has been increasing every time despite its critics. The reason why many of
the managers still prefer using the payback method can be traced to different reasons like the
simplicity of the method. Managers try to avoid other appraisal methods because of the
complexity that is built in it. The manager’s incentives packages has been another reason why
managers has retain this old method in practice, managers will always want to use appraisal
method that will support their incentive plan which it always link to accounting earning. The
managers pursuing of the management objective against the shareholders, has always been traced
to employment contract which tied incentive to earning which is also link to the cash flow. The
payback method is the most effective method to decide this type of investment that will generate
quick cash flow.
Actually, the idea that the payback method does not measure profitability is far from the truth,
the method does measure profitability. The payback method is the reciprocal of internal rate of
return, and IRR is used to measure the profitability of an investment through the decision of
higher IRR to cost of capital of the company for single project, or the highest in of the IRR in
case of many projects. So we can conclude that the payback method indirectly can measure the
profitability of investment so also its profitability.
The important of risk and the uncertainty that the payback period method has included has really
been of such a great advantage for the method. Managers will always want to guide against the
uncertainty in the future cash flow, which may be due to new entry into the industry, customer
dissatisfaction, government legislature and many unprepared reasons for that. The lengthy the
time to generate the cash flow the risk is the investment. So the managers prefer to use method
like the payback method to select a project that will have shorter payback period in order to
minimize the risk.
The use of the payback method will always have its relevance in the corporate organization for
evaluating of capital project because of its major advantages that have been shown in this
project. All managers should try to involve the use of another investment method as
complementary method in order to make a sound investment decision out of the available
options.
Reference
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