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Advanced Corporate Finance Assignment
Fadhal Abdulla A V
Pipelines and R&D. Most companies use multiple techniques for all of their capital budgeting decisions. Marketing. Refining. 2001.10 crore to Rs. but many small businesses lack personnel with awareness of the complexity of capital budgeting. 250 crore and above require also approval of Project Evaluation Committee.50 crore to Rs. Capital budgeting is the process of determining whether or not an investment is worthwhile. 100 crore Above Rs.g. which can also be employed in making decisions.10 crore : Board : Planning & Project Committee of Board : Chairman : Functional Director Project costing Rs. it is best to employ multiple analyses and take the opportunities with the best return according to all techniques. There are a number of minor methods. For example. 50 crore Up to Rs. b) Diversification projects e. Liquefied Natural Gas (LNG). a company might be trying to determine whether to buy new equipment to expand production capacity on an existing product. or to invest in research and development for a new product. c) Globalization Projects – Core/ non-core sector projects overseas. Simply estimating yearly returns in cash flow doesn't offer your small business an accurate representation of an investment's real return value. Accountants use several complex calculations to analyze possible investment returns. such as profitability index and sensitivity analysis. Capital Projects in IOC are broadly divided into: a) Core-sector projects e. 1 . Internal Rate of Return (IRR) and Payback Period. d) Merger / Acquisitions As per revised DOA effective from April 9.100 crore Above Rs. all capital investment proposals above Rs. Petrochemicals and Power etc. Since each method looks at the investment from a different perspective. Often companies will have several opportunities and must measure each one's potential in order to make a comparison and choose just one or a few. CAPITAL BUDGETING IN INDIAN OIL CORPORATION LTD.100 crore require Boards approval as under: Above Rs.CAPITAL BUDGETING Capital budgeting involves determining the most advantageous investment options for your small business's liquid assets.g. Exploration & Production (E&P). The three main methods of taking this measurement are Net Present Value (NPV).
financial and economic analysis of the proposal are undertaken. rationale and background of need for the project.Dynamism of a corporation in the new business environment is often dependent on diversification of investment as well as modernization and expansion of existing projects. Financial Analysis 5. 2 . The Proposal shall present the complete perspective. material inputs. Once the size of the investment is known assessment of project financing is made simultaneously. Five steps are basic in investment analysis. Sensitivity and Risk Analysis The foremost issue that needs to be described in the Capital Investment Proposal pertains to identification of basic objective or need which is sought to be fulfilled by implementation of the proposed project. Financial analysis of a proposal helps in answering the questions: Is the proposal profitable? Are the expected returns commensurate with the costs involved including borrowing costs? Is the proposal profitable in terms of other investment opportunities? Is it worthwhile investing in the project in terms of certainty of returns? The final decision on a proposal is taken only after sensitivity and risk analysis. These two sets of inflows and outflows form the basis for developing the statements required for financial and economic analysis. Technical Feasibility Study 4. On the building blocks of the market and commercial assessment along with technical feasibility studies. Capital investment analysis involves estimating and comparing the benefits of these schemes. technology and equipment. It is an exercise that helps the Corporation to take a decision on the investment proposal under review. From market assessment the revenue stream is set out against the expenditure stream from the technical studies. They are: 1. it helps identify the critical market and economic factors such as demand for the product under review. feasible pricing schemes that impinge on the profitability projections of the proposal etc. As a tool for assessing the commercial dimensions of the project. As the name suggests sensitivity analysis test the proposal’s viability or profitability to modifications in few critical variables. implementation schedule in to the relevant categories of investment (project) cost and operating (production) costs spread over the life of the project. Need and Justification 2. The sensitivity of the project to the critical variables is thereby established. Market and Commercial Assessment 3. Technical feasibility study helps assemble the different components of production as land and site development. labor inputs. Market assessment helps strengthen the case for the project under review. scope for inter-product substitution. The scope of market assessment is vast.
Risk analysis is a more comprehensive extension of sensitivity analysis as it seeks to examine the profitability of the capital invested subject to differing combinations of movements of the critical variables. The capacity utilization shall not be more than 60% in the first year and at 90% from second year onwards till project life cycle. The determination of operating cash flows shall. receipt / repayment of loans and payment of interest shall not be considered while calculating ROI. 3 . OPERATING CASH FLOWS This component of cash flow presents year-wise cash flow generated from operations after the project has been commissioned. to the Corporation after implementation of the project. Financial analysis of capital investment proposals shall be carried out based on realistic set of assumptions duly considering present prices of input / output. Both sensitivity and risk analysis enables the management to comprehend the sources of risk that a project is exposed to cover its projected life period. these are to be considered while calculating ROE. market forces etc. therefore. debt service coverage ratio (DSCR) and break even (BE) analysis etc. initial investment shall comprise of the total project cost as indicated in the capital investment proposal and shall also include incremental value of working capital. entail estimating year-wise operating income. More important. FINANCIAL ANALYSIS The Financial analysis of a project is vital for assessing the viability of the project and hence provides valuable information to the decision-maker. which will accrue. it enables the corporation to undertake measures that help to mitigate risk either through risk sharing procedures or through hedging options. Financial analysis produces an estimate of the financial gains. wherever required. While computing initial investment a care needs to be exercised in respect of following: In respect of proposals where financing through borrowings is envisaged. In other words. DETERMINATION OF CASH FLOWS Determination of year-wise cash flows is the most crucial step of the financial analysis. The Cash flows shall be determined for three components namely: Initial Investment Operating Cash Flows Terminal Cash Flows INITIAL INVESTMENT This component of cash flow mainly represents net cash outlay in the period in which the asset is purchased or constructed. computation of key decision criterion like internal rate of return (ROI & ROE). Sensitivity analysis is the first step towards risk analysis. net present value (NPV) of cash flows. However. input/ raw material cost and operating expenses during the project life. The financial analysis entails determination of year-wise cash flow of the project.
ocean insurance. after implementation of the project. In case there is a tariff cap by regulating authority then it is to be considered. For petroleum products. in this regard. • In case of Export Parity Price.e. • For Pipeline projects. In the base case. Product-wise marketing margins shall be based on 8% mark-up or actual margin whichever is less are to be considered. Freight is to be compared with alternate transportation mode for return on investments (cost of capital). (c) Here it is pertinent to mention that future pricing should factor in likely supply/demand situation and impact of likely substitution. • Sale prices of free trade products in target market and basis of adoption for it. in case competitors’ prices are lower than import parity t hen the same shall be used. INPUT/ RAW MATERIAL COST: a) Landed cost of inputs / raw material shall include all the incidental costs involved including present rate of custom duties. • The prices should take into account the impact of discounts including cost for extended credit. prices are to be considered based on competitors’ prices or Govt.) based on import parity (80% of import parity and 20% of export parity) considering applicable ocean freight. following issues are to be kept in view: • For Refinery projects. prices are to be based on landed cost of substituted products (based on import parity). • For new products. ocean loss. export incentives if available to be considered. present duties. cost with investment. as included in the price build up is to be reckoned. • Further. freight under recovery etc. inland freight etc. 70% of Notional Railway Freight (NRF) shall be considered as revenue generation.OPERATING INCOME: (a) Operating income of a project represents total realization or savings from the operations. policy in this regard. cost without investments vs. there shall be detailed calculations for cost in both cases i. 3 years average import parity (80% of import parity and 20% of export parity) prices on landed cost basis/ as per pricing policy of corporations are to be assumed. / Regulatory authority is applicable then it is to be considered. (b) While computing the Gross operating income. • For diversification products. alternate mode of transportation is to be considered as benchmark. However. Subsidy component of any to be borne by Corporation is to be duly factored in. (d) For such projects where investment shall result in savings in costs. in case any price cap by Govt. However. Refinery Gate Price (3 Years average excluding abnormal fluctuation such as war situation etc. 4 . selling price to be considered based on aver age 3 years FOB price at nearest market having demand for similar or near similar product (excluding abnormal period) minus 5% to take care of the impact of extra supply in the market plus freight charges (ocean and inland)/ other charges. if any. • Sale price of regulated products (if any) is to be considered as per policy of Govt.
no forward cost escalation is being considered while estimating the project cost. depreciation. including freight up to market / storage point is to be considered. Terminal cash flow to be taken in 16th year. Other items to be valued at 30% of the original cost without financing cost. Salvage value shall be considered as under: Land to be valued at original cost. Capital gains shall be taken as terminal value minus written down value as per income tax act. However. expenses and net revenues may be stated in constant prices or values based on today’s investment price levels. wages and salaries. PROJECT LIFE For cash flow determination and financial analysis. is whether such estimates shall be based on current prices or constant prices. (c) A comparative analysis of the estimated operating cost with the similar existing operations shall also be indicated along with reasons for variations. the life of project shall be assumed as 15 years from the date of completion. and fuel) repairs and maintenance. Tax on capital gain should be considered. future income. an issue. since. utilities (like power. wherever applicable. c) For Marketing projects. (b) The expenses under these various heads shall be estimated on a realistic set of assumptions and past experience. which is raised quite frequently. Forecasts in current prices. TERMINAL CASH FLOW The cash flow in the terminal year of the project mainly represents the salvage value of the project plus release of incremental working capital. Further. which include the effects of inflation do not give a realistic picture of the true financial profitability of a project. crude cost may be considered based on 3-year average import parity prices of identified crude (excluding abnormal fluctuation such as war situation etc. rent and insurance. FINANCIAL EVALUATION 5 . water. the project cost shall also be prepared based on completion project cost. The basis for estimating the expenditure shall be clearly indicated in the proposal. OPERATING EXPENSES: (a) The operating expenditure of the project shall include the cost of chemicals and consumables. wherever applicable. cost of procurement of products. other administrative expenses etc.b) For refineries.). unless the project life is shorter. CASH FLOWS BASED ON CONSTANT PRICES While preparing Cash Flow estimates. Therefore. inflation can artificially improve apparent profitability by increasing future revenue as compared with today’s capital costs.
96 15. INTERNAL RATE OF RETURN (IRR) Internal Rate of Return (IRR) is the discounting rate at which present value of cash inflow is equal to the present value of cash outflow.61 8.35% 16% 0.66% 5. Major assumptions are: CAPM model has been used. hurdle rates are linked to cost of long term foreign Currency loan including forward premium. Methodology of Computation of Post-Tax Hurdle rates Hurdle rates (benchmark IRR) are proposed to be linked to long term WACC of IOCL. For global projects.92 . The evaluation shall be carried out through following two methods: Internal Rate of Return (ROI/ROE) Net Present Value (NPV) Both the above methods fully recognize the timing of cash flows through the process of discounted cash flows. Margin over WACC (risk premium) is fixed on nature of projects. The computed IRR shall be compared with Benchmark IRR (hurdle rates). In other words. securities has been considered. Long term debt: equity ratio is considered as 1:1.93% 33. Last 3-years average risk rate of return on 10-year Govt.After determination of cash flow as per methodology enumerated above. the discount rate that yields a ZERO Net Present Value is called Internal Rate of Return. IRR shall be computed for all capital investment proposals and indicated in the Capital Investment Proposals. Hurdle rates shall be revised annually after approval of competent authority. Ke=Rf+B*(Rm-Rf) Cost of Long term Debt Corporate Tax Tax Adjusted cost of Debt (Kd) 6 6. Average cost of Long-term debt based on cost financing for future projects instead of historic actual. Calculation of WACC for the Year 2007 is shown below: Risk free rate of return (Rf) Expected Market Return on equity (Rm) Average Beta of IOC Cost of equity. the next logical step is to financially evaluate the proposal. Last 3-years average Beta of IOC has been considered. Hurdle rates shall be calculated based on Weighted Average Long Term Cost of Capital ( WACC) along with project specific risk premium.
which can be quantified and measured. This discounting rate adopted shall be the Hurdle Rate.77% (say 11%) post tax hurdle rates for Different Projects are Combined projects having linkage with one or more divisions Refinery & pipelines project Marketing division Projects Petrochemical. starting from the year ‘0’ till complete project life i. these are the benefits related to socio and strategic needs of the country. the present value of each year’s net cash flow is calculated. it is equally important that the proposal shall also indicate other intangible benefits of the project. If the project has a positive Net Present Value. but it may also lead to higher productivity. the project is considered to be commercially viable. safety needs. 15 years. Power and R&D projects -Through JVs -In IOC B/S E&P projects Global Projects 14% 16% 19% 14% 13% 13% 13% NET PRESENT VALUE (NPV) The present value of a future sum of money can be found by discounting it to the present point in time or Year ‘O’ at the required rate of return/ discount rate. This includes projects for pollution control. staff welfare etc.Debt:Equity ratio WACC= (Ke+Kd)/2 1:1 10. better safety etc. PRE-REQUISITES FOR BUDGETING 7 . A care needs to be taken while listing the intangible benefits of the project. Divisions shall indicate Net Present Value of all the projects at a discount rate of Hurdle Rate duly enclosing workings with the capital investment proposal. Required rate of return shall not be less than cost of capital. OTHER INTANGIBLE BENEFITS Apart from carrying out the financial analysis of the proposal. For example. Normally.e. shall not be treated as intangible benefits. Gas. Under this method. a project for modernization of equipment may have a number of intangible benefits like lesser pollution. The benefits.77% Based on WACC of 10.
Storage and handling Index of Digboi Refinery for the year 2003-04 & 2004-05 are 429. High capacity majority of SKO & HSD tanks at Digboi refinery are of fixed roof type contributing to fugitive emission loss resulting in high fuel & loss of the refinery. AN ENERGY CONSERVATION PROJECT AT IOCL DIGBOI REFINERY Digboi Refinery with an installed capacity of 1. which inter-alia includes: (a) (b) (c) (d) (e) Brief description of the project.2 and these accounts to a gap of US$ 0.1 23. These products are stored in various storage tanks at Oil Movement & Storage (OM&S).71 Lakhs.8 respectively against Shell benchmark of 86. Any proposal that is initiated for inclusion in the budget shall be supported with the concept and the administrative approval.9 47. The Floating roof facilitates the reduction of evaporative loss that occurred the vapor space of fuels that were stored in fixed – roof tanks. Opportunity exists for reduction of loss by converting high capacity tanks of OM&S from fixed roof to floating roof.Once the items or facilities in which the investments are needed are identified the next step is the initiation of the proposals. The floating roof also virtually eliminates the possibility of a boil over phenomenon that occurs in fixed – roof tank farms where crude oils are stored. As per total cost estimation Tank roof conversion of T-13 & 14 will cost Rs. Aviation Turbine Fuel (ATF) and High Speed Diesel (HSD) as white oil products. Based on cost estimation of engineering services detail cost estimation was prepared for the total job and material with 10 % escalation. 116. Cost of the Project Justification of project Economics of the project Benefits.4 and 458. but also helped to reduce the potential for vapor space explosions that regularly occur in fixed – roof tanks. It has not only proved effective for reducing emissions from the storage of volatile organic compounds when compared to fixed – roof tanks.6 millions. Superior Kerosene Oil (SKO).0 MMTPA has Motor Spirit (MS). DESCRIPTION Equipment & Machinery Erection charges Civil works VALUE ( in lakhs) 66. As per Benchmarking report of Shell Global Solutions International.8 8 . Because of these advantages the floating roof is now used extensively throughout the industry to store petroleum and petrochemical substances in large quantities. COST ESTIMATE For cost estimation engineering services were asked to provide with basic cost estimation for various jobs of roof conversion from Fixed to Floating for tank-13.
2 (With CDM) Years and IRR on investment is 5.9 MT/year S. the proposed facility will contribute towards corporation‘s social commitment for cleaner environment.85 Lakhs/Yr under Clean Development Mechanism (CDM).0 MT of high valued petroleum products and earn extra revenue of Rs. 17.54 Lakhs (Without CDM) Rs. No 1.8% (Without CDM) & 6.8 151. 17.8 13. The project will attract additional recurring benefit of Rs.39 Lakhs (With CDM) Value 66. Parameter Total loss from T-13 with fixed roof Total loss from T-13 with Floating roof Saving by conversion of roof from Fixed to Floating for T-13 9 . Tank – 13 is higher capacity which accounts to high fugitive emission. By conversion of Roof from fixed to floating roof of Tank – 13 Digboi Refinery can save 60.0 MT/year 6.Total Add: 10% contingency Total expenditure 137. 18. ECONOMICS OF THE PROJECT: NET SAVING : Rs.5 %( With CDM) %. 0.54 Lakhs/Annum with average 2005-06. GR inspection recommended for replacement of tank roof in 2006. Loss on crude processing of Digboi is averaged to 0. 2.5% in last Four Years. 3. Digboi Refinery‘s Fuel & Loss is second highest among Indian refining sector and this proposal is towards improvement in this area.9 MT of SKO per Annum respectively. Payback period of investment is 8. Being refinery located in heart of the city.6 JUSTIFICATION OF THE PROJECT: Fugitive emission loss from Tank – 13 has been estimated to be 59.1 MT/year 59. 29281/MT.6 (Without CDM) & 8. 2006-07 & 2007-08 AOR prices of SKO @ Rs.
00 13. 5.54/Mt 13 Estimation of CDM Benefit for Roof Conversion of Tank-13 Parameters Projected fuel saving from Roof Conversion Average density of Saved Oil Calculated C:H ration of saved oil Carbon content of saved oil Value 59.47 51.85 Rs/Lakhs/annum FINANCIAL EVALUATION Case-I :Without considering CDM benefit Case-II: With CDM benefit Projected Annual Benefit (Benefit due to Loss reduction) Total investment cost for Roof conversion of Tank-13 & 14 Annual maintenance /operating cost Cash outflow in 2009 (100% of investment cost) Cash inflow in 2009 (considering 0% benefit in1st year) Cash inflow in 2010 (considering 75% benefit in 2nd year) Yearly Cash inflow throughout 2011-2023 10 17.80 18.58 0. Average SKO price Rs.39 151.4.00 -151.54 151.88 MT/annum Reduction in CO2 emission due to saved oil(Considering 12 MT of 190 MT of CO2 C generates 44 MT of CO2) Equivalent Carbon credit (CER) Prevailing price of CER (Based on inputs from M/S Ernst&Young) Prevailing conversion rate of Euro to INR CDM benefit based on E&Y projection 190 CER 8 Euro/CER 56.00 -151.54 18.15 17.39 .9 MT/yr 0.84 MT/m3 6.18 Rs/euro 0.58 0.Rs.58 0. 17.58 0.00 13. 29281/Mt Monetary saving by conversion of roof from fixed to floating for T.
72 The project is accepted if the internal rate of return is higher or equal to the benchmark IRR is also known as Hurdle rate. As the IRR is found to be lower than the Hurdle rate the project should be rejected. As far as NPV is concerned.77%.77%) Discounted Pay – back period *All in Rs. Hurdle rate for Refinery & Pipelines Divisions’ Projects is 13%. A project shall be rejected if its IRR is lower than the Hurdle rate.85% (43. Lakhs 5. This also proposes to reject the project. 11 .82 6.5% (37.25) 28.99) 22. the project is having a negative NPV at WACC=10.Internal rate of return NPV (WACC=10.
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