INTRODUCTION TO PROJECT AT ECIL CAPITAL BUDETING

Introduction to project:
The term Capital Budgeting refers to long term planning for proposed capital outlay and their Financing . It includes raising long-term funds and their utilization. It may be defined as a firms formal process of acquisition and investment of capital. Capital budgeting decisions are one of the most important decisions, which affect both long and short run existence of a business. It has the major impact on the shareholders wealth in the long run. The project work has recognized the above two phases and conducted this study. The study aims at identifying the extent to which capital budgeting techniques and its related practices are used by the ECIL, and identifying reasonable justifications behind the use of such pattern. To evaluate the above, techniques such as PBP, ARR, NPV, PI, and IRR are used. The study also shows the practices related to capital budgeting techniques such as: cost of capital estimation methods, risk analysis techniques, and cash flow forecasting techniques, which are not widely used by the ECIL within the domination of subjective judgment.

The term Capital Budgeting refers to long term planning for proposed capital outlay and their financing. It includes raising long-term funds and their utilization. It

may be defined as a firms formal process of acquisition and investment of capital. Capital Budgeting may also be defined as The decision making process by which a firm evaluates the purchase of major fixed assets. It involves firms decision to invest its current funds for addition, disposition, modification and replacement of fixed assets. It deals exclusively with investment proposals, which an essentially long term projects and is concerned with the allocation of firms scarce financial resources among the available market opportunities. Some of the examples of Capital Expenditure are Cost of acquisition of permanent assets like land and buildings. Cost of addition, expansion, improvement or alteration in the fixed assets. R&D project cost, etc. ECIL was setup under the Department of Atomic Energy, with a view to generate a strong indigenous capability in the field of professional grade electronics. Many industries these days require concepts of electronics in their production process. Electronics is assuming increasing importance in the monitoring and control of production of many industries like Engineering, Chemical and Metallurgical industries. In India, the electronics industry has growth in many strides both in public and private sectors. A part from this, in the field of industrial electronics , the government of India has taken initiations in 1960s ton set up a industrial units in public sectors in order to produce industrial electronics system with indigenous technology to meet the nations requirement in static areas. Electronics occupies a key position in modern science and technology. It has a vital role to play in the field of Atomic Energy, communication, defense education, Space technology and entertainment. Because

of its dynamic character, its pervasive nature and its significant impact on science, industry and society, Electronics is today in the vanguard of the technology process. Technology process is both very rapid in this field. An intensive promotional effort to both production and research and development is therefore essential to ensure a rapid growth in this field. In this direction, the government of India and its agencies with the aim of developing and promoting industrial Electronics system with indigenous know-how to attain Self-sufficiency in Atomic energy programmed started ELECTRONICS CORPORATION OF INDIA LIMITED on 11th April 1967.

In any growing concern, capital budgeting is more or less a continuous process and it is carried out by different functional areas of management such as production, marketing, engineering, financial management etc. All the relevant functional departments play a crucial role in the capital budgeting decision process of any organization, yet for the time being, only the financial aspects of capital budgeting decision are considered to discuss. The role of a finance manager in the capital budgeting basically lies in the process of critically & in-depth analysis and evaluation of various alternative proposals, then to select one out of these alternatives. As already stated, the basic objectives of financial management is to maximize the wealth of the share holders, therefore the objectives of capital budgeting is to select those long term investment projects that are expected to make maximum contribution to the wealth of the shareholders in the long run.

Objectives of project:
To study the capital budgeting techniques and their related practices that used by ECIL. To study the reasons behind the selection of existing capital budgeting techniques by the ECIL rather than others. To evaluate the effect of the capital budgeting technique used on the ECILs performance. To measure the present value of rupee invested by ECIL. To understand an item wise study of the ECIL of financial performance of the company. To summarize and make suggestions if any, for improving the financial positions of ECIL. To study the financial aspects for future expansion of ECIL. To offer suggestion if required for the better investment proposal to ECIL.

Scope of project:
The scope of this project will not only be limited to understanding the finacial capital budgeting practices employed in ECIL , but it will also analyze the finacial decisions taken by these units using standed capital techniques there by analyzing the various projects undertaken by the ECIL. 1. To know the how money is acquired and from what sources.

2. In what way individual capital project alternatives are identified and evaluated by ECIL.

3. How minimum requirements of acceptability are set. 4. How final project selections are made by ECIL.

Methodology:
To achieve a fore said objective the following methodology has been adopted. The information for this report has been collected through the primary and secondary sources. PRIMARY SOURCES: It is also called as first handed information the data is collected through the observation in the organization and interviews with officials. Information is collected by circulating questionnaires to the officials of the finance department. A part from these some information is collected through the personal interviews and suggestions collected from required personals.

SECONDARY SOURCES: These secondary data is the existing data which is collected by others that is sources are financial journals, annual reports of the ECIL or ECIL website, and other concerned publications.

Limitations of project:
Lack of time is another limiting factor the schedule period 6 weeks are not sufficient to make the study independently regarding Capital budgeting in ECIL.

The busy schedule of the officials in the ECIL is another Limiting factor. Due to the busy schedule of officials may restrict me in collecting the complete information about organization.

Availability of confidential financial data is a constraint There is no scope of gathering current information, as the auditing has not been done by the time of the project work.

The study is carried basing on the information and documents provided by the organization with the various employees and based on the interaction with the various employees of the respective departments.

COMPANY PROFILE
ABOUT ECIL A. ECIL HISTORY

"Let us work up the embers of national pride latent in all of us and build up our morale so that we can confidently aim high and achieve greater goals"

Dr. A.S.Rao, Founder MD of ECIL Ayyagari Sambasiva Rao, the founder managing director of the Electronics Corporation of India Limited (ECIL), died on Friday at Nims Hospital, after a prolonged illness, family sources said. He was 89. He is survived by his wife, four sons and three daughters. A.S.Rao, was born in Mogallu of West Godavari district in the year 1914, obtained his engineering degree from Stanford University in 1947 and joined the Department of Atomic Energy as a nuclear physicist to work with the likes of Homi J Bhabha. He was the director of radiation health protection and electronics groups at Bhabha Atomic Research Centre (Barc) and later played a key role in setting up ECIL in the city in 1967 when the DAE decided to go commercial in its electronics research.

ECIL was setup under the Department of Atomic Energy on 11th April, 1967 with a view to generate a strong indigenous capability in the field of professional grade electronics. The initial accent was on total self-reliance and ECIL was engaged in the Design, Development, 7

Manufacture and Marketing of several products with emphasis on three technology lines viz. Computers, Control Systems and Communications. Over the years, ECIL pioneered the development of various complex electronics products without any external technological help and scored several 'firsts' in these fields prominent among them being country's
First Digital Computer First Solid State TV First Control & Instrumentation of Nuclear Power Plants First Earth Station Antenna First Computerized Operator Information System First Radiation Monitoring & Detection Systems First Automatic Message Switching Systems First Operation & Maintenance Center For E-108 Exchange

The company played a very significant role in the training and growth of high caliber technical and managerial manpower especially in the fields of Computers and Information Technology. Though the initial thrust was on meeting the Control & Instrumentation requirements of the Nuclear Power Program, the expanded scope of self-reliance pursued by ECIL enabled the company to develop various products to cater to the needs of Defense, Civil Aviation, Information & Broadcasting, Telecommunications, Insurance, Banking, Police, and Para-Military Forces, Oil & Gas, Power, Space Education, Health, Agriculture, Steel and Coal sectors and various user departments in the Government domain. ECIL thus evolved as a multi-product company serving multiple sectors of Indian economy with emphasis on import of country substitution and development of products & services that are of economic and strategic significance to the country.

A. VISION, MISSION & OBJECTIVES a. Vision To contribute to the country in achieving self reliance in strategic electronics.

b. Mission ECIL's mission is to consolidate its status as a valued national asset in the area of strategic electronics with specific focus on Atomic Energy, Defence, of strategic national importance.

Security and such critical sectors

c. Objectives To continue services to the country's needs for the peaceful uses Atomic Energy. Special and Strategic requirements of Defense and Space, Electronics Security Systems and Support for Civil Aviation sector. To establish newer technology products such as Container Scanning Systems and Explosive Detectors. To explore new avenues of business and work for growth in strategic sectors in addition to working for realizing technological solutions for the benefit of society in areas like Agriculture, Education, Health, Power, Transportation, Food, Disaster Management etc. To progressively improve shareholder value of the company.

To strengthen the technology base, enhance skill base and ensure succession planning in the company.

To re-engineer the company to become nationally and internationally competitive by paying particular attention to delivery, cost and quality in all its activities. To consciously work for finding export markets for the company's

products. A. BOARD OF DIRECTORS In terms of Sec 617 of the Companies Act, 1956, ECIL is a Government Company. Presently, the entire paid up capital of the Company is held by nominees. The Board,

the President of India, including 3 shares held by his

as on 31.03.2010 comprises of nine Directors - Chairman & Managing Director, three Whole-time Director and five Non-Executive Directors. The Board meets at regular intervals and is responsible for the proper direction and management of the Company.

B. JOINT VENTURES Electronics Corporation of India Limited (ECIL) entered into a collaboration with OSI Systems Inc. (www.osi-systems.com) and set up a Joint Venture "ECIL-RAPISCAN LIMITED". This Joint Venture manufacture the equipments manufactured by

RAPISCAN, U.K and U.S.A with the same state of art Technology. Requisite Technology is supplied by RAPISCAN and the final product is manufactured at ECIL facility. ECIL-RAPISCAN have supplied many X-RAY BAGGAGE/CARGO INSPECTION SYSTEMS (XBIS) of this Technology to high profile Indian Customers like Customs, Airports Authority, Parliament House, Defence, Air lines, State Police etc. ECIL-RAPISCAN exported XBIS to Tribhuvan International Airport, Kathmandu,

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Nepal, X-Ray generators to USA and Malaysia. ECIL-RAPISCAN continue to receive large number of orders from existing as well as new customers. This is basically due to our strength in Latest International Technology, Quality Assurance, The exhaustive spares inventory to meet the spares requirement. Strong Manufacturing and After Sales Service set up in 10 different centers located all over India.

VIRTICLES
a. OVERVIEW ECIL, established in 1967 under the Department of Atomic Energy had the primary objective of productionising the products developed at BARC, Mumbai in order to support the Countrys Nuclear Power and other Atomic Energy Programmes. Concurrently, it has endeavored to create a strong indigenous / production base in the Country for professional grade electronics spanning from small passive components to large and complex computer based systems. Though the initial thrust was on meeting the C&I requirements of NPP, the expanded scope of self-reliance pursued by the Company enabled it to develop various special purpose products and systems to cater to the needs of Defence, Civil Aviation, Information & Broadcasting, Telecommunications, Space, Security, Oil & Ga Power, Education and several other user departments in the Government domain s.

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The Company has thus evolved over the years as a multi-product Company serving multiple sectors of Indian economy with emphasis on Import Substitution and development of products and services that are of economic and strategic importance to the Country spanning the strategic sectors of Atomic Energy, Defence, Space, Security, IT & eGovernance. b. AEROSPACE ECIL Played a pioneering role in supporting the ambitious programs of ISRO. ECILs Antenna Products Division has its lineage that dates back to 1968, when ARVI Satellite Communication (ASCOM) group was constituted by drawing experts from various organizations to execute the design, develop, manufacture, install, test and commission the countrys 1st INTELSAT Class-A Earth Station Antenna at ARVI, Pune for providing the gateway for overseas communications for the traffic originating around Mumbai region. ASCOM Group has designed the 97ft Earth Station Antenna with a king post Elevation over Azimuth pedestal, servo system and antenna control unit. The station was installed and commissioneds in 1968. The Feed was imported. The control and servo system was developed by BARC. After the completion of the above project, Microwave Antenna System Engineers Group {MASEG (ISRO)} was formed to further the R&D activities on Microwave and satellite earth station antennas for providing communication facilities in the country. The MASEG group got merged with ECIL in 1972, and Antenna Products Division

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was formed in ECIL with the aim of taking up commercial production of Microwave and Earth station antennas. In 1975, ECIL delivered another 97ft Earth Station Antenna with king post pedestal (similar to ARVI Antenna) at Lachhiwala in Dehradun for providing the International gateway to the traffic originating from Delhi region. The expertise gained during the execution of above two projects has firmed up the knowledge base at ECIL to take up design and production of various types of communication antennas. Communication antennas per se can broadly be classified into 3 types.

1. For Terrestrial Communication a. Troposcatter antennas b. Line of Sight (LoS ) antennas 2. for Satellite Communication c. Ground/Earth Station Antennas

Troposcatter Antennas : Large Bill Board antennas focus a high power radio beam at the troposphere mid way between the transmitter and receiver. A certain portion of the signal is refracted and received at a similar antenna at the receiving station.
Earth Station Antennas : On the earth station front, ECIL continued its progress and delivered and installed 3 Nos. of 8m earth station antennas at Port Blair, Kavaretti and Aizwal with indigenous design to bring the far flung areas of Northeast into countrys telecom network.

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When the INSAT programme was initiated, ECIL developed and delivered 2 Nos. of reflectors required for 14m diameter Antennas for TTC application at MCF, Hassan with control system by jointly working with BARC. During the same period, ECIL also successfully absorbed the limited know-how from NEC, Japan in productionising medium sized Earth station antennas of diameter 11M, 7.5M and 4.5M.Several of these antennas were delivered to various users like DOT, ONGC, NTPC and MCF. In 1987, ECIL successfully designed, developed,

manufactured and installed the 11M diameter full motion antenna for TTC application at MCF, Hassan. The 32m diameter Wheel & Track antenna was installed at ARVI, Pune which was executed jointly in collaboration with NEC, Japan. During this period, ECIL acquired know-how for the indigenous realization of a 32M Wheel & Track antenna employing the beam wave guide feed from NEC, Japan. A full fledged Design Center exists, where more than 30 engineers work in the Antenna design involving various disciplines of Structural, Mechanical, Microwave and Control systems aspects. The center is well equipped with various software like NASTRAN, PATRAN, SIMULINK, Auto CAD, CATIA for Structural and Mechanical designs, WASPNET for RF design etc. to provide cost effective solutions, many pre and post processing support routines for verifying design compliance with regard to surface accuracy, pointing error, system performance predictions, both for

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structural and RF are available in the design center.

C.DEFENCE ECIL has played a pioneering role in spurring the growth of Electronics Industry in the country. Spanning miniature components to mammoth systems and encompassing control, communication & computer technologies, today, ECIL is a multi-product, multi disciplinary and multi technology organization providing cutting-edge technology solutions in the strategic areas of Atomic Energy, Defence, Space and Electronic Security systems. Multidisciplinary capability ECILs expertise harnesses electronics & communication technologies to meet Indias defence needs on land, sea and air. Some of the areas in which ECIL has contributed significantly to the Defence Sector are:

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1. Secure and Jam- resistant communications 2. Electronic Warfare Systems & Simulators 3. COMINT & Interception Systems 4. Antenna, Satellite Communication Systems (SATCOM Systems), networks 5. Stabilized platforms for air-borne Radars 6. CI systems & Missile support Systems 7. Encryption and Secrecy Systems 8. Electronic Fuzes for artillery and Navy 9. Precision Electro-Mechanical components, sensors & Inertial Navigation Systems

A. NUCLEAR Electronics Corporation of India was created essentially to meet the Control & Instrumentation requirements of the Nuclear Power Programme of India by productionising the R&D efforts in the Bhabha Atomic Research Centre (BARC). Right from its inception in 1967, it has been totally supporting all the plans, programmes and endeavours of the Department of Atomic Energy in the chosen areas of Electronics, Instrumentation, IT and Security. ECIL significantly facilitated Indias Nuclear Energy Programme to reach greater heights. Today the company is proud to claim that all the operating Nuclear Power Plants in the country are supported by the Instrumentation and Control Systems engineered & manufactured by ECIL for the safe and reliable operation of the Reactors. These offerings cover diverse Reactor technologies with the I & C

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footprints in the entire Nuclear Fuel Cycle, starting from Ore extraction to the Spent-fuel management. It is a matter of pride that the company made the country self-sufficient in this vital area of electronics, which is significant in the context of technology denials clamped on the nation from time to time. ECIL thus contributed towards creating a strong and dependable indigenous Technology base in the Nuclear Power area.

B. I.T AND eGOV The first age : Mainframe Computing A computer system consists of 3 basic functions presentation, which manages the way users interact with the system; application, which supports the logic of what to do with the data and data management, which supports the storage of information. The second age : Client Server Computing New applications with graphics and user interfaces required decentralized processing at the user end. Client Server computing distributed the work required to perform these functions among two or more computers. A server is akin to the mainframe, in that it coordinates activities of all clients and handles communications, but the processing is done largely at each clients end. The Third age : Network Centric Computing We are now moving to a environment where connectivity between computers and even other devices has pervaded computing. The network was born out of the C/S concept it is now possible to connect computers of different makes and yet enable them to work together. The popularity of the largest network of them all, the Internet has established Network Centric computing as the next wave in computing.

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With a totally different scenario in the country in Information Technology, at present ECIL is focusing on applications in the following technologies: 3-tier architecture Web technologies ERP Data Warehousing and Data Mining Network Security e-Governance ECIL apart from its own internal R&D efforts has also been

acquiring know-how from various R&D establishments and outsourcing R&D work to some of the academic institutions.

CAREERS
a. TECHNICAL EXPERTS Right from inception, ECIL has been a Technology-driven Company. Starting with supporting the Country's Atomic Energy Programme, the Company pioneered a number of technologies and introduced a number of products for the first time in the Country. In the formative years, ECIL was able to attract the best brain to facilitate the pursuit of its endeavors.

The global village creators aftermath of liberalization, privatization and globalization attracted many well trained technologists and managers from the Company and as a result the reservoir of the competencies started depleting.

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Attrition has become global phenomena and the worst hit is the Electronics & IT field. Customer requirements are also changing dynamically and many of them, especially in the areas of Strategic Electronics, are expecting Total solutions. In a highly competitive market environment, with outsourcing as a business inevitability, every operation needs to hire the services of Experts in select areas. Today, atleast a multi-disciplinary organization like ECIL, it is very difficult, if not impossible to have the required expertise within the organization. The age of the organization and also the retirement profile also aggravates the situation.

Therefore, top management of the Company decided to hire the services of experts in the areas of relevance to the Company, to supplement the efforts of the Project Teams in the Strategic Business Units and other service functions. The required expertise is sought in those areas, which are depleted due to superannuation and some specialized areas which are non-existent to required levels within Company and also essential. As a Policy, ECIL appoints experts in the following levels: Senior Technical Experts Technical Experts

b. HUMAN RESOURCE ECIL was setup under the Department of Atomic Energy in the year 1967 with a view to generating a strong indigenous capability in the field of professional grade electronics. The present employee strength of the company is about 5100 (3000 officers and 2100 workmen). The company, which started as a manufacturing company wedded to indigenization and self-reliance had a majority of human

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resources deployed in manufacturing operations. The post-liberalization era posed a number of challenges to the company especially in the area of HR, Due to the right sizing and restructuring compelled by the market forces. With the help of Government of India, the company offered attractive Voluntary Retirement schemes to the employees which invited reasonable response. The company has also intiated a number of programmes to retrain and redeploy the existing manpower so as to ensure gainful employment and achievement of targets.

c. OUR CULTURE We Embrace diversity, Diversity is a cornerstone of our culture. Being an organization with a global foot print, you will notice our employees come from the most diverse of backgrounds: be it location, race, educational background, faith, all working towards one common goal. This diversity manifests to boundless energy, which percolates to all levels across the organization.

MANAGEMENT SYSTEM

a. QUALITY MANAGEMENT SYSTEM Standards And Quality Assurance Group (SQAG) at ECIL is a Corporate Quality Assurance Service Facility. While the individual business groups have their own Quality Control / Quality Assurance sections, this corporate facility caters to the common requirements. Faculty for training personnel in Product divisions on ISO awareness and on Internal Quality Audits, Helping in developing their quality system documentation, planning, conducting and managing internal quality audits

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and reporting of audit results. A well equipped and NABL accredited Calibration and Measurements Laboratory equipped with standards traceable to National Standards and catering to the calibration requirements of the Product divisions in the field of electro-technical measurements. An Environmental Test laboratory meant for both component / unit / system evaluation. It has Dry / Damp heat chambers, Walk in chambers, Dust / Rain chambers, Vibration and bump test facilities. A Technical information Centre.

Equipped with such facilities with service as its motto SQAG has adapted and declared its quality policy as "To render reliable and professional services in the fields of Quality Assurance, Testing and Calibration to the satisfaction of its CUSTOMERS." Standards and Quality Assurance Group (SQAG) is a Corporate Services Group catering to the needs of all Production divisions in the following areas. 1. Standards 2. Quality Assurance 3. Environmental and Calibration Services 4. Industrial Engineering a. ENVIRONMENT MANAGEMENT SYSTEM In recent times, environmental concern is increasing among Public as they are facing air pollution, traffic congestion, and land pollution due to dumping the waste (including electronic waste) in open lands without proper disposal. This feeling is predominantly high at national and international level. All

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environmental Scientists are alerting the nations from time to time by bringing awareness and cautioning the ecological imbalances in the world. In this direction, all nations have responded in their own way. As usual, Internal Organization for Standardization (ISO) also showed their concern by constituting a Technical Committee and assigned the responsibility of formulating a standard with a view to certifying the organizations against that standard. This certification results in practical realization of prevention of pollution and conservation of energy. To this effect, ISO brought out a standard on Environmental Management System ISO 14001 in 1996. Later on it was revised in the year 2004 which is in practice. Top Management felt that, even though pollution in electronic industry is at low level which will not affect anybody, the environmental management system should be implemented in ECIL to demonstrate to customers, suppliers, employees and Society that no pollution will be created by the very existence of the company through any act of theirs. It was therefore decided in August, 2004 to implement the EMS in the company. It was also concluded that one certificate should be obtained for the whole company covering all activities of all divisions.

PRODUCTS

a. TELECOM DIVISION Products Major custome

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Surveillance Systems - GSM, CDMA, Satellite & Wire line

rs DAE

monitoring Systems MOD Encryption systems - Wireless Encryption - Radios, CDMA, GSM Wire NTRO line Encryption- Voice / Data / fax / IP / STM / Bulk NPCIL Design & Implementation of Access Control Systems & Integrated Security Systems Design & implementation of Network Solutions on turnkey basis MHA Law Enforcing agencies PSUs

b. INSTRUMENTS AND SYSTEMS DIVISION

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Sectors of operation / Product major customers Directorate of Logistics, Airports, Banks, Govt. X ray baggage inspection system Departments, Courier Services. Steel, Coal Cement, Nuclear Industrial Instruments Electronic Toll Collection, industry, BARC/ DAE Weigh in motion Transport sector Agricultural departments, Spectrophotometers BARC, Research institutes Upgraded EVM Election Commission Energy meters & Energy Management System Electricity boards Ship Installed Radiac Systems XBT Probes Defense (Navy) CCTV, Access Control, Perimeter protection System, Fire DAE, NPCIL, Defense, PSUs, Alarm system, Gate Systems, Explosive detector DFMD etc as stand alone system, UVSS, Bollards, Tyre Killers, Road Blockers and vehicle scanning Railways, central and state govt. establishments, Temples etc.

c. CONTROL AND AUTOMATION DIVISION Major products 1.Simulators 2. C & I for PHWRs 3. B1-B2 4. CC & I Panels 5. HV & Pulsed P/s 6. Sensors 7. C&I PFBR Customer Power Plants NPCIL Project BARC BHEL ITER & FAIR BHEL & other power stations BHAVINI

d. CUSTOMER SUPPORT DIVISION

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COOPERATE SOCIAL RESPONSIBILITIES

The Company has initiated measures to adopt CSR as a tool for systematic growth. All measures, initiated in this regard in accordance with the Guidelines and CSR issued by the Department of Public Enterprises are well integrated in the business processes of the Company rather than being mere stand-alone activities. a. SOCIETAL APPLICATIONS OF TECHNOLOGY: Community Development The Company has been addressing inclusively contemporary technological solutions for the benefit of society, more so to the rural masses, particularly the poor that reflect its commitment to CSR activities. A few relevant ones are enumerated below. High technology Health Care Solutions : Digital Radiology System, Tele-radiology Consultancy and Tele-medicine Hospital Management System.

Education : Tele- education, Rural IT education

Agriculture: Farmer-friendly Market Yard Systems

In addition, as a significantly beneficial application of technology for the citizen of the Nation, the Company has executed the pilot phase of Multipurpose National Identity Card (MNIC) Project. a. IMPLEMENTATION OF ENVIRONMENTAL MANAGEMENT AND OTHER SYSTEMS The Company achieved EMS Certification as per ISO-14001:2004. The beneficial outcome includes:

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Increasing the green belt in and around the factory premises Tree plantation by VIPs visiting ECIL and development of lawns etc.

Installation of solar power in place of conventional heating mechanisms in areas like Canteen and Guest House. Installation of effluent treatment processes on scientific lines for disposal of used hazardous chemicals and other effluents a. Encouraging Academic Pursuits As part of Industry-Academia synergy efforts, the Company has instituted specific measures that would encourage academic pursuits and result in competency building. A few such important measures are : MoU with premier Institutes like Institute of Public Enterprise and Universities like JNTU, Osmania University etc. for supporting academic pursuits including M.Tech (sponsored) programmes. Providing Project work facility for Graduates / Post Graduates / Engineering Studen

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News and Events Awards

1. BEST HOUSE KEEPING AWARD for SERVO SYSTEMS DIVISION (SSD) presented by Shri Y S Mayya, C&MD on 15th August 2010 to Shri R Mahendran, Offtg. Head -SSD.

2. Mr. Y.S.Mayya, Chairman & Managing Director, ECIL receiving MoU Excellence Award for the Year 2007 -08 from the Honorable Prime Minister of India Dr. Manmohan Sing

3. Mr. Y.S.Mayya, Chairman & Managing Director, ECIL receiving SCOPE Excellence Award for the Year 2007 -08 from the Honorable Prime Minister of India Dr. Manmohan Singh

4.Shri S Hanumantha Rao, Director (Personnel) & Chairman, OLIC of ECIL is receiving the Rajbhasha Shield for 2006-07 from Major General (Retd) Rajneesh Gosai, C&MD of BDL at the Annual Function and 26th Half Yearly meeting of TOLIC (U) and others can also be seen.

ECIL Headquarters and its Branches ECIL offices network are: a. ECIL has 6 Regional maintenance centers they are, DELHI, KOLKATA, MUMBAI, HYDERABAD, CHENNAI, BANGLORE.

b. It has 84 Service centers.

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c. Hyderabad as head office of ECIL.

THEORETICAL BACKGROUND ON CAPITAL BUDGETING.

Capital budgeting is the planning process used to determine whether An organisation's long term investments such as new machinery, replacement machinery, new plants, new products, an research development projects are worth pursuing. It is budget for major capital, or investment, expenditures. Capital Budgeting is a project selection exercise performed by the business enterprise. Capital budgeting uses the concept of present value to select the projects. Capital budgeting uses tools such as pay back period, net present value, internal rate of return, profitability index to select projects.

CAPITAL BUDGETING
Definitions Capital budgeting is long term planning for making and financing proposed capital outlays.

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T.Horngreen Capital budgeting is concerned with allocation of the firms scarce financial resources among the available market opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project with immediate and subsequent streams of expenditure for it.

A systematic approach to capital budgeting implies:

a) the formulation of long-term goals b) the creative search for and identification of new investment opportunities c) classification of projects and recognition of economically and/or statistically dependent proposals d) the estimation and forecasting of current and future cash flows e) a suitable administrative framework capable of transferring the required information to the decision level f) the controlling of expenditures and careful monitoring of crucial aspects of project execution g) a set of decision rules which can differentiate acceptable from unacceptable alternatives is required.

Features of Capital Budgeting:

The important features, which distinguish capital budgeting decisions in other Day-to-day decisions, are
Capital budgeting decisions involve the exchange of current funds for the benefits to be achieved in future. The futures benefits are expected and are to be realized over a series of years. The funds are invested in non-flexible long-term funds.

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They have a long terms are significant effect on the profitability of the concern.

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

Importance of Capital Budgeting:

The importance of capital budgeting can be understood from the fact that an unsound investment decision may prove to be fatal to the very existence of the organization.
The importance of capital budgeting arises mainly due to the following:

1. Large investment: Capital budgeting decision, generally involves large investment of funds. But the funds available with the firm are scarce and the demand for funds for exceeds resources. Hence, it is very important for a firm to plan and control its capital expenditure. 2. Long term commitment of funds: Capital expenditure involves not only large amount of funds but also funds for long-term or an permanent basis. The long-term commitment of funds increases the financial risk involved in the investment decision. 3. Irreversible nature: The Capital expenditure decisions are of irreversible nature. Once, the decision for acquiring a permanent asset is taken, it becomes very difficult to dispose of these assets without incurring heavy losses.

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4. Long terms effect on profitability:

Capital budgeting decision has a long term and significant effect on the profitability of a concern. Not only the present earnings of the firm are affected by the investments in capital assets but also the future growth and profitability of the firm depends up to the investment decision taken today. Capital budgeting decision has utmost importance to avoid over or under investment in fixed assets. 5. Difficulties of investment decision: The long terms investment decisions are difficult to be taken because uncertainties of future and higher degree of risk. 6. Notional Importance: Investment decision though taken by individual concern is of national importance because it determines employment, economic activities and economic growth.

Kinds of Capital Budgeting:

Every capital budgeting decision is a specific decision in the given situation, for a given firm and with given parameters and therefore, an almost infinite number of types or forms of capital budgeting decisions may occur. Even if the same decision being considered by the same firm at two different points of time, the decision considerations may change as a result of change in any of the variables. However, the different types of capital budgeting decisions undertaken from time to time by different firms can be classified on a number of dimensions. Some projects affect other projects the firm is considering and analyzing. At the other extreme, some proposals are pre-requisite for other projects. The projects may also be classified as revenue generating projects or cost reducing projects. In general, the projects can be categorized as follows:

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1.

From the point of view of firm's existence: The capital budgeting decisions may be taken by a newly incorporated firm or by an already existing firm.

a)

New Firm: A newly incorporated firm may be required to take different decisions such as selection of a plant to be installed, capacity utilization at initial stages, to set up or not simultaneously the ancillary unit etc.

b)

Existing: Firm: A firm which is already existing may also be required to take various decisions from time to time to meet the challenges of competition or changing environment. These decision may be :

i.

Replacement and Modernization Decision: This is a common type of a capital budgeting decision. All types of plant and machineries eventually require replacement. If the existing plant is to be replaced because the economic life of the plant is over, then the decisions may be known as a replacement decision. However, if an existing plant is to be replaced because it has become technologically outdated (though the economic life may not be over), the decision may be known as a modernization decision. In case of a replacement decision, the objective is to restore the same or higher capacity, whereas in case of modernization decision, the objective is to increase the efficiency and/or cost reduction. In general, the replacement decision and the modernization decisions are also known as cost reduction decisions.

ii.

Expansion: Some times, the firm may be interested in increasing the installed production capacity so as to increase the market share. In such a case, the finance manager is required to evaluate the expansion program in terms of marginal costs and marginal benefits.

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iii.

Diversification: Some times, the firm may be interested to diversify into new product lines, new markets, production of spare parts etc. In such a case, the finance manager is required to evaluate not only the marginal cost and benefits, but also the effect of diversification on the existing market share and profitability. Both the expansion and diversification decisions may also be known as revenue increasing decisions.

Assumptions in Capital Budgeting:

The capital budgeting decision process is a multi-faceted and analytical process. A number of assumptions are required to be made. These assumptions constitute a general set of conditions within which the financial aspects of different proposals are to be evaluated. Some of these assumptions are: 1. Certainty with respect to cost and benefits: It is very difficult to estimate the cost and benefits of a proposal beyond 2-3 years in future. However, for a capital budgeting decision,It is assumed that the estimates of cost and benefits are reasonably accurate and certain. 2. Profit motive: Another assumption is that the capital budgeting decisions are taken with a primary motive of increasing the profit of the firm. No other motive or goal influences the decision of the finance manager. 3. No Capital Rationing: The Capital Budgeting decisions in the present chapter assume that there is no scarcity of capital. It assumes that a proposal will be accepted or rejected on the strength of its merits alone. The proposal will not be considered in combination with other proposals to consider the maximum utilization of available funds.

Basic steps of Capital Budgeting

1. Estimate the cash flows 2. Assess the risky ness of the cash flows.

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3. Determine the appropriate discount rate. 4. Find the PV of the expected cash flows. 5. Accept the project if PV of inflows > costs. IRR > Hurdle Rate and/or payback < policy

The classification of investment projects

a) By project size Small projects may be approved by departmental managers. More careful analysis and Board of Directors' approval is needed for large projects of, say, half a million dollars or more. b) By type of benefit to the firm an increase in cash flow a decrease in risk an indirect benefit (showers for workers, etc). c) By degree of dependence mutually exclusive projects (can execute project A or B, but not both) complementary projects: taking project A increases the cash flow of project B. substitute projects: taking project A decreases the cash flow of project B. d) By degree of statistical dependence Positive dependence Negative dependence Statistical independence. e) By type of cash flow Conventional cash flow: only one change in the cash flow sign e.g. -/++++ or +/----, etc Non-conventional cash flows: more than one change in the cash flow sign, e.g. +/-/+++ or -/+/-/++++, etc. The analysis stipulates a decision rule for: I) accepting or II) rejecting investment projects.

METHODS AND TECHNIQUES OF CAPITAL BUDGETING

There are many methods for evaluating the profitability of investment proposals. The various commonly used methods are 34

Traditional methods: 1. Payback period method (P.B.P)

2. Accounting Rate of return method (A.R.R) 3. Discounted Payback

Time adjusted or discounting techniques:

1. Net Present value method (N.P.V) 2. Internal rate of return method (I.R.R) 3. Profitability index method (P.I) 4. Modified Internal Rate of Return (MIRR) 5. Equivalent Annual Annuity

1) Net Present Value: Is also known as the discounted cash flow technique or NPV is the amount the shareholders wealth would increase if the firm selected the project if this number is positive then the firm should select the project. Using the following formula we can find the NPV of the two projects. The NPV method is a modern method of evaluating investment proposals. This method takes in to consideration the time value of money and attempts to calculate the return on investments by introducing time element. The net present values of all inflows and outflows of cash during the entire life of the project is determined separately for each year by discounting these flows with firms cost of capital or predetermined rate. The steps in this method are 1. Determine an appropriate rate of interest known as cut off rate.

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2. Compute the present value of cash outflows at the above-determined discount rate. 3. Compute the present value of cash inflows at the predetermined rate. 4. Calculate the NPV of the project by subtracting the present value of cash outflows, from present value of cash inflows.

Decision rule: If NPV is positive (+): accept the project If NPV is negative(-): reject the project

The NPV method is used for evaluating the desirability of investments or projects.

where: Ct = the net cash receipt at the end of year t Io = the initial investment outlay r = the discount rate/the required minimum rate of return on investment n = the project/investment's duration in years.

Advantages:
It recognizes the time value of money and is suitable to apply in a situation with uniform cash outflows and uneven cash inflows.

It takes in to account the earnings over the entire life of the project and gives the true view of the profitability of the investment

Takes in to consideration the objective of maximum profitability.

Disadvantages:
More difficult to understand and operate.

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It may not give good results while comparing projects with unequal investment of funds.

It is not easy to determine an appropriate discount rate.

1) Internal Rate of Return (IRR): The IRR is the discount rate that makes the net present value of the project equal to zero. A projects IRR should be compared to the companys cost of capital or hurdle rate. The hurdle rate is the rate that the project must exceed to create positive shareholder wealth effects. (Assume the hurdle rate (r) is 5%). The internal rate of return method is also a modern technique of capital budgeting that takes in to account the time value of money. It is also known as time-adjusted rate of return or trial and error yield method. Under this method the cash flows of a project are discounted at a suitable rate by hit and trial method, which equates the net present value so calculated to the amount of the investment. The internal rate of return can be defined as that rate of discount at which the present value of cash inflows is equal to the present value of cash outflows.

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

Determination of IRR When annual cash flows are equal over the life of the asset.
Initial Outlay FACTOR = --------------------------- x 100

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Annual Cash Inflow

When the annual cash flows are unequal over the life of the asset:

Pv of cash inflows at lower rate - Pv of cash outflows IRR = LR + ------------------------------------------------------------------------(hr-lr)

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

Advantages: It takes into account, the time value of money and can be applied in situations with even and even cash flows. It considers the profitability of the projects for its entire economic life. The determination of cost of capital is not a pre-requisite for the use of this method. It provides for uniform ranking of various proposals due to the percentage rate of return. This method is also compatible with the objective of maximum profitability.

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

Net present value vs internal rate of return

Independent vs dependent projects NPV and IRR methods are closely related because: i) both are time-adjusted measures of profitability, and ii) their mathematical formulas are almost identical. So, which method leads to an optimal decision: IRR or NPV? a) NPV vs IRR: Independent projects Independent project: Selecting one project does not preclude the choosing of the other. With conventional cash flows (-|+|+) no conflict in decision arises; in this case both NPV and IRR lead to the same accept/reject decisions. Figure 6.1 NPV vs IRR Independent projects

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If cash flows are discounted at k1, NPV is positive and IRR > k1: accept project. If cash flows are discounted at k2, NPV is negative and IRR < k2: reject the project. Mathematical proof: for a project to be acceptable, the NPV must be positive, i.e.

Similarly for the same project to be acceptable:

where R is the IRR. Since the numerators Ct are identical and positive in both instances: implicitly/intuitively R must be greater than k (R > k); If NPV = 0 then R = k: the company is indifferent to such a project; Hence, IRR and NPV lead to the same decision in this case. b) NPV vs IRR: Dependent projects NPV clashes with IRR where mutually exclusive projects exist. Example: Agritex is considering building either a one-storey (Project A) or five-storey (Project B) block of offices on a prime site. The following information is available:
Initial Investment Outlay Net Inflow at the Year End Project A -9,500 Project B -15,000 11,500 18,000

Assume k = 10%, which project should Agritex undertake?

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= $954.55

= $1,363.64 Both projects are of one-year duration: IRRA: $11,500 = $9,500 (1 +RA)

= 1.21-1 therefore IRRA = 21% IRRB: $18,000 = $15,000(1 + RB)

= 1.2-1 therefore IRRB = 20% Decision: Assuming that k = 10%, both projects are acceptable because: NPVA and NPVB are both positive IRRA > k AND IRRB > k Which project is a "better option" for Agritex? If we use the NPV method: NPVB ($1,363.64) > NPVA ($954.55): Agritex should choose Project B. If we use the IRR method: IRRA (21%) > IRRB (20%): Agritex should choose Project A. See figure 6.2. Figure 6.2 NPV vs IRR: Dependent projects

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Up to a discount rate of ko: project B is superior to project A, therefore project B is preferred to project A. Beyond the point ko: project A is superior to project B, therefore project A is preferred to project B The two methods do not rank the projects the same.

1)

Modified Internal Rate of Return (MIRR):

The modified IRR assumes that cash flows are reinvested at the companys cost of capital. The cash flows are first brought forward to their future values at the companys cost of capital. Next the terminal value is calculated by summing all of the future value cash flows. Finally the terminal value is brought to the present value of the initial investment at the MIRR rate. (Assume a cost of capital of 5%). Modified IRR (MIRR).

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The MIRR is similar to the IRR, but is theoretically superior in that it overcomes two weaknesses of the IRR. The MIRR correctly assumes reinvestment at the projects cost of capital and avoids the problem of multiple IRRs. However, please note that the MIRR is not used as widely as the IRR in practice.

There are 3 basic steps of the MIRR: 1. Estimate all cash flows as in IRR. 2. Calculate the future value of all cash inflows at the last year of the projects life. 3. Determine the discount rate that causes the future value of all cash inflows determined in step 2, to be equal to the firms investment at time zero. This discount rate is know as the MIRR.

t =0

Cash Outflowt

( 1+ r )

= t =0

Cash Inflow ( 1 + r )
( 1 + MIRR )
N N

N 1

PV of costs =

Terminal value

( 1 + MIRR )

= PV of terminal value

1) Profitability Index (PI):

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The profitability index is the present value of the projects cash flows divided by the cost. (Assume a 5% cost of capital) PI tells us how much profit we can earn for each dollar invested. Profitability ratio is otherwise referred to as Benefit/Cost ratio. This is an extension of the Net Present Value Method. This is a relative valuation index and hence is comparable across different types of the projects requiring different quantum of initial investments. Profitability index (PI) is the ratio of sent value of cash inflows to the present value of cash outflows. The present values of the cash flows are obtained at a discount rate equivalent to the cost of capital. The profitability index, or PI, method compares the present value of future cash inflows with the initial investment on a relative basis. Therefore, the PI is the ratio of the present value of cash flows (PVCF) to the initial investment of the project. It is also a time-adjusted method of evaluating the investment proposals. PI also called benefit cost ratio or desirability factor is the relationship between present value of cash inflows and the present values of cash outflows. Thus

PV of cash inflows Profitability index = -----------------------------PV of cash outflows

NPV Net profitability index = ----------------------------Initial Outlay

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Advantages: Unlike net present value, the profitability index method is used to rank the projects even when the costs of the projects differ significantly. It recognizes the time value of money and is suitable to applied in a situation with uniform cash outflows and uneven cash inflows. It takes into an account the earnings over the entire life of the project and gives the true view of the profitability of the investment. Takes into consideration the objective of maximum profitability.

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

1) Payback Period: The payback period is the expected number of years required to recover the original investment.

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The payback period method has three main flaws: 1) dollars received in different years are all given the same weight 2) cash flows beyond the payback year are not considered 3) payback period analysis does not provide an indication of how much shareholder wealth should increase (like NPV) and 4) payback period analysis does not indicate how much the project will yield over the cost of capital (like IRR).Payback period is the time duration required to recoup the investment committed to a project. Business enterprises following payback period use "stipulated payback period", which acts as a standard for screening the project.

Rules to follow: A project is accepted if its payback period is less than the period specific decision rule.

A project is accepted if its payback period is less than the period specified by the management and vice-versa.

Pay Back Period

Initial Cash Outflow = -----------------------------Annual Cash Inflows

Advantages: It is easy to understand and apply. The concept of recovery is familiar to every decision-maker. Business enterprises facing uncertainty - both of product and technology will benefit by the use of payback period method since the stress in this technique is on early recovery of investment. So enterprises facing

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technological obsolescence and product obsolescence - as in electronics/computer industry - prefer payback period method. Liquidity requirement requires earlier cash flows. Hence, enterprises having high liquidity requirement prefer this tool since it involves minimal waiting time for recovery of cash outflows as the emphasis is on early recoupment of investment.

Disadvantages: The time value of money is ignored. For example, in the case of project. A Rs.500 received at the end of 2nd and 3rd years are given same weightage. Broadly a rupee received in the first year and during any other year within the payback period is given same weight. But it is common knowledge that a rupee received today has higher value than a rupee to be received in future. But this drawback can be set right by using the discounted payback period method. The discounted payback period method looks at recovery of initial investment after considering the time value of inflows. Another important drawback of the payback period method is that it ignores the cash inflows received beyond the payback period. In its emphasis on early recovery, it often rejects projects offering higher total cash inflow.

1) Discounted Payback: This method is similar to the payback period method except the cash flows are discounted by the projects cost of capital. The discounted payback period is the

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number of years required to recover the investment from the discounted net cash flows. (Assume a cost of capital of 5%)

Discounted Payback = Number of years prior to full recovery* + Unrecovered cost at start of year * Cash flow during full recovery year *

*considers discounted cash flows

2) Accounting Rate of Return on Investment (ROI): Firms make capital investments to earn a satisfactory rate of return. Determining a satisfactory rate of return depends on the cost of borrowing money, but other factors can enter into the equation. Such factors include the historic rates of return expected by the firm. In the long run, the desired rate of return must equal or exceed the cost of capital in the marketplace. The accounting rate of return on investment (ROI) calculates the rate of return from an investment by adjusting the cash inflows produced by the investment for depreciation. It gives an approximation of the accounting income earned by the project. Accounting rate of return is the rate arrived at by expressing the average annual net profit (after tax) as given in the income statement as a percentage of the total investment or average investment. The accounting rate of return is based on accounting profits. Accounting profits are different from the cash flows from a project and hence, in many instances, accounting rate of return might not be used as a project evaluation decision. Accounting rate of return does find a place in business decision making when the returns expected are accounting profits and not merely the cash flows.

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This method takes into account the earnings from the investment over the whole life. It is known as average rate of return method because under this method the concept of accounting profit (NP after tax and depreciation) is used rather than cash inflows. According to this method, various projects are ranked in order of the rate of earnings or rate of return.

Rule to follow: The project with higher rate of return is selected and vice versa. The return on investment method can be used in several ways, as

Average Rate of Return Method:

Under this method average profit after tax and depreciation is calculated and then it is divided by the total capital out lay.
Average Annual profits (after dep. & tax) Average rate of return = --------------------------------------------------- x 100 Net Investment

Advantages: It is very simple to understand and easy to calculate. It uses the entire earnings of a project in calculating rate of return and hence gives a true view of profitability. As this method is based upon accounting profit, it can be readily calculated from the financial data.

Disadvantages:

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It ignores the time value of money. It does not take in to account the cash flows, which are more important than the accounting profits.

It ignores the period in which the profits are earned as a 20% rate of return in 2 years is considered to be better than 18% rate if return in 12 years.

This method cannot be applied to a situation where investment in project is to be made in parts.

1) Equivalent annual annuity: What do you do when project lives vary significantly? An easy and intuitively appealing approach is to compare the equivalent annual annuity among all the projects. The equivalent annuity is the level annual payment across a projects specific life that has a present value equal to that of another cash-flow stream. Projects of equal size but different life can be ranked directly by their equivalent annuity. This approach is also known as equivalent annual cost, equivalent annual cash flow, or simply equivalent annuity approach. The equivalent annual annuity is solved for by this equation: Equivalent Annuity = PV (Cash Flows) / (present value factor of n-year annuity)

CAPITAL BUDGETING ANALYSIS

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Capital Budgeting Analysis is a process of evaluating how we invest in capital assets; i.e. assets that provide cash flow benefits for more than one year. We are trying to answer the following question: Will the future benefits of this project be large enough to justify the investment given the risk involved? It has been said that how we spend our money today determines what our value will be tomorrow. Therefore, we will focus much of our attention on present values so that we can understand how expenditures today influence values in the future. A very popular approach to looking at present values of projects is discounted cash flows or DCF. However, we will learn that this approach is too narrow for properly evaluating a project. We will include three stages within Capital Budgeting Analysis:

Decision Analysis for Knowledge Building

Option Pricing to Establish Position Discounted Cash Flow (DCF) for making the Investment Decision

Stage 1: Decision Analysis Decision-making is increasingly more complex today because of uncertainty. Additionally, most capital projects will involve numerous variables and possible outcomes. For example, estimating cash flows associated with a project involves working capital requirements, project risk, tax considerations, expected rates of inflation, and disposal values. We have to understand existing markets to forecast project revenues, assess competitive impacts of the project, and determine the life cycle of the project. If our capital project involves production, we have to understand operating costs, additional overheads, capacity utilization, and start-up costs. Consequently, we 51

can not manage capital projects by simply looking at the numbers; i.e. discounted cash flows. We must look at the entire decision and assess all relevant variables and outcomes within an analytical hierarchy. In financial management, we refer to this analytical hierarchy as the Multiple Attribute Decision Model (MADM). Multiple attributes are involved in capital projects and each attribute in the decision needs to be weighed differently. We will use an analytical hierarchy to structure the decision and derive the importance of attributes in relation to one another. We can think of MADM as a decision tree which breaks down a complex decision into component parts. This decision tree approach offers several advantages: We systematically consider both financial and non-financial criteria. Judgments and assumptions are included within the decision based on expected values. We focus more of our attention on those parts of the decision that are important. We include the opinions and ideas of others into the decision. Group or team decision making is usually much better than one person analyzing the decision. Stage 2: Option Pricing The uncertainty about our project is first reduced by obtaining knowledge and working the decision through a decision tree. The second stage in this process is to consider all options or choices we have or should have for the project. Therefore, before we proceed to discounted cash flows we need to build a set of options into our project for managing unexpected changes. In financial management, consideration of options within capital budgeting is called contingent claims analysis or option pricing. For example, suppose you have a choice between two boiler 52

units for your factory. Boiler A uses oil and Boiler B can use either oil or natural gas. Based on traditional approaches to capital budgeting, the least costs boiler was selected for purchase, namely Boiler A. However, if we consider option pricing Boiler B may be the best choice because we have a choice or option on what fuel we can use. Suppose we expect rising oil prices in the next five years. This will result in higher operating costs for Boiler A, but Boiler B can switch to a second fuel to better control operating costs. Consequently, we want to assess the options of capital projects. Options can take many forms; ability to delay, defer, postpone, alter, change, etc. These options give us more opportunities for creating value within capital projects. We need to think of capital projects as a bundle of options. Three common sources of options are:
1.

Timing Options: The ability to delay our investment in the project. Abandonment Options: The ability to abandon or get out of a project that has gone bad. Growth Options: The ability of a project to provide long-term growth despite negative values. For example, a new research program may appear negative, but it might lead to new product innovations and market growth. We need to consider the growth options of projects. Option pricing is the additional value that we recognize within a project because it has flexibilities over similar projects. These flexibilities help us manage capital projects and therefore, failure to recognize option values can result in an under-valuation of a project.

2.

3.

Stage 3: Discounted Cash Flows So we have completed the first two stages of capital budgeting analysis: (1) Build and organize knowledge within a decision tree and (2) Recognize and build options within our capital projects. We can now make an investment decision based on Discounted Cash Flows or DCF. Unlike 53

accounting, financial management is concerned with the values of assets today; i.e. present values. Since capital projects provide benefits into the future and since we want to determine the present value of the project, we will discount the future cash flows of a project to the present. Discounting refers to taking a future amount and finding its value today. Future values differ from present values because of the time value of money. Financial management recognizes the time value of money because:
1.

Inflation reduces values over time: i.e. $ 1,000 today will have less value five years from now due to rising prices (inflation).

2.

Uncertainty in the future: i.e. we think we will receive $ 1,000 five years from now, but a lot can happen over the next five years.

3.

Opportunity Costs of money: $ 1,000 today is worth more to us than $ 1,000 five years from now because we can invest $ 1,000 today and earn a return.

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