Professional Documents
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Project report submitted to Indore Management Institute and Research Centre in partial fulfillment for second semesters Summer Internship Project which is necessary to award of Post Graduate Diploma in Management (PGDM) 2010-12 By
Akansha Gupta
INDORE MANAGEMENT INSTITUTE & RESEARCH CENTRE Khandwa road, Indore, Madhya Pradesh, INDIA march-June, 2011
DECLARATION
I hereby declare that the project work entitled CAPITAL BUDGETING submitted to the INDORE MANAGEMENT INSTITUTE , is a record of an original work done by me under the guidance of Mr. Pranav chatterjee Sr. financial manager of Ritspin synthetic pvt. Ltd., and this project work has not performed the basis for the award of any Degree or diploma/ associate ship/fellowship and similar project if any.
PREFACE
To study without practically doing it is futile & waste. With this in mind, I started my project at RITSPIN SYNTHETIC LTD., Pithampur. There are various books available relating to financial matters but without practically doing it & knowing how they are computed its difficult to understand, their essence & importance. This 3 months project of practical training in a well established company has radically changed my outlook towards business management. It has helped me in thinking objectively with a more methodical approach towards problem in the real life situation & their solutions.
ACKNOWLEDGEMENT
The journey Started as a Student stepping Towards The Professional Life With The aim in Mind To Learn The Practical Aspect of Life, Ended as a memorable experience, Also helped me to come off with flying color.
My special thanks to Mr. P.Chatterjee for providing me this opportunity to associate myself with RITSPIN SYNTHETIC LTD for my summer training.
I would also like to express my sincere gratitude to my training guide Mr. B. suryavanshi & Mr. R.shankar Jha for providing me the most valuable guidance and affable treatment given to me at every stage to boost my morale, which helped me to add a feather in my cap.
Last but not the least my sincere gratitude to all those people who knowingly or unknowingly supported me, for my moral to make this project a reality.
TEXTILE
Textile is one of the major items of Indias export basket. Its share in total export from India is 10% in 2009 2010 and estimated to be 12% IN 2010 -2011. It is major foreign exchange earner for India . companies like welspun, maral overseas, raymonds, Ritspin , Indorama and others have contributed a lot in the development of textile industry. India has a comparative cost advantage in the textile as compared to other international player . India has cheap and efficient Labour . Further government support through schemes like DEPB, DFRC, etc has increased potential of Indian textile industry. Removal of multi fiber agreement in 2005 has given tremendous opportunity for Indian textile industry in international market .Due to this international textile companies like Brandix group the largest textile exporter of SRILANKA is doing investment in Indian textile industry.
RITSPIN is one of the growing textile companies of India. It is government recognized export house .It was formed in the year 1996. Its corporate office is in Calcutta and its production plant is in PITHAMPUR (INDORE). RITSPIN export polyester yarn and blended yarn. RITVANG is RITSPIN own new product .Its market are SPAIN, ITALY, GERMANY, SAUDI ARABIA, MOROCCO and INDONESIA.
POSITION
OF
INDIAN
TEXTILE
INDUSTRY-
The textile industry has been very badly affected by the global slowdown of 2008, with the handloom and powerloom production declining 3.8% and 3.2% respectively. During 2007 - 08, the total production of fabric was 57 billion sq mtrs, compared to 53 billion sq mtrs in 2006 - 07 and 50 billion sq mtrs in 2005 - 06. During 2006 - 07, the per capita availability of cloth was 39.60 sq mtrs, compared to 36.10 sq mtrs in 2005 - 06 and 33.10 sq mtrs in 2004 05. The textiles sector has witnessed a spurt in investment during the last four years, increasing from Rs 7,941 crore in 2004 - 05 to Rs 16,194 crore in 2005 - 06, to Rs 61,063 crore in 2006 - 07, and to Rs 19,308 crore in 2007 - 08. The investment between 2004 08 was Rs 1,04,506 crore and it is expected that investments will touch Rs 1,50,600 crore by 2012. This enhanced investment will generate 17.37 million jobs (comprising 12.02 million direct and 5.35 million indirect jobs) by 2012. According to the provisional data available, production in the handloom sector in 2008 - 09 stood at 6,677 million square metres, as compared to 6,947 million square metres the year before. But, the production in mills increased a marginal 0.8% from 1,781 million square metres to 1,796 million square metres. Also, the hosiery sector witnessed an increase of 2.3% in its annualproduction.
Indian
job
market
After the last year's global recession, the Indian job market is on recovery path, finds the latest quarterly Labour Bureau Survey conducted to assess the impact of economic downturn on the employment scenario in India. Where the country had lost five lakh jobs between October and December 2008, it has recorded an increase of 2.5 lakh jobs in several crucial sectors between January and March this year. The surprise gainer in the latest quarter has been the gems and jewellery sector that had witnessed a severe job crash of 10.28 per cent between October and December last. It has bounced back now, registering an increase of 3.08 per cent in employment between January and March. Other gainers are textiles (0.96 per cent rise in jobs), IT and BPO sector (0.83 per cent rise), handloom/power loom sector with 0.28 per cent job rise and automobiles at 0.10 per cent increase. The findings show that there was 0.30 per cent increase in the employment of direct workers over the past year - between April 2008 and March 2009. The sectors studied include textile, leather, metals, automobiles, gems, jewellery, transport, IT/BPO, handloom and powerlooms.
Reasons for the current situation * Global recession * Infrastruct ure (Example: power at particularl y in Tamil Nadu)
* *
Raw Less
Materials export
(cotton
prices) order
Indian textile sector losing its global competitiveness? The dismantling of the quotas came as a great boom to Indian textile industry and in the year the quotas were removed, export grew by 29%. The years that followed 2005 onwards, the growth started tapering off. It was just 7% CAGR between 2005 and 2008 and in 2008 - 09; Exports have registered a 10% negative growth, more so due to the economic downturn. As per ICRA report, except India, all other Asian economies have increased their market size and share even during this period. India has been losing its market share as it is losing its relative competitiveness steadily. For example, China has increased its drawback from 12% to 17%. Pakistan has introduced R&D rebate of 7.5% while Bangladesh enjoys zero import duty in to EU and is attracting large investments from china and South Korea and is rapidly expanding its exports and Vietnam, which has competitive costs also benefiting from overseas investments and is growing rapidly. Bangladesh has exceeded Indian garment export and very soon, Vietnam too is set to exceed India. India on the other hand has been reducing the benefits offered to exporters. The drawback over the last four years has come down steeply. In the case of cotton yarn the reduction in benefits is 43% and in fabrics the reduction is by as much as 19%.
The short and medium term solutions for increasing exports of cotton textiles could be achieved by restoring the competitiveness of the inherently strong Indian textile industry by refunding of taxes and duties including taxes suffered on fuel oils since, most textile exporting companies, particularly from Tamil Nadu, suffer from very large power cuts, forcing them to use gensets.
Relief
measures
for
global
economic
slowdown-
The Government has already introduced several packages of relief measures in the wake of the global economic slowdown, to provide relief to the domestic industry including textiles industry. These measures include:* Additional allocation of Rs 1,400 crore to clear the entire backlog of Technology Upgradation Fund Scheme (TUFS). * All items of handicrafts to be included under Vishesh Krishi & Gram Udyog Yojana (VK&GUY). * Across-the-board cut of 4% in the ad-valorem Cenvat rate till 31.3.2009. * Interest subvention of 2% up to 31.3.2009 subject to a minimum of 7% per annum on pre and post-shipment export credit (since extended to 20.9.09 in the Union Budget 2009 10). * Provision of additional funds for full refund of Terminal Excise Duty/Central Sales Tax. * Enhanced back-up guarantee to ECGC to cover for exports to difficult markets/products. * Refund of Service Tax on foreign agent commissions of up to 10% of FOB value of exports as well as refund of service tax on output service while availing benefits under Duty Drawback Scheme. * Credit targets of Public Sector Banks revised upward to reflect the needs of the economy. * State Level Bankers Committee would hold meetings for resolution of Credit issues of MSMEs. * Guarantee cover under Credit Guarantee Scheme doubled to Rs 1 crore with cover of 50%. * DEPB rates restored to pre - November, 2008 levels and extended till 31.12.2009. * Duty Drawback on knitted fabrics enhanced retrospectively from 1.9.2008. Investments for Indian textile industry Investment has increased significantly in the textiles sector, and is expected to touch Rs
1,50,600 crore by 2012. This enhanced investment will generate 17.37 million jobs (comprising 12.02 million direct and 5.35 million indirect jobs) by 2012. Investment in the textiles and clothing sector in the past three years increased from Rs 7,941 crore in 2004 - 05 to Rs 16,194 crore in 2005 - 06, and Rs 61,063 crore in 2006 - 07, and Rs 19,308 crore in 2007 - 08 amounting to a total investment of Rs 1,04,506 crore. The textiles industry which was growing at 3 - 4 per cent during the last six decades has now accelerated to an annual growth rate of 16 per cent in value terms and will reach a level of US $ 115 billion (exports US$ 55 billion; domestic market US$ 60 billion) by 2012, from US$ 52 billion in 2007 - 08. Technical textiles sector is still in its infancy and a tangible growth will be highly visible by 2035 when the growth in this sector will beexponential.
The textiles industry in India is experiencing an increase in the collaboration between national and international companies
International apparel companies like Hugo Boss, Liz Claiborne, Diesel, Ahlstorm, Kanz, Baird McNutt, etc have already started their operations in India and these companies are trying to increase it to a considerable level
National and the international companies that are involved in collaborations include Rajasthan Spinning & Weaving Mills, Armani, Raymond, Levi Strauss, De Witte Lietaer, Barbara, Jockey, Vardhman Group, Gokaldas, Vincenzo Zucchi, Arvind brands, Benetton, Esprit, Marzotto, Welspun, etc.
Foreign Direct Investments (FDI) up to 100% is allowed in this sector through the automatic route by the Reserve Bank of India
In order to provide quality cotton raw materials at reasonable price to the manufacturers, the Technology Mission on Cotton was launched
In order to facilitate the technological advancement in the textile industry, the Technology Upgradation Fund Scheme (TUFS) was set up.
The Scheme for Integrated Textile Park (SITP) is set up to provide world standard infrastructure facilities
The reservations for the small scaled units in textiles were abolished.
Company Information
Location Year of incorporation No of employees Annual Turnover Manufacturing Indore- [India] 1996 1500(approx) USD Not Available Acrylic Blended Yarn, Cotton Blended Yarn, Polyester Blended Yarn, Viscose Blended Yarn, Polyester Yarn 100% Acrylic Blended Yarn, Cotton Blended Yarn, Polyester Blended Yarn, Viscose Blended Yarn
Trading
Ritspin synthetic ltd. Is a part it was established since 1996 ago. Ritspin Synthetic ltd ,a spinning unit was established in 1996 to give a new definition to spinning of synthetic spun yarn in INDIA .Despite being members of one of the oldest industry known to mankind i.e. textiles. RITSPIN was born to think and act laterally.
A small yarn manufacturing company is having team of 1000 people with clear vision of shaping a bright future. It is complete forfill company having State of art infrastructure for complete textile related work. Its head office has been located in Kolkata whose address is Crescent Towers,229, A.J. and recently it has decided to open one of its branch at khasrabad at DIST. khargoan in M.P. With its constant drive for improvement of standard and quality. Today RITSPIN SYNTHETIC is a proud partner of various reputed international market like EGYPT, MALASIA, SWEDEN, ISRAEL, SOUTH AFRICA, COLUMBIA, and many more.
LOCATION
Ritspin synthetic ltd. Is situated in the lush green environs of the PITHAMPUR industry area, RITSPIN SYNTHETIC is spread over 40 acres of land the Pithampur industrial area more commonly known as defrcut of India is situated approximately of 45 minutes drive from Indore city Airport, the city is also known as commercial capital of the state of MADHYA-PRADESH.
PRODUCT
100% Polyester spun yarn. 100% Viscose Spun Yarn. Polyester / Viscose Blended with cotton / polyester / viscose / Limen . Viscose / polyester blended spun yarn. Viscose / Silk blended Spun Yarn. Wellman Polyester based spun yarn.
A PASSION OF FASHION
Ritvang , a Product from the House of Ritspin is a unique blend of comfort, Style and status that is spindled to perfection , giving you quality yarn that churn out some of the best garments that make it to the high value fashion segment . Ritvang is a revolutionary product that has made major inroads into the International branded segment with its remarkably versatile quality.
KEY FEATURES
Ritving caters to the fashion conscious , up-market segment , and capable of making a statement with its expressive quality . Soft handing and drape enables Ritvang to create a microclimate around the body , Providing total comfort , Ritvang, with its soft ,yet strong texture makes highly versatile fabric , maintaining elasticity without being harsh on skin. Another winner from the house of Ritspin Ritvang is an indispensable from of fabric for readymade garment manufacturing the world over.
Ritvang stands out as a distinctively body friendly fabric and the overall look and feel of the outfits made from it suggest supreme comfort , with a touch of class . Ritvang is specially developed to provide complete comfort to the body. Ritvang with its unique texture takes care of the comfort, while the filament through orientation of the polymer chain, handles the body contours. Ritvang is easily mould-able and the technology renders it indeform able by building resistance to bagging increase resistant to the core, Ritvang is virtually un-crushable. Soft, silky and easy to handle , Ritvang processes delicate qualities. Ritving offers permanent elasticity . Absorbing sweat easily ,Ritvang helps skin to breath e easy .
EASY THE PROCESSING The fabric design enables easy processing . solid shades and two tons effects can be derived with equal case . In fact , Ritvang processing is as easy as the processing of polyester ,viscose and polyamide yarn.
WHY RITVANG ?
Ritvang outshine the usual longitudinal stretch yarn as it delivers a three dimensional effect by providing style , comfort and richness. A quality product from the house of Ritspin , that boasts of an excellent track record backed by an ultra modern Research and development wing , that works overtime to deliver goods of the highest Possible standard .
APPLICATIONS
There is a reason the global buyer returns to Ritspin , Again and again A super , superior experience. Exhaustive quality controls ; Timely deliveries ; Promote ; Personalized Attention ; and of course a yarn that , quality simple , is sublime in its appeal.
No matter which way you look at it . Powering its own trailblazing path on , forward , and ahead.
Commitments to its exclusive brand of clientele ( in India and Abroad ) and to its own vision has made sure it takes the reigns in its own hands , minimizing dependence on outside parameters . Ritspin generates its energy in-house , in its 4-MW, 11,000 Volts , on site Power plant , from WARTSILANSD , FINLAND. The latest generation machinery in the textile spinning industry have been imported from world renowned manufacturers who are the leaders in their field .
Blow and Room & Cards Draw frames Speed frames Ring frames Auto corners Two for one twister Humidification system 4 MW Captive Power Plant
Crosrol U.K. Cherry hara , JAPAN. Toyada , JAPAN. Zinser, GERMANY Murata, JAPAN. Murata, JAPAN. LTG Ameliorair, FRANCE.
BELIEVE IN THE BEST , we nurture this ideology and our machinery set up of the best possible spinning machineries in the world , is evidence to we do, what we believe in
ALLIANCES PARTENER
Thursday, 1st Aug 1996 Ritspin signed the agreement for equity participation with ITOCHU Corporation of JAPAN, A foreign 500 ranked company and one of the largest trading houses in the world. ITOCHUS direct equity investment gives Ritspin an international recognition .
Mixing of raw material: - initially raw material i.e. polyester and viscose is
mixed in specified ratio as per market requirement.
Blow room:- After mixing opening and mixing of fiber takes place. It is done
with the help of blow room machine.
Draw frame: -Paralization of fiber is done through draw frame machine. Speed frame: -In speed frame ram wing is prepared with the help of speed
frame machine.
Auto corner: - At this stage winding and clearing of yarn is done. T.F.O.: - It is a final stage at which yarn is finally prepared and ready for sale.
PACKING Packing is significant in manufacturing. In case of export packing is to be done as per buyer requirement. In case of yarn wooding pallets and cartons are used for packing.
India has never before faced such a tremendous window of opportunity to become a significant player in the global economy as now. India and the global economy: Vast potential but also difficult challenges.
Strengths:
* India is one of the largest exporters of yarn in international market and contributes around 25% share of the global trade in cotton yarn. * Growing economy and potential domestic and international market. * Availability of large varieties of cotton fibre . * Availability of low cost and skilled manpower provides competitive advantage to industry.
* Abundant raw material availability that helps industry to control costs and reduces the lead-time across the operation. * RSL has large and diversified segments that provide a wide variety of products.
Weaknesses:
* Higher indirect taxes, power and interest rates. * Lack of technological development that affect the productivity. * Industry is highly dependent on cotton. * Lacking to generate economies of scale. * Infrastructural bottlenecks and efficiency. * Unfavourable labour laws.
Opportunities:
* Emerging retail industry and malls. * Elimination of quota restriction leads to greater market. * Growth rate of domestic textile industry. * Shifting towards branded readymade garment. * Product development and diversification.
Threats:
* In export, elimination of quota system will lead to fluctuations. * Geographical demerits.
* Balance between price and quality, demand and supply. * Continuous quality improvement. * International environmental laws. * Competition from other developing countries, especially China. India compares in a number of important variables with three benchmark countries; China, South Korea, and the United States. A great, if not the greatest advantage of India is its people. With a population of over one billion, India is second only to China. Although India accounts for roughly 17 per cent of world population, it contributes less than 2 per cent to world GDP and 1 per cent or less of world trade in goods and world foreign direct investment (FDI) inflows. Even in terms of purchasing power parity, per capita GDP in India is only about half that of China and less than one-tenth that of the United States. Indias GDP growth has soared from 5 - 6%. If this growth is sustained, as the 11th Plan hopes to do, average living standards will rise and poverty will be reduced. The good sign, however, is the positive indications of increase in consumer confidence and consumer demand in the developed economies, namely, USA, the Europe and Japan. The demand contraction and low consumer spending in the USA, the EC and Japan had decisively impacted the demand for imported textiles and clothing from, both the USA and the Europe. Due to above, and the ongoing slow pickup in demand, and prices, the domestic textile sector is in static mode, due mainly to slow lifting of fabrics and madeups owing to continuing slowdown in demand for clothing and apparels in both global and domestic markets.
VISION
RSLs Vision is to have a team of professionals who have vast experience in their respective fields. Its aim is to fulfill buyers requirement & satisfy them. Its vision also includes* Internationally Integrated * Globally Competitive * Fully equipped to exploit the opportunities .
MISSION
RSL through its innovative technology and effective resource management has maintained high ethical and professional standards. The core values are its commitment, integrity, excellence, teamwork, transparency and creativity. It is committed to;
Produce quality and fault free products for its valued customers by continuous improvements, providing proper training and development programs, upgrading of resources, setting quality objectives by analyzing customers' feedback. Provide good returns and security to its shareholders.
MANAGEMENT Customer Oriented Policy Our clients are our main concern. We constantly listen to them, and anticipate and satisfy their needs through total Quality Management. Furthering the professional advancement of employees Each manager encourages his collegues development and supports internal promotion in a climate of trust and mutual understanding and encouragement. Safe-keeping of the company's interest In all actions and decisions, we take account not only of our own objectives, but also the global objectives of the company. Responsibilities We make decisions in an authentic and open manner and aim to keep those concerned properly informed. We commit ourselves and assume responsibility for our decisions and actions. Human Resource Management A rigorous approach to our organisation and management style encourages the will to succeed through effective communication.
Applied Management Our managers are personally commited to attaining their goals and objectives within quality standards and time limits.
OUR PHILOSOPHY
All customers are unique. Our customers are our partner because we know them &can offer them services which match their needs.
OUR METHOD
Promoting individual responsibility. Team work. Effective communication.
OUR STRENGTH
Professionalism. Indepth knowledge of our job & our product.
OUR APPROACH
Entrepreneurial.
OUR MOTTO
Built confidence.
OUR BOAST
Quality.
LIST OF BANKERS WITH WHICH IT DEALSi. ii. iii. iv. v. vi. HDFC (Kolkata) HDFC (indore) HSBC SBI(pithampur) SBI(indore) UBI
MEANING OF FINANCE
The definition of finance is the provision of funds or loan supplied to an individual or company. Often this term is used for the study of economics and how money is controlled. It can be also defined as the management of funds and capital required by a business and private activities. Management of finance has also developed into a specialized branch within the financial sector and is carried out by finance managers. Managing this involves dealing with the optimization and allocation of funds to various areas either by borrowing or by using those available from internal resources. The word Optimizing may sound strange but it refers to taking measures that minimize the cost of financing while simultaneously attempting to maximize the profits out of the employed finance. Bad debts are poor finance management where rules have not been followed; the result of this is depressed markets, low production and a cash crisis. It is for this very reason that finance managers are very careful with finance they agree too and where it is funded from. It is not uncommon to hear finance managers referred to as bean counters as they are looking at immediate returns and initial costs against the potential at a later stage. Finance managers are the pessimists whereas sales managers are the optimists who look to the future and not to the past! Often though, problems occur with small businesses who
fail to see the distinction between a business loan and a personal one. Most lenders will cancel the loan if they feel they have been deceived this way because they are unsure what the money is to be invested in. Hopefully by educating the small (and large) business owners of their fiscal responsibilities they may build the basis of an improved company in the future. Small businesses can be very flexible, however, and call upon friends, other businesses, family members, even their own bank for finance.
FINANCIAL FUNCTION
1st Function To Prepare the Budget.
It is duty of finance department of company to make the budget before actual providing money to any department. It will be helpful to fulfill each department with minimum cost. Finance department can take the past records from respective department. It will be useful for making better budget.
2nd
function
Financial
Management
In this function finance department gets money from capital market at very low risk and cost. Finance department analyzes all the resources of funds and create a good financial structure of company. In this structure, finance
department analyze whether it will decrease the overall cost of capital on Average basis or not.
Finance department takes many measures for managing the financial risks of company. For reducing loss of fund due to happening liquidity, solvency or financial disaster, finance department makes a good plan and also takes the help of debt collectors, insurance companies and other rating agencies for reducing financial risk.
MEANING OF CAPITAL BUDGETINGIt basically means planning for capital assets. capital budgeting decision means as to whether or not money should be invested in long term projects. such project may include the a) setting up of a factory b) Installing a machinery c) Creating additional capacities to a part which at present may be purchased from outside etc.
Typical investment decisions include the decision to build another grain silo, cotton gin or cold store or invest in a new distribution depot. At a lower level, marketers may wish to evaluate whether to spend more on advertising or increase the sales force, although it is difficult to measure the sales to advertising ratio. Capital budgeting is vital in marketing decisions. Decisions on investment, which take time to mature, have to be based on the returns which that investment will make. Unless the project is for social reasons only, if the investment is unprofitable in the long run, it is unwise to invest in it now. Often, it would be good to know what the present value of the future investment is, or how long it will take to mature (give returns). It could be much more profitable putting the planned investment money in the bank and earning interest, or investing in an alternative project.
Capital budgeting versus current expenditures A capital investment project can be distinguished from current expenditures by two features: a) such projects are relatively large b) a significant period of time (more than one year) elapses between the investment outlay and the receipt of the benefits.. As a result, most medium-sized and large organisations have developed special procedures and methods for dealing with these decisions. A systematic approach to capital budgeting implies: a) the formulation of long-term goals b) the creative search for and identification of new investment opportunities c) classification of projects and recognition of economically and/or statistically dependent proposals d) the estimation and forecasting of current and future cash flows e) a suitable administrative framework capable of transferring the required information to the decision level f) the controlling of expenditures and careful monitoring of crucial aspects of project execution g) a set of decision rules which can differentiate acceptable from unacceptable alternatives is required.
The classification of investment projectsa) 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 economic evaluation of investment proposals The analysis stipulates a decision rule for: I) accepting or II) rejecting investment projects The time value of money Recall that the interaction of lenders with borrowers sets an equilibrium rate of interest. Borrowing is only worthwhile if the return on the loan exceeds the cost of the borrowed
funds. Lending is only worthwhile if the return is at least equal to that which can be obtained from alternative opportunities in the same risk class. The interest rate received by the lender is made up of: i) The time value of money: the receipt of money is preferred sooner rather than later. Money can be used to earn more money. The earlier the money is received, the greater the potential for increasing wealth. Thus, to forego the use of money, you must get some compensation. ii) The risk of the capital sum not being repaid. This uncertainty requires a premium as a hedge against the risk, hence the return must be commensurate with the risk being undertaken. iii) Inflation: money may lose its purchasing power over time. The lender must be compensated for the declining spending/purchasing power of money. If the lender receives no compensation, he/she will be worse off when the loan is repaid than at the time of lending the money.
We can derive the Present Value (PV) by using the formula: FVn = Vo (I + r)n By denoting Vo by PV we obtain: FVn = PV (I + r)n by dividing both sides of the formula by (I + r)n we derive:
Rationale for the formula: As you will see from the following exercise, given the alternative of earning 10% on his money, an individual (or firm) should never offer (invest) more than $10.00 to obtain $11.00 with certainty at the end of the year.
b) Annuities
A set of cash flows that are equal in each and every period is called an annuity. Example: Year Cash Flow ($) 0 -800 1 400 2 400 3 400 PV = $400(0.9091) + $400(0.8264) + $400(0.7513) = $363.64 + $330.56 + $300.52 = $994.72 NPV = $994.72 - $800.00 = $194.72 Alternatively,
PV of an annuity = $400 (PVFAt.i) (3,0,10) = $400 (0.9091 + 0.8264 + 0.7513) = $400 x 2.4868 = $994.72 NPV = $994.72 - $800.00 = $194.72
c) Perpetuities
A perpetuity is an annuity with an infinite life. It is an equal sum of money to be paid in each period forever.
where: C is the sum to be received per period r is the discount rate or interest rate Example: You are promised a perpetuity of $700 per year at a rate of interest of 15% per annum. What price (PV) should you be willing to pay for this income?
= $4,666.67 A perpetuity with growth: Suppose that the $700 annual income most recently received is expected to grow by a rate G of 5% per year (compounded) forever. How much would this income be worth when discounted at 15%? Solution: Subtract the growth rate from the discount rate and treat the first period's cash flow as a perpetuity.
= $735/0.10 = $7,350
METHODS USED IN CAPITAL BUDGETING1) Net present value (NPV)Using a minimum rate of return known as the hurdle rate, the net present value of an investment is the present value of the cash inflows minus the present value of the cash outflows. A more common way of expressing this is to say that the net present value (NPV) is the present value of the benefits (PVB) minus the present value of the costs (PVC) NPV = PVB - PVC By using the hurdle rate as the discount rate, we are conducting a test to see if the project is expected to earn our minimum desired rate of return. Here are our decision rules:
Should we expect to earn at Accept the least investment? our minimum rate of return?
Positive
Accept
Zero
Benefits = Costs
Exactly equal to
Indifferent
Negative
Reject
Remember that we said above that the purpose of the capital budgeting analysis is to see if the project's benefits are large enough to repay the company for (1) the asset's cost, (2) the cost of financing the project, and (3) a rate of return that adequately compensates the company for the risk found in the cash flow estimates. Therefore, if the NPV is:
positive, the benefits are more than large enough to repay the company for (1) the asset's cost, (2) the cost of financing the project, and (3) a rate of return that adequately compensates the company for the risk found in the cash flow estimates. zero, the benefits are barely enough to cover all three but you are at breakeven - no profit and no loss, and therefore you would be indifferent about accepting the project. negative, the benefits are not large enough to cover all three, and therefore the project should be rejected.
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. The discount factor r can be calculated using:
Examples:
MERITSa) This method takes into account the time value of money. b) The whole stream of cash flows is considered. c) The net present value can be seen as the addition to the wealth of shareholders.the criterion of NPV is thus in conformity with basic financial objectives. d) The NPV uses the discounted cash flows i.e. expresses cash flows in terms of current rupees..the NPVs of different projects therefore can be compared.it implies that each project can be evaluated independent of others on its own merit. DEMERITSa) It involves difficult calculations. b) The application of this method necessitates forecasting cash flows & the discount rate.thus accuracy of NPV depends on accurate estimation of these two factors which may be quite different in practice. c) The decision under NPV method is based on absolute measure.It ignores the difference in initial outflows,size of different proposals etc.while evaluating mutually exclusive projects.
2) The internal rate of return (IRR)The IRR is the discount rate at which the NPV for a project equals zero. This rate means that the present value of the cash inflows for the project would equal the present value of its outflows. The IRR is the break-even discount rate. The IRR is found by trial and error.
where: Q (n,r) is the discount factor Io is the initial outlay C is the uniform annual receipt (C1 = C2 =....= Cn). Example: What is the IRR of an equal annual income of $20 per annum which accrues for 7 years and costs $120?
=6 From the tables = 4% Economic rationale for IRR: If IRR exceeds cost of capital, project is worthwhile, i.e. it is profitable to undertake. MERITSa) This method makes use of the concept of time value of money. b) All the cash flows in the project are considered. c) IRR is easier to use as instantaneous understanding of desirability can be determined by comparing it with the cost of capital. d) IRR technique helps in achieving the objective of minimization of shareholders wealth.
DEMERITS-
a) The calculation process is tedious if there are more than one cash outflows interspersed between the cash inflows, there can be multiple IRRs,the interpretation of which is difficult. b) The IRR approach creates a peculiar situation if we compare two projects with different inflow/outflow patterns. c) It is assumed that under this method all the future cash inflows of a proposal are reinvested at a rate equal to the IRR. It is ridiculous to imagine that the same firm has a ability to reinvest the cash flows at a rate equal to IRR. d) If mutually exclusive projects are considered as investment options which have considerably different cash outlays. A project with a larger fund commitment but lower IRR contributes more in terms of absolute NPV & increases the shareholders wealth. In suechniquch situation decision based only on IRR criterion may not be correct.
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.
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 11,500 Project B -15,000 18,000 Assume k = 10%, which project should Agritex undertake?
= $954.55
= 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
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. Differences in the scale of investment NPV and IRR may give conflicting decisions where projects differ in their scale of investment. Example: Years 0 1 2 3 Project A -2,500 1,500 1,500 1,500 Project B -14,000 7,000 7,000 7,000 Assume k= 10%. NPVA = $1,500 x PVFA at 10% for 3 years = $1,500 x 2.487 = $3,730.50 - $2,500.00 = $1,230.50. NPVB == $7,000 x PVFA at 10% for 3 years = $7,000 x 2.487 = $17,409 - $14,000 = $3,409.00.
IRRA =
IRRB =
= 2.0
Therefore IRRB = 21% Decision: Conflicting, as: NPV prefers B to A IRR prefers A to B NPV IRR Project A $ 3,730.50 36% Project B $17,400.00 21% See figure 6.3. Figure 6.3 Scale of investments
To show why: i) the NPV prefers B, the larger project, for a discount rate below 20% ii) the NPV is superior to the IRR a) Use the incremental cash flow approach, "B minus A" approach b) Choosing project B is tantamount to choosing a hypothetical project "B minus A". 0 1 2 3
Project B - 14,000 7,000 7,000 7,000 Project A - 2,500 1,500 1,500 1,500 "B minus A" - 11,500 5,500 5,500 5,500 IRR"B Minus A" = 2.09 = 20% c) Choosing B is equivalent to: A + (B - A) = B d) Choosing the bigger project B means choosing the smaller project A plus an additional outlay of $11,500 of which $5,500 will be realised each year for the next 3 years. e) The IRR"B minus A" on the incremental cash flow is 20%. f) Given k of 10%, this is a profitable opportunity, therefore must be accepted. g) But, if k were greater than the IRR (20%) on the incremental CF, then reject project. h) At the point of intersection, NPVA = NPVB or NPVA - NPVB = 0, i.e. indifferent to projects A and B. i) If k = 20% (IRR of "B - A") the company should accept project A. This justifies the use of NPV criterion. Advantage of NPV: It ensures that the firm reaches an optimal scale of investment. Disadvantage of IRR: It expresses the return in a percentage form rather than in terms of absolute dollar returns, e.g. the IRR will prefer 500% of $1 to 20% return on $100. However, most companies set their goals in absolute terms and not in % terms, e.g. target sales figure of $2.5 million. The timing of the cash flow The IRR may give conflicting decisions where the timing of cash flows varies between the 2 projects.
Note that initial outlay Io is the same. 0 1 2 Project A - 100 20 125.00 Project B - 100 100 31.25 "A minus B" 0 - 80 88.15 Assume k = 10% NPV IRR Project A 17.3 20.0% Project B 16.7 25.0% "A minus B" 0.6 10.9% IRR prefers B to A even though both projects have identical initial outlays. So, the decision is to accept A, that is B + (A - B) = A. See figure 6.4. Figure 6.4 Timing of the cash flow
The horizon problem NPV and IRR rankings are contradictory. Project A earns $120 at the end of the first year while project B earns $174 at the end of the fourth year.
0 1 23 4 Project A -100 120 - - Project B -100 - - - 174 Assume k = 10% NPV IRR Project A 9 20% Project B 19 15% Decision: NPV prefers B to A IRR prefers A to B
= 4 years Example 2:
Years 0 1 2 3 4 Project B - 10,000 5,000 2,500 4,000 1,000 Payback period lies between year 2 and year 3. Sum of money recovered by the end of the second year = $7,500, i.e. ($5,000 + $2,500) Sum of money to be recovered by end of 3rd year = $10,000 - $7,500 = $2,500
= 2.625 years MERITSa) It is very simple & quite method to understand.it has the advantage of making it clear that there is no profit on any project the payback period is over. This method is particularly suitable in the case of industries where the risk of technological obsolescence is very high.in such industries,only those projects which have a shorter payback period should be financed since the change in technology would make the projects totally obsolete before their costs are recovered. b) In the case of case of routine projects also the use of payback period method favours projects which generates cash inflows in earlier years ,thereby eliminating projects bringing cash inflows in later years which generally are conceived to be risky as risk tends to increase with futurity. c) The pay back period can be compared to a break even point,the point at which the costs are fully recovered but profits are yet to commence. The risk associated with a project arises due to uncertainty associated with the cash inflows.a shorter payback period means that the uncertainty with respect to the project is resolved faster. DEMERITS-
It ignores the timing of cash flows within the payback period, the cash flows after the end of payback period and therefore the total project return. It ignores the time value of money. This means that it does not take into account the fact that $1 today is worth more than $1 in one year's time. An investor who has $1 today can either consume it immediately or alternatively can invest it at the prevailing interest rate, say 30%, to get a return of $1.30 in a year's time. It is unable to distinguish between projects with the same payback period. It may lead to excessive investment in short-term projects.
Note that net annual profit excludes depreciation. Example: A project has an initial outlay of $1 million and generates net receipts of $250,000 for 10 years. Assuming straight-line depreciation of $100,000 per year:
= 15%
= 30%
MERITSThis method is quite simple & popular because it is easy to understand & includes income from the project throughout its life.
DEMERITSIt does not take account of the timing of the profits from an investment. It implicitly assumes stable cash receipts over time. It is based on accounting profits and not cash flows. Accounting profits are subject to a number of different accounting treatments. It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment. It takes no account of the length of the project. it ignores the time value of money.
Despite the limitations of the payback method, it is the method most widely used in practice. There are a number of reasons for this: It is a particularly useful approach for ranking projects where a firm faces liquidity constraints and requires fast repayment of investments. It is appropriate in situations where risky investments are made in uncertain markets that are subject to fast design and product changes or where future cash flows are particularly difficult to predict. The method is often used in conjunction with NPV or IRR method and acts as a first screening device to identify projects which are worthy of further investigation. it is easily understood by all levels of management. It provides an important summary method: how quickly will the initial investment be recouped?
5)PROFITABILITY INDEXIt is the division of total discounted cash inflow & cash outflow. In certain cases we have to compare a number of proposals each involving different amount of cash inflows. one of the methods of comparing such proposals isto workout what is known as desirability factor or profitability index . In general terms a project is acceptable if its profitability index is greater than 1. Mathematically; The desirability factor is calculated as below: Sum of discounted cash inflows Initial cash outlay/Total cash outflow (as the case may be) Suppose we have three projects involving cash outflow of Rs. 5,50,000, Rs. 75,000 & Rs.1,00,20,000 resp. Suppose further that the sum of discounted cash inflows for these projects are Rs. 6,50,000,Rs.95,000 & Rs.10,030,000 resp .The desirability factors for the three projects would be as follows: 1. Rs.6,50,000 = 1.18 Rs. 5,50, 000
3.Rs. 1,00,30,000 = 1.001 Rs. 1,00,20,000 It would be seen that in absolute terms project 3 gives the highest cash inflows yet its desirability factor is low.This is because the outflow is also very high.the desirability/profitability index factor helps in ranking various projects.
Decision rule: PI > 1; accept the project PI < 1; reject the project If NPV = 0, we have: NPV = PV - Io = 0 PV = Io Dividing both sides by Io we get:
PI of 1.2 means that the project's profitability is 20%. Example: PV of CF Io PI Project A 100 50 2.0 Project B 1,500 1,000 1.5
MERITS a) This method also uses the concept of time value of money. b) It is a better project evaluation technique than NPV.
DEMERITSa) Profitability index fails as a guide in resolving capital rationing where projects are indivisible where projects are indivisible.once a single large project with high NPV is selected,possibility of accepting several small projects which together may have higher NPV than the single project is excluded. b) Situations may arise where a project with a lower profitability index selected may generate cash flows in such a way that another project can be taken up one or two years later,the total NPV in such case being more than the one with a project with high profitability index.
Thus profitability index cannot be used indiscriminately but all other type of alternatives of projects will have to be worked out.
EXAMPLE 1
A project entails an initial investment of $1,000, and offers cash returns of $400, $500, and $300 at the end of years one, two and three respectively. The companys cost of capital is 10%. Year 0 1 2 3 NPV IRR Project cash flow ($) -1,000.00 400.00 600.00 300.00 Discounted cash flow ($) -1,000.00 363.64 495.87 225.39 84.90 14.92% The table shows the discounted cash flow, the NPV of the project, and its IRR. The project is viable in NPV terms, and notice also that this is reflected in the IRR which is greater than the firms cost of capital of 10%. There are four methods we can use to determine the MIRR, two using a spreadsheet package, and two manual method.
Method 3 calculator
Now you have learnt how to perform the calculations on a computer, we also look at two approaches to MIRR calculations by hand and with a calculator. The traditionally taught calculator method is laborious and easy to get wrong. We will therefore proceed in two stages. Stage 1: Taking the project cash flows from the return phase (ie year one forward in this case), compound each cash flow forward to the end of the project using the firms cost of capital. Year 0
Project cash flow ($) -1,000.00 400.00 600.00 300.00 Year 1 cash flow compounded at 10% for two years ($) 484.00 Year 2 cash flow compounded at 10% for one year ($) -1,000.00 660.00 Modified cash flow ($) -1,000.00 1,444.00 Note, as with the first spreadsheet method we have a modified cash flow which has an identical NPV to the original project. Stage 2: Taking the total of the cash flows extended to year three, calculate the discount rate required to set this value when discounted equal to the outlay. To do this we need to use the following formula:
Outlay=
n is the number of years of the project. We can rearrange this formula and find a solution for this project as follow The only problem with this method is that it is time consuming to perform for anything but the smallest project.
MERITSThe advantages of using MIRR rather than IRR in support of capital investment decisionmaking are many. Take this example: Bill Smith of Siding Warehouse Inc. is preparing a capital-investment analysis for a new product line. Machinery and related working capital total $50,000. Smith projects that this product line will generate $25,000 of cash flows for three years, and estimates Sidings cost of capital to be 12 percent. The IRR on this investment is approximately 23 percent. The MIRR is approximately 19 percent, assuming Smith can reinvest the annual cash flows and earn 12 percent for the three-year projected life. The traditional IRR measure tells Siding that it must earn 23 percent on the annual cash flows for the new product line to generate an overall 23-percent rate of return. In other words, at a 23-percent cost of capital, the NPV of this product line is zero. This is the only value of the 23-percent measure. An MIRR estimate gives a different view. The new product line has the potential to earn a 19-percent rate of return. The analysis rests on the assumption that Siding can reinvest the funds at 12 percentits estimated cost of capital. This seems like a reasonable assumption. At a 19-percent return, the owners wealth is increasing. The project rate of return is greater than the cost of capital.
DEMERITSThat said, MIRR does have one disadvantage. All percentage measures suffer from a scale problem, which means that management shouldnt use MIRR to compare projects of different sizes. Instead, use NPV, which points to potential wealth creation.
Capital Rationing
Capital rationing is a strategy used by organizations attempting to limit the costs of their own investments. Typically, a company engaging in capital rationing has made unsuccessful investments of capital in the recent past and would like to raise the return on those investments prior to engaging in new business. Why Ration Capital
The main goal of capital rationing is to protect a company from over-investing its assets. If this were to occur, the company might continue to see low return on investment and even face a compromised financial position. Further, this can cause a company's stock to drop. How to Ration Capital The main device for capital rationing is increasing the cost of capital. "Cost of capital" is a term used to describe the cost of debt and equity, and it can be raised or lowered based on the company's willingness to borrow money or issue stocks. A company can increase the cost of capital by borrowing less, thus making it more challenging to invest. The company would engage in new products only if the anticipated return is higher than the new cost of capital. For example, raising the cost of capital from 10 percent to 5 percent would demand the company see a 5 percent higher return on any future investment than on those in the past. MERITThe main benefit of capital rationing is budgeting a company's corporate resources. When a company issues stock or borrows money, it can use these resources for new investments. However, if the company does not see a good return on investments, it is wasting these resources. By capital rationing, which is the process of increasing the cost of capital, the company can make sure it takes on fewer projects. Further, it can take on only projects for which the anticipated return on investment is high. This will prevent the company from over-extending its finances, which would cause a decrease in stock price and stability.
DEMERIT The capital rationing may lead to several small investment projects rather than the large scale investment projects. This may likely to have a bearing on the risk complexion of the business firm. The project under capital rationing are selected certain criterion doesnot account or add intermediate cashflows. The provision to account intermediate cash inflows is to be provided by an investment project. Some of the investment projects/proposals may yield relatively higher total cash flow in the initial or early years than other projects. The availability of such funds tends to reduce capital budgeting constraints of the early/future years & these can be used to finance profitable investment proposals. Therefore the management should consider more than one period in the allocation of initial capital for investment proposals. capital rationing usually results in an investment policy that is less than the desired profitability.
This is because the capital rationing doesnot allow the business firm to accept all profitable investment projects, which could add to net present value. Capital rationing brings down opportunity cost to the extent of NPV forgone on account of non acceptance of otherwise acceptable investment proposals.
Let us take a look at Keymer Farm's required rate of return. If it invested $10,000 for one year on 1 January, then on 31 December it would require a minimum return of $4,000. With the initial investment of $10,000, the total value of the investment by 31 December must increase to $14,000. During the year, the purchasing value of the dollar would fall due to inflation. We can restate the amount received on 31 December in terms of the purchasing power of the dollar at 1 January as follows: Amount received on 31 December in terms of the value of the dollar at 1 January:
= $10,769 In terms of the value of the dollar at 1 January, Keymer Farm would make a profit of $769 which represents a rate of return of 7.69% in "today's money" terms. This is known as the real rate of return. The required rate of 40% is a money rate of return (sometimes known as a nominal rate of return). The money rate measures the return in terms of the dollar, which is falling in value. The real rate measures the return in constant price level terms. The two rates of return and the inflation rate are linked by the equation: (1 + money rate) = (1 + real rate) x (1 + inflation rate) where all the rates are expressed as proportions. In the example, (1 + 0.40) = (1 + 0.0769) x (1 + 0.3) = 1.40
In Keymer Farm's case, the cash flows are expressed in terms of the actual dollars that will be received or paid at the relevant dates. Therefore, we should discount them using the money rate of return. TIME CASH FLOW DISCOUNT FACTOR PV $ 40% $ 0 (150,000) 1.000 (100,000) 1 90,000 0.714 64,260 2 80,000 0.510 40,800 3 70,000 0.364 25,480 30,540 The project has a positive net present value of $30,540, so Keymer Farm should go ahead with the project. The future cash flows can be re-expressed in terms of the value of the dollar at time 0 as follows, given inflation at 30% a year: TIME ACTUAL CASH FLOW CASH FLOW AT TIME 0 PRICE LEVEL $ $ 0 (100,000) (100,000) 1 90,000 69,231 2 3 80,000 70,000 47,337 31,862
The cash flows expressed in terms of the value of the dollar at time 0 can now be discounted using the real value of 7.69%. TIME CASH FLOW DISCOUNT FACTOR PV $ 7.69% $ 0 (100,000) 1.000 (100,000) 1 69,231 64,246 2 47,337 40,804
31,862
25,490 30,540
CPP is a system of accounting which makes adjustments to income and capital values to allow for the general rate of price inflation. CCA is a system which takes account of specific price inflation (i.e. changes in the prices of specific assets or groups of assets), but not of general price inflation. It involves adjusting accounts to reflect the current values of assets owned and used. At present, there is very little measure of agreement as to the best approach to the problem of 'accounting for inflation'. Both these approaches are still being debated by the accountancy bodies.
regarding the increase in cost of project due to delay beyond the expected time.The increase will be due to many factors like inflation & increase in overhead expenditure etc.
2) ESTIMATION OF ADDITIONAL WORKING CAPITAL REQUIREMENTS-The next step isto ascertain the additional
working capital required for financing the increased activity on account of the new capital expenditure project.It has often been seen that the project planners donot ake into account the amount required to finance the additional working capital.In many cases it is quite possible that the increase in additional working capital may even exceed amount of capital expenditure required.untill & unless this factor is taken into account,the cashflow will remain incomplete. Thus the finance manager should make a careful estimate of the requirements of additional working capital.As the new capital project starts opening,the requirements should be shown in terms of cash outflows. At the expiry of the useful life of the project the working capital will be released & can therefore,be treated as cash inflow.the impact of inflation should also be brought into account ,while working out the cash outflows on account of working capital. In an inflationary economy the requirements of working capital may rise progressively even though there is no increase in activity of a new project.This is because the value of stock etc.may rise due to inflation.Hence,additional working capital requirements on this account should be shown as cash outflows.
initial year of its commercial production ,the company may even have cash outflows in terms of losses. On the basis of the additional production units that can be sold & the price at which they can be sold,the gross revenues from a project can be worked out.However ,in doing so the possibility of a reduction in the of cheaper or more efficient product by competitors recession in the market conditions & such other factors must be kept in mind.
Cash inflows can also be worked out backwards,by adding interest on long term funds & depreciation to the net profits & deducting the liability for taxation for the year.
TYPES OF DECISIONS-
CAPITAL
INVESTMENT
There are many ways to classify the capital budgeting decisions.Generally capital investment decisions are classified in two ways & they area) incorporated On the basis of firms existence. b) On the basis of decision situation.
market s etc.for reducing the risk of failure by dealing in different products or by operating in several markets. Both expansion & diversification expansion decisions. decisions are called revenue
MUTUALLY EXCLUSIVE DECISIONS-The decisions are said to be mutually exclusive if two or more alternate proposals are such that the acceptance of one proposal will exclude the acceptance of the other alternative proposals. For instance,a firm may be considering proposal to install a semi-automatic or highly automatic machine.If the firm install a semi-automatic machine it exclude the acceptance of proposal to install highly automatic machine. ACCEPT REJECT DECISIONS-The accept-reject decisions occurs when proposals are independent & donot compete with each oter.The firm may accept or reject a proposal on te basis of a minimum return on the required investment. All those proposals which give a higher return than certain desired rate of return are accepted & the rest are rejected. Contigent decisions-The contingent decisioins are dependable proposals.The investment in one proposal require investment in one or more other proposals.For example if a company accepts a proposal to set up a factory in remote area it may have to invest in infrastructure also.e.g.building of roads,houses for employees etc.
Very Important:
A capital budgeting analysis conducts a test to see if the benefits (i.e., cash inflows) are large enough to repay the company for three things: (1) the cost of the asset, (2) the cost of financing the asset (e.g., interest, etc.), and (3) a rate of return (called a risk premium) that compensates the company for potential errors made when estimating cash flows that will occur in the distant future.
If we make our decision based solely on the NPV's dollar amount, we would choose asset B since it has the higher NPV. However, per dollar invested, asset A obviously has the higher return. If the cost of the two assets differ by a considerable amount, we should use the profitability index instead of the NPV to make our decision. The profitability index, by definition, is the ratio of the present value of the benefits (PVB) to the present value of the cost (PVC). This simple benefits-to-costs ratio will remove the scale effect's bias. We obviously prefer to invest in the asset that has the higher value for the profitability index.
IMPORTANCE OF CAPITAL BUDGETINGCapital budgeting decisions are of paramount importance in financial decision. So it needs special care on account of the following reasons:
1. Long-term Implications: A capital budgeting decision has its effect over a long
time span and inevitably affects the companys future cost structure and growth. A wrong decision can prove disastrous for the long-term survival of firm. On the other hand, lack of investment in asset would influence the competitive position of the firm. So the capital budgeting decisions determine the future destiny of the company.
the firm from earning profit from other investments which could not be undertaken.
economic-political social and technological factors. EVALUATION OF A PROJECT REGARDING OPENING OF A NEW BRANCH IN KHARSABAD.RELEVANT INFORMATIONS ARE GIVEN BELOW-
DETAILS OF SALES PRICE & EXPENSES COMBED COTTON SEMI COMBED COTTON MOTHLY AMOUNT
COUNT
TOTAL
BLEND
2/30 2/30 1/30 SEMI 1/30 COMBED COMBED COMBED COMBED COTTON COTTON COTTON COTTON 100% 100% 100% 100%
GROSS SELLING PRICE LESS: EXPENSES FREIGHT/KG SALES TAX EXCISE DUTY EX-MILL PRICE AGENCY COMMISSION EX.MILL REALISATION RAW MATERIAL COST EXCISE DUTY FOR STORES & PACK. PACKING COST CONTRIBUTION
10.3
1.50%
3.89 255.77
3.91 256.73
3.94 258.7
3.67 241.29
51428 3377132
15.429 1013.14
208.55
208.55
190.6
190.58
2685722
805.716
0 2.5 44.72
0 2.5 45.68
0 2.5 65.58
0 2.5 48.2
0 33498 657913
0 10.049 197.374
7353
1760
4286
DESCRIPTION 1.RAW MATERIAL (Transit Days 3 + 7 Days RMG) cotton cotton TOTAL 2. WORK IN PROGRESS STOCK Fibre stage yarn stage 3.FINISHED GOODS STOCK Export Domestic 4.DEBTORS Export debtors Domestic debtors 5.STORE SPARES & PACKING STOCK Consumable Stores Packing material - Export Packing material - Export Diesel/Fo 6.EXPENSES Power Wages Salary
Rate
502.46 0 502.46
150 0 150
854.19 0 854.19
10
167.49
285
785.85 854.19
7 7
93.79 93.79
183 199
683.35 170.84
7 7
75.03 18.76
159 40
321.58 80.39
175 175
562.76 140.69
10 9
107.19 24.12
188 42
321.58 80.39
2.5 1.75
22 8.04 1.41 22
30 30 30
22 8 1 22
50 10 8.25
58 25 5
Admn. Expenses Store spares consumption Selling expenses (Ocean frt.,Local frt,Comm. & Others) TOTAL CREDIT AVAILABLE Cotton credit Store Creditors(50% 0f Cash pur.) Packing materials TOTAL NET add-cotton extra stock
10 22 9 9 1287
502.46
170
854.19 22 9.45
30 60 60
16.75%
30%
EVALUATION OF PROJECT- It involve different stages which we need to follow & they are as follows-
Sales LESSRaw material Wages Power Packing material Selling expenses Freight Sales tax Agency comm. CONTRIBUTION LESSSalary Adm.exp. Stores & spare parts CASH PROFIT(monthly)
4.9777 5.1316
212.5 150
2)Calculation of cashflow from operation(IN CR.) Cash profit(104.3493*12*1 LAKH/1 CRORE) (-)dep. Profit before tax 12.5219 1.724 10.7979
9.2825
3)EVALUATION OF PROJECT THROUGH DISCOUNTED CASH FLOW ANALYSISpresent Discounted value cash cash(In Particulars year factor flow crores)
Project cost Working capital Cashflow from operation working capital recovery NPV 0 0 1 to 49 49 1 1 5.968 0.001 45 2.54 9.2825 2.54 -45 -2.54 55.39796 0.00254 7.8605
CONCLUSION-since NPV is positive here , it shows that it will be profitable to open one of its kh Branch in Khasrabaad.
BIBLOGRAPHY www.Ritspin.com Financial management book of ICAI www.Investopedia.com www.Business.mapsofindia.com Information from RSL. www.economywatch.com