1

UNIVERSITY OF MUMBAI

THE STUDY OF CAPITAL BUDGETING

A Project Submitted to

University of Mumbai for partial completion of the degree of

Master in Commerce

Under the faculty of Commerce

By

KHAN RUFIYA SUFIYAN AHMED

Under the guidance of

Prof. Ms. NAZNEEN MOMIN

K.M.E. Society’s G.M. Momin Women’s College

2018 - 2019
 2

K.M.E. SOCIETY's G.M. MOMIN WOMENS COLLEGE

CERTIFICATE

This to certify that Ms. KHAN RUFIYA SUFIYAN AHMED has worked and
duly completed her Project Work for the degree of Master in Commerce under the
Faculty of Commerce in the subject of ACCOUNTING.

And her project is entitled, “THE STUDY OF CAPITAL BUDGETING ” under

my supervision. I further certify that the entire work has been done by the learner
under my guidance and that no part of it has been submitted previously for any
Degree or Diploma of any University.

It is her own work and facts reported by her personal findings and investigations.

Seal of the Name and Signature of

Seal of the
Guiding Teacher
College

Date of Submission:
 3

DECLARATION BY LEARNER

I the undersigned Miss. KHAN RUFIYA SUFIYAN AHMED here by, declare
that the work embodied in this project work titled “THE STUDY OF CAPITAL
BUDGETING ” , Forms may own contribution to the research work carried out
under the guidance of Prof. NAZNEEN MOMIN is a result of my own research
work and has not been previously submitted to any other University for any other
Degree/Diploma to this or any other University.

Wherever reference has been made to previous work of others, it has been clearly
indicated as such and included in the bibliography.

I, here by further declare that all information of this document has been obtained
and presented in accordance with academic rules and ethical conduct.

Name and Signature of the learner

Certified by
Name and Signature of the guiding teacher
 4

ACKNOWLEDGEMENT

To list who all have helped me is difficult because they are so numerous and the
depth is so enormous.

I would like to acknowledge the following as being idealistic channels and fresh
dimensions in the completion of this project.

I take this opportunity to thank the University of Mumbai for giving me chance to
do this project.

I would like to thank my Principal, Dr. M.J. KOLET for providing the necessary
facilities required for completion of this project.

I take this opportunity thank our Coordinator Ms. NAZNEEN MOMIN for her
moral support and guidance.

I would like to thank my College Library, for having provided various reference
books and magazines related to my project.

Lastly, I would like to thank each and every person who directly or indirectly
helped me in the completion of the project especially my Parents and Peers who
supported me throughout my project.
 5

INDEX

CHAPTER No. TITLES OF THE CHAPTER Pg.no

1. INTRODUCTION 06

2. RESEARCH METHODOLOGY 18

3. LITERATURE REVIEW 22

4. DATA ANALYSIS, INTERPRETATION

AND PRESENTATION 29

5. CONCLUSION 41

BIBILIOGRAPHY 42
 6

CHAPTER 1 : INTRODUCTION

All of us, at one time or another, have had to deal with either preparing or following a budget. In
fact, many households manage their financial affairs through a budget. Businesses do the same
things through what is know as capital budgeting.
The process of capital budgeting is vital to any responsible, well managed business. If that business
is public and owned by public shareholders, the budgeting process becomes more crucial, since
shareholders can hold management accountable for accepting unprofitable projects that can have
the effect of destroying shareholder value.
Capital budgeting involves choosing projects that add value to a company. The capital budgeting
process can involve almost anything including acquiring land or purchasing fixed assets like a new
truck or machinery. Corporations are typically required, or at least recommended, to undertake
those projects which will increase profitability and thus enhance shareholders' wealth.
When a firm is presented with a capital budgeting decision, one of its first tasks is to determine
whether or not the project will prove to be profitable. The net present value (NPV), internal rate
of return (IRR), and payback period (PB) methods are the most common approaches to project
selection. Although an ideal capital budgeting solution is such that all three metrics will indicate
the same decision, these approaches will often produce contradictory results. Depending on
management's preferences and selection criteria, more emphasis will be put on one approach over
another. Nonetheless, there are common advantages and disadvantage associated with these widely
used valuation methods.

Meaning of Capital Budgeting:

Capital budgeting, and investment appraisal, is the planning process used to determine whether an
organization's long term investments such as new machinery, replacement of machinery, new
plants, new products, and research development projects are worth the funding of cash through the
firm's capitalization structure (debt, equity or retained earnings). It is the process of allocating
resources for major capital, or investment, expenditures. One of the primary goals of capital
budgeting investments is to increase the value of the firm to the shareholders.

Definition of Capital Budgeting :

R.M.LYNCH has defined Capita Budgeting as “Capital Budgeting consists of
employment of available capital for the purpose of maximizing the long term profitability of
the firm .”
CAPITAL BUDGETING is many sided activity. It includes searching for new and more profitable
investments proposals, investigating, engineering, and marketing considerations to predict the
consequences of accepting the investment and making economic analysis to determine the profit
potential of each investment proposal.
 7

NATURE OF CAPITAL BUDGETING :

Capital Budgeting decisions include acquisition, replacement, expansion and modernization of
assets. Any investment decision with long term implications can be looked at as a capital
expenditure decision. When a pharmaceutical firm decides to invest in R & D, a car manufacturer
considers investment in a new plant, an airline plans to buy a fleet of aircraft, a bank plan
computerisation, a firm plan to launch new products line. They are all capital budgeting decisions.
These decisions have following features:
1. Usually involves huge outlays.
2. Decisions are difficult.
3. They have long term consequences.
4. Growth of an organization depends on the quality of such decisions.
5. Higher degrees of risk is involved.
6. They benefit future periods.
7. They have the effect of increasing the capacity, efficiency, span of life regarding future
benefits.

PRINCIPLES OF CAPITAL BUDGETING:

Capital budgeting typically adopts the following principles:

1. Decisions are based on cash flows and not on accounting concepts such as net income
2. The timing of cash flows is critical
3. Cash flows are based on opportunity costs. A comparison is made between the
incremental cash flows that occur with an investment and without the investment.
4. Cash flows are analyzed on an after-tax basis. Taxes have to be fully reflected in capital
budgeting decisions.
5. The financing costs are ignored. Financing costs are already reflected in the required rate
of return and therefore including them again in the cash flows and in the discount rate
would lead to double counting.
6. The capital budgeting cash flows are not the same as accounting net income.
 8

NEEDS AND IMPORTANCE OF CAPITAL BUDGETING:

Capital budgeting decisions are of paramount importance in financial decision. The profitability
of a business concern depends upon the level of investment made for long period. Moreover, the
investments are made properly through evaluating the proposals by capital budgeting. So it needs
special care. In this context, the capital budgeting is getting importance. Such importance are
briefly explained below.
1. Long-term Implications of Capital Budgeting
A capital budgeting decision has its effect over a long time span and inevitably affects the
company’s 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.
2. Involvement of large amount of funds in Capital Budgeting
Capital budgeting decisions need substantial amount of capital outlay. This underlines the need for
thoughtful, wise and correct decisions as an incorrect decision would not only result in losses but
also prevent the firm from earning profit from other investments which could not be undertaken.
3. Irreversible decisions in Capital Budgeting
Capital budgeting decisions in most of the cases are irreversible because it is difficult to find a
market for such assets. The only way out will be scrap the capital assets so acquired and incur
heavy losses.

4. Risk and uncertainty in Capital budgeting

Capital budgeting decision is surrounded by great number of uncertainties. Investment is present
and investment is future. The future is uncertain and full of risks. Longer the period of project,
greater may be the risk and uncertainty. The estimates about cost, revenues and profits may not
come true.

5. Difficult to make decision in Capital budgeting

Capital budgeting decision making is a difficult and complicated exercise for the management.
These decisions require an over all assessment of future events which are uncertain. It is really a
marathon job to estimate the future benefits and cost correctly in quantitative terms subject to the
uncertainties caused by economic-political social and technological factors.

6. Large and Heavy Investment

The proper planning of investments is necessary since all the proposals are requiring large and
heavy investment. Most of the companies are taking decisions with great care because of finance
as key factor.

7. Permanent Commitments of Funds

The investment made in the project results in the permanent commitment of funds. The greater
risk is also involved because of permanent commitment of funds.

8. Long term Effect on Profitability

 9

Capital expenditures have great impact on business profitability in the long run. If the expenditures
are incurred only after preparing capital budget properly, there is a possibility of increasing
profitability of the firm.

9. Complicacies of Investment Decisions

Generally, the long term investment proposals have more complicated in nature. Moreover,
purchase of fixed assets is a continuous process. Hence, the management should understand the
complexities connected with each projects.

10. Maximize the worth of Equity Shareholders

The value of equity shareholders is increased by the acquisition of fixed assets through capital
budgeting. A proper capital budget results in the optimum investment instead of over investment
and under investment in fixed assets. The management chooses only most profitable capital project
which can have much value. In this way, the capital budgeting maximize the worth of equity
shareholders.

11. Difficulties of Investment Decisions

The long term investments are difficult to be taken because decision extends several years beyond
the current account period, uncertainties of future and higher degree of risk.

12. Irreversible Nature

Whenever a project is selected and made investments as in the form of fixed assets, such
investments is irreversible in nature. If the management wants to dispose of these assets, there is a
heavy monetary loss.

13. National Importance

The selection of any project results in the employment opportunity, economic growth and increase
per capita income. These are the ordinary positive impact of any project selection made by any
company.
 10

CAPITAL BUDGETING DECISIONS

According to Pandey (1995), the investment decision of a firm, popularly known as the capital
budgeting or capital expenditure decision, may be defined as the firm’s decision to invest its current
funds most efficiently in long term assets in anticipation of expected flow of benefits over a series
of years. It is the process of making investment decisions in capital expenditure, defined as that
expenditure which is incurred at one point of time whereas the benefits of it are realized at different
points of time in future. It involves sacrifice of a certain amount of present resources in exchange
for a future return and an arbitrage over time that involves risk. To quote Jain and Kumar (1998),
“A typical investment or capital budgeting involves certain
sacrifice of resources now in exchange for an uncertain but hopefully large inflow of resources in the near
or distant future.” Capital expenditure may take several forms like cost of acquisition, addition, expansion,
improvement in the fixed assets as land and building, plant and machinery, goodwill etc., cost of
replacement of permanent assets, research and development, and diversification into new business areas.
Investment decision is important because it determines the value of a firm by influencing its growth,
profitability and risk. It is considered to be one of the most important decisions because it has long-term
implications for a firm. The financial manager before going in for any kind of investment engages himself
with rational matching of present value of benefits with present costs so as to increase Net Present Value of
a project, which in turn will increase the market value of shares of a firm and ultimately maximizes
shareholders’ wealth.
In short, capital budgeting is the process of deciding what investment decision should be taken and which
project is beneficial for a period of time keeping in mind the objective of maximization of shareholders’
wealth. These decisions involve commitment of huge funds that too for a longer period which also changes
the risk complexion of business. This decision, if undertaken judiciously, helps in providing the benefits of
maximization of wealth not only for the concerned organization and industry but also for the economy as a
whole. On the other hand, if this decision is not given its due importance, it will ultimately lead to the
decline and demise of even a growing prosperous organization.
 11

METHODS OF CAPITAL BUDGETING

Following are the various methods and criteria involved in a CAPITAL BUDGETING decisions.
They are classified as follows:

1. AVERAGE RATE OF RETURN (ARR):

Accounting rate of return, also known as the Average rate of return, or ARR is a financial
ratio used in capital budgeting. The ratio does not take into account the concept of time value of
money. ARR calculates the return, generated from net income of the proposed capital investment.
The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to
earn seven cents out of each dollar invested (yearly). If the ARR is equal to or greater than the
required rate of return, the project is acceptable. If it is less than the desired rate, it should be
rejected. When comparing investments, the higher the ARR, the more attractive the investment.
More than half of large firms calculate ARR when appraising projects.
The key advantage of ARR is that it is easy to compute and understand. The main disadvantage of
ARR is that it disregards the time factor in terms of time value of money or risks for long term
investments. The ARR is built on evaluation of profits and it can be easily manipulated with
changes in depreciation methods. The ARR can give misleading information when evaluating
investments of different size.

 BASIC FORMULAS

ARR = Average return during periods / Average Investment

Where,
Average Investment = (Opening Investment + Closing Investment) / 2
Average Return during periods = (Incremental Revenue – Incremental Expenses)
/ Initial Investment
Average Profit = Profit after tax / Life of Investment
2. AVERAGE ACCOUNTING RETURN (AAR):
The average accounting return (AAR) is the average project earnings
after taxes and depreciation, divided by the average book value of the investment during its
life. Approach to making capital budgeting decisions involves the average accounting return
(AAR). There are many different definitions of the AAR. However, in one form or another,
the AAR is always defined as: Some measure of average accounting profit divided by some
measure of average accounting value. The specific definition we will use is: Average net
income divided by Average book value. It is kinds of decision rule to accept or reject the
finance project. For decide to these projects value, it needs cutoff rate. This rate is kind of
deadline whether this project produces net income or net loss.
There are three steps to calculating the AAR.
 12

First, determine the average net income of each year of the project's life. Second, determine the
average investment, taking depreciation into account. Third, determine the AAR by dividing the
average net income by the average investment. After determine the AAR, compare with target
cutoff rate. For example, if AAR determined is 20%, and given cutoff rate is 25%, then this project
should be rejected. Because AAR is lower than cutoff rate so this project will not make sufficient
net income to cover initial cost.

Average accounting return(AAR) does have advantages and disadvantages. Advantages; It is

easier to calculate than other capital budgeting decision rules. It only needs net income data and
book values of the investment during its life. Another advantage is needed information will usually
be available. Disadvantage; it does not take time value of money into account. When we average
figures that occur at different times, we are treating the near future and the more distant future in
the same way. Therefore, there is no clear indication of profitability. Also the use of an arbitrary
benchmark cutoff rate is a disadvantage. The last disadvantage is it is based on accounting net
income and book values, not cash flows and market values.

3. PAYBACK PERIOD
Payback period in capital budgeting refers to the period of time required to recoup the funds
expended in an investment, or to reach the break-even point. For example, a $1000
investment made at the start of year 1 which returned $500 at the end of year 1 and year 2
respectively would have a two-year payback period. Payback period is usually expressed in
years. Starting from investment year by calculating Net Cash Flow for each year: Net Cash
Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1. Then Cumulative Cash Flow =
(Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3, etc.) Accumulate
by year until Cumulative Cash Flow is a positive number: that year is the payback year.
The time value of money is not taken into account. Payback period intuitively measures how
long something takes to "pay for itself." All else being equal, shorter payback periods are
preferable to longer payback periods. Payback period is popular due to its ease of use despite
the recognized limitations described below.
The term is also widely used in other types of investment areas, often with respect to energy
efficiency technologies, maintenance, upgrades, or other changes. For example, a compact
fluorescent light bulb may be described as having a payback period of a certain number of
years or operating hours, assuming certain costs. Here, the return to the investment consists
of reduced operating costs. Although primarily a financial term, the concept of a payback
period is occasionally extended to other uses, such as energy payback period (the period of
time over which the energy savings of a project equal the amount of energy expended since
project inception); these other terms may not be standardized or widely used.
 FORMULA FOR PAYBACK PERIOD

PAYBACK PERIOD = Initial Cash Outflow / Annual Cash Inflow

OR

PAYBACK PERIOD = Year before full recovery + (Uncovered Amounts of Investment ÷

 13

Cash Flow during the Year )

4. NET PRESENT VALUE (NPV):

In finance, the net present value (NPV) or net present worth (NPW) applies to a series of
cash flows occurring at different times. The present value of a cash flow depends on the
interval of time between now and the cash flow. It also depends on the discount rate. NPV
accounts for the time value of money. It provides a method for evaluating and comparing
capital projects or financial products with cash flows spread over time, as in loans,
investments, payouts from insurance contracts plus many other applications.
Time value of money dictates that time affects the value of cash flows. Net present value (NPV)
is determined by calculating the costs (negative cash flows) and benefits (positive cash flows) for
each period of an investment. The period is typically one year, but could be measured in quarter-
years, half-years or months. After the cash flow for each period is calculated, the present value
(PV) of each one is achieved by discounting its future value at a periodic rate of return (the rate of
return dictated by the market). NPV is the sum of all the discounted future cash flows.

 FORMULA

NET PRESENT VALUE = P.V. Of all Cash Inflows – P.V. of all Cash Outflows

5. PROFITABILITY INDEX (PI):

Profitability index (PI), also known as profit investment ratio (PIR) and value investment
ratio(VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking
projects because it allows you to quantify the amount of value created per unit of investment.
Assuming that the cash flow calculated does not include the investment made in the project, a
profitability index of 1 indicates breakeven. Any value lower than one would indicate that the
project's present value (PV) is less than the initial investment. As the value of the profitability
index increases, so does the financial attractiveness of the proposed project.

 FORMULA of PI

PROFITABILITY INDEX = P.V. of Cash Inflows ÷ P.V. of Cash Outflow

6. INTERNAL RATE OF RETURN (IRR):

The internal rate of return on an investment or project is the "annualized effective compounded
return rate" or rate of return that sets the net present value of all cash flows (both positive and
negative) from the investment equal to zero. Equivalently, it is the discount rate at which the net
present value of the future cash flows is equal to the initial investment, and it is also the discount
rate at which the total present value of costs (negative cash flows) equals the total present value of
the benefits (positive cash flows).
 14

The internal rate of return (IRR) is a measure of an investment’s rate of return. The
term internal refers to the fact that the calculation excludes external factors, such as the risk-free
rate, inflation, the cost of capital, or various financial risks.
It is also called the discounted cash flow rate of return

 FORMULA FOR IRR

IRR = Lower Discount Rates + (NPV at Lower rate / NPV at Lower rate –
NPV at Higher rates ) × (Higher rates – Lower rates )

7. MODIFIED INTERNAL RATE OF RETURN (MIRR):

The modified internal rate of return (MIRR) is a financial measure of an investment's
attractiveness. It is used in capital budgeting to rank alternative investments of equal size. As the
name implies, MIRR is a modification of the internal rate of return (IRR) and as such aims to
resolve some problems with the IRR.
While there are several problems with the IRR, MIRR resolves two of them.
Firstly, IRR is sometimes misapplied, under an assumption that interim positive cash flows are
reinvested at the same rate of return as that of the project that generated them. Secondly, more than
one IRR can be found for projects with alternating positive and negative cash flows, which leads
to confusion and ambiguity. MIRR finds only one value.

 CALCULATIONS OF MIRR
STEPS:
1. Compute total terminal value of Allah Cash Inflows using reinvestment rates
as under
1st year = C1¹×(1+k)n-1
nd
2 year = C1²×(1+k)n-2
rd
3 year = C1³×(1+k)n-3 and so on.
2. Compute MIRR
Initial Cash Outflows (1+r)n = Total Terminal Value of all Cash Inflows.

8. EQUIVALENT ANNUAL COST (EAC):

In finance, the equivalent annual cost (EAC) is the cost per year of owning and operating an
asset over its entire lifespan. It is calculated by dividing the NPV of a project by the "present value
of annuity factor":

EAC = NPV / At,r

where r is the annual interest rate and t is the number of years.
 15

Alternatively, EAC can be obtained by multiplying the NPV of the project by the "loan repayment
factor".

EAC is often used as a decision making tool in capital budgeting when comparing investment
projects of unequal lifespans. However, the projects being compared must have equal risk:
otherwise, EAC must not be used.
The technique was first discussed in 1923 in engineering literature and, as a consequence, EAC
appears to be a favoured technique employed by engineers, while accountants tend to prefer net
present value (NPV) analysis. Such preference has been described as being a matter of professional
education, as opposed to an assessment of the actual merits of either method. In the latter group,
however, the Society of Management Accountants of Canada endorses EAC, having discussed it
as early as 1959 in a published monograph.

9. REAL OPTIONS VALUATION (ROV):

Real options valuation, also often termed real options analysis, (ROV or ROA) applies option
valuation techniques to capital budgeting decisions. A real option itself, is the right—but not the
obligation—to undertake certain business initiatives, such as deferring, abandoning, expanding,
staging, or contracting a capital investment project. For example, the opportunity to invest in the
expansion of a firm's factory, or alternatively to sell the factory, is a real call or put option,
respectively.

Real options are generally distinguished from conventional financial options in that they are not
typically traded as securities, and do not usually involve decisions on an underlying asset that is
traded as a financial security. A further distinction is that option holders here, i.e. management,
can directly influence the value of the option's underlying project; whereas this is not a
consideration as regards the underlying security of a financial option. Moreover, management
cannot measure uncertainty in terms of volatility, and must instead rely on their perceptions of
uncertainty. Unlike financial options, management also have to create or discover real options, and
such creation and discovery process comprises an entrepreneurial or business task. Real options
are most valuable when uncertainty is high; management has significant flexibility to change the
course of the project in a favorable direction and is willing to exercise the options.

Real options analysis, as a discipline, extends from its application in corporate finance, to decision
making under uncertainty in general, adapting the techniques developed for financial options to
"real-life" decisions. For example, R&D managers can use Real Options Valuation to help them
allocate their R&D budget among diverse projects; a non business example might be the decision
to join the work force, or rather, to forgo several years of income to attend graduate school. It,
thus, forces decision makers to be explicit about the assumptions underlying their projections, and
for this reason ROV is increasingly employed as a tool in business strategy formulation. This
extension of real options to real-world projects often requires customized decision support
systems, because otherwise the complex compound real options will become too intractable to
handle.
 16

These methods use the incremental cash flows from each potential investment, or project.
Techniques based on accounting earnings and accounting rules are sometimes used - though
economists consider this to be improper - such as the accounting rate of return, and "return on
investment." Simplified and hybrid methods are used as well, such as payback
period and discounted payback period.
 17

CAPITAL BUDGETING PROCESS

Capital budgeting is a very complicated process as it involves steps relating to the investment of
current funds for benefits in future. The process may differ from one concern to another but,
overall, the process involves following steps:
1. Identification of investment proposal: Capital budgeting process starts with identification
of investment proposals. It is very important to select the best investment proposal. The
departmental head analyses various proposals in the light of the corporate strategies and submits
the suitable proposals to the Capital Expenditure Planning Committee of the business enterprise.
2. Screening of proposals: After identifying proposals, the Capital Expenditure Planning
Committee screens various proposals, which are received from different departments. The
committee views and checks these proposals and compares it with the company strategies.
3. Evaluation of various proposals: The next step in this process is to evaluate the profitability
of various proposals. To evaluate the profitability, various methods can be used, e.g. Payback
period method, Accounting Rate of Return method, Net Present Value method and Internal Rate
of Return method etc.
4. Fixing priorities: It is very important to fix the priorities because on the basis of priorities
decisions are taken and proposals are selected. Unprofitable or uneconomic proposals are rejected.
It is very essential to rank the various proposals and to establish priorities of these proposals.
5. Final approval and preparation of capital expenditure budget: After evaluation of proposals
and fixing priorities, the other criterion of final approval is its contribution in the capital
expenditure budget. It is very necessary to take correct decision or accept the final proposal so that
the company can get profits in future.
6. Implementing proposal: After preparation of a capital expenditure budget and
incorporation of a particular proposal in the budget, the next step involves implementation of the
project. When the project is implemented, it is very essential to assign responsibilities for
completing the project so as to avoid unnecessary delays and cost overruns.
 18

LIMITATIONS OF CAPITAL BUDGETING:

The following are the limitations of capital budgeting.

1. The economic life of the project and annual cash inflows are only an estimation. The actual
economic life of the project is either increased or decreased. Likewise, the actual annual cash
inflows may be either more or less than the estimation. Hence, control over capital expenditure can
not be exercised.
2. The application of capital budgeting technique is based on the presumed cash inflows and cash
outflows. Since the future is uncertain, the presumed cash inflows and cash outflows may not be
true. Therefore, the selection of profitable project may be wrong.

3. Capital budgeting process does not take into consideration of various non-financial aspects of
the projects while they play an important role in successful and profitable implementation of them.
Hence, true profitability of the project cannot be highlighted.

4. It is also not correct to assume that mathematically exact techniques always produce highly
accurate results.

5. All the techniques of capital budgeting presume that various investment proposals under
consideration are mutually exclusive which may not be practically true in some particular
circumstances.

6. The morale of the employee, goodwill of the company etc. cannot be quantified accurately.
Hence, these can substantially influence capital budgeting decision.
7. Risk of any project cannot be presumed accurately. The project risk is varying according to the
changes made in the business world.

8. In case of urgency, the capital budgeting technique cannot be applied.

9. Only known factors are considered while applying capital budgeting decisions. There are so
many unknown factors which are also affecting capital budgeting decisions. The unknown factors
cannot be avoided or controlled.
 19

CHAPTER 2: RESEARCH METHODOLOGY

OBJECTIVE OF THE STUDY

The overall objective of the study is to examine in detail the capital budgeting practices being
adopted by Indian companies in the turbulent and risk prone business environment. The specific
objectives of the study are:
1. To study the corporate practices regarding the capital budgeting techniques or methods
used for evaluating an investment proposal.
2. To study the criticality in terms of level of difficulty, importance and riskiness of
different stages of capital budgeting process, and the factors affecting capital budgeting
techniques which are being applied by the companies.
3. To investigate the corporate practices concerning cost of capital and cost of equity
capital.
4. To analyze the different sources of risk, their adjustments by companies, and the
corporate practices regarding the capital budgeting techniques incorporating risk.
5. To identify the non financial and other factors considered by the companies and their
relative importance while evaluating projects.
To study the impact of different variables on the selection of capital budgeting technique and risk
handling techniques used by different companies.
 20

SCOPE OF THE STUDY

The scope of my is to understand the Corporate practices regarding

Capital Budgeting. . Thus, the present study aims to fill up this research
gap by unveiling the status of capital budgeting in Indian corporate sector,
and studying the capital budgeting methods particularly the techniques
incorporating risk being preferred by these companies for taking
investment decisions. To address these issues, it is proposed to undertake
a comprehensive primary survey of companies in India to analyze the
capital budgeting practices being practiced by them. The scope of this
study is limited not merely to determining the corporate practices
regarding capital budgeting in Indian corporate sector but also to study
different variables or factors that have had an impact on the methods of
capital budgeting.
 21

METHODS OF DATA COLLECTION

1. Primary Data usually consists of the data that are collected afresh for the first time and
thus is Original in character.

2. Secondary Data consists of data that are collected from some existing
literature. It has been already analyzed by someone else earlier and is derived
from that source. Secondary data used in the study are:

 Newspapers,
 Books,

Analysis Pattern
 Statistical Tools- Graphs and Charts
 Tabulation of Data.
 22

LIMITATIONS OF THE STUDY:

 There can be a possibility of “Individuals Biasness" on the part of respondents.

 Sample size to be taken may not be the true representative of the Companies.

 Study would be confined to some Public & Private Companies.

 Due to paucity of time only Limited Information can be collected.

 23

CHAPTER 3 : LITERATURE REVIEW

INTRODUCTION:

A number of researchers in finance and accounting have examined corporate capital budgeting
practices. Many of these articles survey corporate managers and report the frequency with which
various evaluation methods, such as payback, internal rate of return (IRR), net present value
(NPV), discounted payback, profitability index (PI), or average return on book value are used.
The best known field studies about the practices of corporate finance are Gitman and Forrester’s
(1977) study of Capital Budgeting Techniques Used by Major U.S. Firms, Porwal’s (1976) study
on Capital Budgeting Techniques and Profitability and Graham and Harvey’s (2001) study on
capital budgeting, cost of capital, and capital structure. It is believed that the findings of this study
in the context of India are useful to academia and practitioners in learning how corporate India
operates, developing new theories, and identifying areas where finance theory is not implemented.

What are the capital budgeting tools and techniques being practiced by the industry and how
popular are they? Do firms use methods that help to maximize the firm value? The review of
empirical surveys and studies help to find answers to these questions.

The changes in capital budgeting procedures over the decades have been well documented in prior
studies. The research of Canada and Miller, Fremgen, Gitman and Forrester, Kim and Farragher,
Stanley Block all indicate that increasingly sophisticated capital budgeting procedures have been
put in practice.

LITERATURE REVIEW: INDIAN STUDIES

Prasanna Chandra (1975) conducted a survey of twenty firms to examine the importance
assigned to economic analysis of capital expenditures, methods used and its rationale for analyzing
capital expenditures and ways to improve economic analysis of capital expenditures. The findings
of the study reveals that the nature of economic analysis of capital expenditures varies from project
to project but in most of the firms surveyed the analysis is done in sketchy terms. The most
commonly used method for evaluating investments of small size is the PBP and for large size
investments the ARR is used as the principal criterion and the PBP is used as a supplementary
criterion. DCF techniques are gaining importance particularly in the evaluation of large
investments. Several other criterias such as profit per rupee invested, cost saving per unit of
product, investment required to replace a worker are used for evaluating investments. Most of the
firms do not have fixed standards for acceptance/rejection of projects. The most common methods
used for incorporating the risk factor into the capital expenditure analysis are conservative
estimation of revenues, safety margin in cost figures, flexible investment yardsticks, acceptable
overall certainty index and judgement on three point estimates of rate of return.

Porwal L S (1976) had done an empirical study of the organizational, quantitative, qualitative,
and behavioural and control aspects of capital budgeting in large manufacturing public limited
 24

companies in the private sector in India. He had selected 118 companies out of which 52
companies (44%) provided usable responses. The majority of the companies studied give more
importance to earning more profits or achieving a higher accounting rate of return on investment
in assets. The final authority to make a capital expenditure decision rests with the Board of
Directors (BOD) in case of four-fifths of the companies. Important key stages in the capital
expenditure process are(i) initiation, (ii) evaluation, (iii) approval and (iv) control. Though 44%
of the respondents ranked first preference for DCF techniques, however, most companies were
using combination of traditional and ‘theoretically correct’ economic evaluation techniques of
capital expenditure proposals. IRR is favoured for new product lines whereas ARR is most
favoured in case of existing product lines but PBP continues to be the next favoured technique.
Competitive position is the main non-financial factor that is given due consideration for the capital
budgeting decision. High profitability companies prefer ‘cost of funds used to finance the
expenditure’ more than the WACC for determining the cut-off point. Capital rationing is not much
of a problem in Indian industries. So far as risk in the capital budgeting is concerned, uncertainty
in the availability of inputs, inability to predict key factors and uncertainty in government policy
are reasons of project risk. Most companies in India are using one or more methods for
incorporating risk. The shorter payback period and higher cut-off rate are the popular techniques
used by companies in India. Priorities and higher rate of return are the two main criteria for
minimizing disappointment and perceived conflict among the departments of a firm. For
controlling capital expenditures, about two-thirds of the companies under study have reported that
they adopt post-audit.

Pandey I M (1989) In a study of the capital budgeting practices of fourteen medium to large size
companies in India, it was found that all companies, except one, used payback. With payback
and/or other techniques about two-thirds of companies used IRR and about two-fifths NPV. IRR
was found to be the second most popular method. The reasons for the popularity of payback in
order of significance were stated to be its simplicity to use and understand, its emphasis on the
early recovery of investment and focus on risk. It was found that one-third of companies always
insisted on the computation of payback for all projects, one-third for majority of projects and
remaining for some of the projects. For about two-thirds of companies’ standard payback ranged
between 3 and 5 years. According to his survey, reasons for the secondary role of DCF techniques
in India included difficulty in understanding and using these techniques, lack of qualified
professionals and unwillingness of top management to use DCF techniques. For capital rationing
it is found that most companies do not reject projects on account of capital shortage. They face
the problem of shortage of funds due to the management’s desire to limit capital expenditure to
internally generated funds or the reluctance to raise capital from outside. But generally companies
do not reject profitable projects under capital rationing; they postpone them till funds become
available. The most commonly used methods of risk analysis in practice are sensitivity analysis
and conservative forecasts. Except a few companies most companies do not use the statistical and
other sophisticated techniques for analyzing risk in investment decisions.
 25

Sahu P K (1989) has done a study on Capital budgeting in corporate sector in the state of Orissa.
He made an attempt to study the trends in fixed investment and its financing between 1960-61 to
1973-74. He took a sample of 15 companies. It was observed that routine investments were
financed through internal sources of funds while investments for the growth purpose are financed
through the external sources of funds. Short term financing is generally used for financing fixed
investments only during growth periods and that too for short periods. It was observed that PBP
and ARR were the methods generally preferred by firms followed by discounting methods NPV
and IRR.

Dhankar R S (1995) examined methods of evaluating investments and uncertainty in Indian

companies. He selected a sample of 75 firms. His findings revealed that 33% of firms used non-
discounted methods like PBP and ARR whereas 16% of companies were using modern DCF
techniques. Moreover, almost 50% of the companies incorporated risk by ‘Adjusting the Discount
Rate’ and ‘Capital Asset Pricing Model’.
U. Rao Cherukuri’s (1996) survey of 74 Indian companies revealed that 51% use IRR as project
appraisal criterion. Firms typically use (92% or more) multiple evaluation methods. ARR and PBP
are widely used as supplementary decision criteria. WACC is the discount rate used by 35% of
the sample firms. The most widely used discount rate is 15%, and over 50% use an after-tax rate.
About three-fifths of the respondents explicitly consider risk in capital project analysis and mostly
use sensitivity analysis for purposes of risk assessment. The most popular method used by
respondents to adjust for risk is shortening the PBP followed by increasing the required rate of
return. 35% of the respondents included leasing in the capital budgeting process. A few Indian
firms in his survey also used none of the methods listed on questionnaire. They were using
profitability and cash flow analysis for assessing capital expenditure. Apart from the formal
budgeting techniques due weightage is given to qualitative aspects like quality improvement
expected from the capital expenditure, capital expenditure for enhanced safely and capital
expenditure to meet statutory requirements and for benefit to the company’s personnel from health
considerations and social benefits like housing. The favorite capital budgeting methods of earlier
years, ARR (about 19%) and PBP (about 38%) have been used as primary methods.

C Prabhakara Babu & Aradhana Sharma (1996) had done an empirical study on capital
budgeting practices in Indian Industry. The authors have conducted a survey of 73 companies in
and around Delhi and Chandigarh. They used personal interview method. It has been found by
them that 90% of companies have been using capital budgeting methods. Around 73% of the
companies have been using DCF methods. The popular investment appraisal methods are the
‘IRR’ and the ‘PBP’, used either individually or jointly. Around 70% executives felt that it is
possible to estimate accurately the cash flows associated with each capital investment separately.
They have observed that capital investment proposals are prepared by the concerned departments
and the final decision is vested with other personnel/committee. The popular discount rate used
by the firms is ‘the term lending rate of financial institutions’ closely followed by ‘cost of capital’.
 26

The most often used method to resolve the uncertainty in the future returns seems to be ‘inflating
or deflating the future cash flows’-and it is followed by the use of ‘sensitivity analysis’. Most of
the executives (around 75%) appreciate the suitability of the DCF technique in our country.

Jain P K and Kumar M (1998) has done a comparative study of capital budgeting practices in
Indian context and observed that 25% of sample companies invested for expansion and
diversification and firms were making regular investments for replacement and maintenance. The
selected sample companies preference for evaluating capital budgeting projects were PBP, due to
its simplicity, easy understanding, less cost and less time, followed by NPV and IRR. Companies
preferred WACC followed by ‘Arbitrary rate’ and ‘Marginal cost of additional funds’ as cutoff
rate for discounting the projects. For adjusting risk, the ‘sensitivity analysis’ was preferred
followed by ‘Higher cut off rate’ and ‘Shorter Pay Back Period’.

Anand Manoj (2002) surveyed 81 CFOs of India to find out their corporate finance practices vis-
à-vis capital budgeting decisions, cost of capital, capital structure, and dividend policy decisions.
It analyzed the responses by the firm characteristics like firm size, profitability, leverage, P/E ratio,
CFO’s education, and the sector. The analysis reveals that practitioners do use the basic corporate
finance tools that the professional institutes and business schools have taught for years to a great
extent. It is also observed that the corporate finance practices vary with firm size. As per his
findings, the firms use DCF techniques more than before. They use multiple criteria in their project
choice decisions. 85% of the respondents consider IRR as a very important/important project
choice. About 65% of the respondents always or almost always use NPV. The PBP method is also
popular. Large firms are significantly more likely to use NPV than small firms. Small firms are
more likely to use PBP method than large firms. High growth firms are more likely to use IRR
than the low growth firms. The sensitivity analysis and scenario analysis are most widely used
techniques for assessing the project risk.

Gupta Sanjeev, Batra Roopali and Sharma Manisha (2007) has made an attempt to explore
which capital budgeting techniques is used by industries in Punjab, and the influence of factors
such as size of capital budget, age and nature of the company, and education and experience of
the CEO in capital budgeting decisions. They conducted a primary survey of 32 companies in
Punjab. Almost one-third of the companies had capital budget exceeding Rs. 100mn. Majority of
the sample companies still use non-discounted cash flow techniques like PBP and ARR. Only a
few companies use DCF, and among them very negligible number use NPV technique to evaluate
a new project. The most preferred discount rate is WACC. The most popular risk incorporating
technique is ‘Shorter PBP. Many companies feel that CEO education and experience play an
important role in selecting the capital budgeting technique. Further, The study did not find any
significant relationship between the size of capital budget and capital budgeting methods adopted.
 27

Similarly, though at some instances it appears that young companies prefer DCF techniques than
the older ones, the same is not true in case of NPV method. Thus, age of the company also does
not influence the selection of the capital budgeting technique. Similarly no significant relationship
could be established between the nature of industry and investment evaluation techniques.

LITERATURE REVIEW: FOREIGN STUDIES

Klammer, Thomas P. (1972) surveyed a sample of 369 firms from the 1969 Compustat listing
of manufacturing firms that appeared in significant industry groups and made at least $1 million
of capital expenditures in each of the five years 1963-1967. Respondents were asked to identify
the capital budgeting techniques in use in 1959, 1964, and 1970. The results indicated an increased
use of techniques that incorporated the present value (Klammer, 1984).

Fremgen James (1973) surveyed a random sample of 250 business firms that were in the 1969
edition of Dun and Bradsheet’s Reference Book of Corporate Management. Questionnaire were
sent to companies engaged in manufacturing, retailing, mining, transportation, land development,
entertainment, public utilities and conglomerates to study the capital budgeting models used,
stages of the capital budgeting process, and the methods used to adjust for risk. He found that
firms considered the Internal Rate of Return model to be the most important model for decision-
making. He also found that the majority of firms increased their profitability requirements to adjust
for risk and considered defining a project and determining the cash flow projections as the most
important and most difficult stage of the capital budgeting process.

Petty J William, Scott David P., and Bird Monroe M. (1975) examined responses from 109
controllers of 1971 Fortune 500 (by sells dollars) firms concerning the techniques their companies
used to evaluate new and existing product lines. They found that Internal Rate of Return was the
method preferred for evaluating all projects. Moreover, they found that present value techniques
were used more frequently to evaluate new product lines than existing product lines.

Bierman (1993) finds that 73 of 74 Fortune 100 firms use discounted cash flow (DCF) analysis,
with internal rate of return (IRR) being preferred over net present value(NPV). The pay back
period method also remains a very popular method in practice, though not as a primary technique.
93 per cent of the respondents use company-wide WACC for discounting free cash flows and 72
per cent use the discount rate applicable to project based on its risk characteristics.

Bierman Harold (1993) surveyed Fortune 500 industrial companies regarding the capital
budgeting methods used by these firms in 1993. He found that every responding firm used some
type of DCF method. The payback period was used by 84 percent of his surveyed companies.
 28

However, no company used it as the primary method, and most companies gave the greatest
weight to a DCF method. 99 percent of the Fortune 500 companies used IRR, while 85 percent
used NPV. Thus, most firms actually used both methods. 93 percent of companies calculated a
weighted average cost of capital as part of their capital budgeting process. A few companies
apparently used the same WACC for all projects, but 73 per cent adjusted the corporate WACC
to account for project risk, and 23 per cent made adjustments to reflect divisional risk.
Drury, Braund and Tayles’ (1993) survey of 300 manufacturing companies with annual sales
exceeding £20 million indicates that payback (86%) and IRR (80%) are the most widely used
project appraisal methodologies. The most widely used project risk analysis technique is
sensitivity analysis. Forty-nine per cent of the respondents do not use statistical analysis for risk
analysis and 95 per cent of the respondents never use either CAPM or Monte Carlo simulation due
to lack of understanding.

Petry and Sprow’s (1993) study of 151 firms listed in the 1990 Business Week 1,000 firms
indicates that about 60 per cent of the firms use the traditional payback period either as a primary
or as a secondary method for capital budgeting decisions. Ninety per cent of the firms use NPV
and IRR either as a primary or as a secondary capital budgeting decision methodology. Most of
the financial managers indicated that either they had not heard of the problems of IRR (multiple
rates of return, NPV and IRR conflict) or such problems rarely occurred.

Joe Walker, Richard Burns, and Chad Denson (1993) focused on small companies. They noted
that 21 percent of small companies used DCF. They also observed that within their sample, the
smaller the firm, the smaller the likelihood that DCF would be used. The focal point of their study
was why small companies use DCF so much less frequently than large firms. The three most
frequently cited reasons, according to the survey, were (1) small firms’ preoccupation with
liquidity, which is best indicated by payback, (2) a lack of familiarity with DCF methods, and (3)
a belief that small project sizes make DCF not worth the effort.

Richard Pike (1996) has done a longitudinal capital budgeting study based on surveys conducted
between 1975 and 1992 compiled by conducting cross-sectional surveys on the same firms at
approximately five yearly intervals. According to him, over the 17-year review period, there have
been the greatest changes in the areas of risk analysis, NPV analysis and post-completion audits.
The usage of DCF techniques have increased with each survey. His other findings are that firm
size is still significantly associated with degree of use for DCF methods but not for payback and
the use of ARR is unchanged. It is suggested that firm size per se may not be the direct causal
factor in determining use of sophisticated methods; size of firm influences the use of computer
based capital budgeting packages which, in turn, influence the use of discounting methods,
sensitivity analysis, and risk analysis techniques. Once size ceases to be associated with use of
computers in capital budgeting it is envisaged that it will also have far less impact on capital
 29

budgeting technique usage rates. He has reported the general increase in so-called sophisticated
capital budgeting techniques to a point where the gap between theory and practice is trivial, at
least for large firms due to three main factors viz., technical, educational and economic. This paper
has sought to provide a more reliable and comprehensive analysis of how capital budgeting
practices in large UK companies have evolved in recent years and, in so doing, provide a clearer
backdrop against which earlier studies can be interpreted and future studies enacted.

Truong G., Partington and Peat M. (2006) surveyed Australian firms which revealed that real
options techniques have gained a toehold in Australian capital budgeting but are not yet part of
the mainstream. Projects are usually be evaluated using NPV, but the company is likely to also
use other techniques such as the PBP. The project cash flow projections are made from three to
ten years into the future. The project cash flow will be discounted at the WACC as computed by
the company, and most companies will use the same discount rate across divisions. The
discount rate will also be assumed constant for the life of the project. The WACC will be based
on target weights for debt and equity. The CAPM will be used in estimating the cost of capital,
with the T-bond used as a proxy for the risk free rate, the beta estimate will be obtained from
public sources, and the market risk premium will be in the range of 6% to 8%. Asset pricing
models other than the CAPM will not be used in estimating the cost of capital.
However, consistent with recent overseas studies, Graham and Harvey (2001) and Bruner, et. Al.
(1998) the CAPM is the most popular method used in estimating the cost of capital in Australia.
Kester et al (1999) found that 73% of companies surveyed in six Asia Pacific countries, used
CAPM. Compared to two previous surveys of US companies, Gitman and Mercurio (1982) and
Gitman and Vandenberg (2000), increasing popularity of the CAPM model is apparent.

Lord Beverley R. and Boyd Jennifer R. (2004) surveyed half of the New Zealand local
authorities to find out how they undertook capital budgeting. This study was later extended to
all New Zealand local authorities. Results of the two surveys show that 75% of local authorities
use cost-benefit analysis and NPV in financially evaluating capital investments. However,
compared to studies of the private sector, there is a greater focus on qualitative aspects of
decision-making. Post-audits were also highly used, but with a focus on quantitative information.
 30

CHAPTER 4: DATA ANALYSIS , INTERPRETATION

AND PRESENTATION

INTRODUCTION:

This chapter examines the trend in capital budgeting practices of twenty eight companies operating
in different industry. The search for a reliable method of project appraisal dates back to decades.
The issue not only continues to be a matter of concern for academicians and managers but is also
becoming equally significant for shareholders and other investors of the organization. There are
number of tools available to determine the extent of profitability of a project but some of these
methods are not taking care of the continuous changes taking place in business environment where
shareholders value (wealth) maximizing is becoming a very important decision-making criterion.
Further, these methods sometimes fail to address the basic problems of investment appraisal while
some of these methods require complex decision making processes or it may require too much
application of computers. Thus, the choice of appropriate capital expenditure appraisal method is
becoming a difficult task for project managers, which requires critical analysis of various tools.
Finance experts’ propose various options to address the basic problems of investment management.

My literature review reveals that the traditional discounted cash flow techniques (DCF) are most
commonly used technique (Pay back Period) by many firms. Many organizations are greatly using
modern discounted techniques at the same time some scholars are proposing to use techniques
such as Monte Carlo simulations, real options etc. but all these techniques have been criticized for
its own limitations also. For instance, traditional methods lack strategic vision. DCF techniques do
not help in appraising all types of projects at all the stages of project implementation which leads
to selecting many projects on intuitions, experience and rule of thumb. Further, techniques like
simulation analysis, Monte Carlo, real options etc. are complex and requires too much
computational work and information. The techniques like EVA (economic value added) are
criticized for using accounting information and not cash flow information and also for not
addressing to the shareholder value maximization criterion.
The present study aims to unravel the status of capital budgeting practices in companies in India
and throws light on methods preferred by them while taking investment decisions. Before
presenting the results, description of the sample is given in terms of industries they are representing
in Table 5.1.
The study relies on the primary survey conducted. A structured non-disguised questionnaire was
used to collect the data from the 30 companies working in India. The researcher sent the
questionnaire to 200 companies, spread geographically over the length and breath of the country
covering representation of 9 industries, out of which 10 questionnaire came back may be due to
change in address, 5 companies said that it is not their company policy to participate in such survey.
 31

The responses obtained from 40 companies, for a response rate of 20%, which is comparable to
similar surveys of which 28 were usable responses. One responding firm is not using capital
budgeting methods at all so finally data analysis is done for 27 companies.
Table 5.1 Industry wise Distribution of Sample

Frequency Percent

Cement 1 3.7

Chemical 3 11.1

Consumer 2 7.4

Engineering 10 37.0

IT 1 3.7

Oil 1 3.7

Pharmaceutical 7 25.9

Sugar 1 3.7

Textile 1 3.7

Total 27 100.0

No. of companies using capital budgeting methods

27
27
Companies uses Capital Budgeting Tools & 01 Company does not use Capital Budgeting Tools.
Figure 5.1

Data Analysis & Findings:

 32

The questionnaire was comprised of 28 questions which were mainly open-ended and close ended.
The open-ended questions are used for writing theory while close-ended questions were
dichotomous, multiple choice and questions based on Likert scale. The primary data were analyzed
by applying tabular and chi-square analysis using SPSS rigorously.

Capital Budgeting Practices Amongst Sample Companies

Table 5.2 : Size of Annual Capital Budget

Average Size (Rs. Lakhs) Frequency Percent

Less than 100 1 3.7

101-500 5 18.5

501- 1000 7 25.9

1001-5000 6 22.2

Above 5000 8 29.6

Total 27 100.0

All the companies responded to the survey indicated that they are using capital budgeting methods
have specific amount of average size of annual capital budget. The results are summarized in the
above table 5.2. The median size of annual capital budget of Indian firms is Rs. 1042.20 Lakhs.

Table 5.3 Project Size Requires a Formal Quantitative Analysis

Amount Frequency Percent

 33

No specific amount 5 18.5

50001 to 100000 1 3.7

100001 to 500000 1 3.7

500001 to 1000001 5 18.5

1000001-5000000 7 25.9

> 5000001 8 29.6

Total 27 100.0

The researcher also wanted to know the project size that requires a formal quantitative analysis in
the Indian firms. As one can observe in Table 5.3, all project size requires a formal quantitative
analysis. However, as per the opinion of some respondents, the use of capital budgeting techniques
for evaluating capital expenditure projects depends on the nature and size of the particular projects.
Some respondents said that for replacement decision or process improvement they may use only
PBP. The median size of the project requiring formal quantitative analysis is Rs. 2200000.5
The table 5.4 given below summarizes the results for time frame for planning capital expenditures
of the organization i.e. how many years in advance usually the capital budgets are prepared for
achieving firm’s objectives.

Table 5.4 Time Frame for Capital Expenditure Budgets

Frequency Percent

1 Year Ahead 13 48.1

2 Year Ahead 5 18.5

3 Year Ahead 7 25.9

4 Year Ahead 1 3.7

 34

More than 4 year 1 3.7

Total 27 100.0

The survey indicates that nearly half of the companies (48.1%) have been planning capital budget
1 year ahead while almost one fourth of the firms are planning 3 years in advance. But surprisingly
only one of the responding companies has reported to be planning in advance for more than 4
years. Perhaps, it may be due to highly dynamic, turbulent and volatile macro-economic conditions
prevailing at global level. But this finding does not support the findings of the Porwal (1976)
which indicates that more than two-thirds of sample companies were found to be planning five
years in advance while nearly one-third of sample companies planning only one year in advance.
It even contradicts the findings of Jain
P. K., Jain S. K. and Tarde S. M. (1995) which revealed that 45.3% firms have been planning
capital budget five years ahead.
One of the objectives of this study is to determine which of the quantitative evaluation techniques
are currently used by firms operating in India. Therefore, the researcher wanted to know whether
the firms are using theoretically sound investment appraisal techniques. There are mainly two types
of techniques used in evaluating projects viz., Discounted cash flow/Time-adjusted techniques like
NPV, IRR and PI which takes into account the time value of money and Non-discounted cash
flow/Traditional techniques like PBP, ARR. The firms were asked to indicate the relative
importance of each of quantitative techniques on a Likert Scale of 1 to 5 (where 1 = not used,
2=unimportant, 3=somewhat important, 4=important and 5=very important). This approach not
only reveals which of the techniques are used, it also provides information on the relative
importance of each technique in decision-making.
 35

Importance of Capital Budgeting Techniques

80

70

60

50

40
30

20

10

0
IRR PBP NPV ARR PI
TECHNIQUES

Not Used Unimportant Somewhat Important Important Very

Important

Figure 5.2

The results are shown in figure 5.2 ranked according to perceived importance. The responding
firms ranked PBP (59.3%), IRR (40.7%) and NPV (33.3%) as the most important techniques
respectively. Among these techniques PBP is getting highest rating even though it ignores time
value of money and it also ignores cash flow beyond pay back period. It seems as it is easy to
calculate and understand, PBP is still a very popular technique. Although it is not directly
comparable, these results are consistent with the findings of Wong, Farragher and Leung (1987),
who found that payback, IRR and ARR were equally the most popular techniques used in
Singapore. However, IRR is ranked second and NPV is ranked third as the most important but
44.4% consider it as an important technique in this survey. Surprisingly, no respondent consider
ARR as most important technique, in fact 70.4% respondents are not using this technique at all.
The respondents were also asked to indicate the capital budgeting techniques used by them for
evaluating various investment decisions. The results are summarized in the Table 5.5.
 36

Table 5.5 : Capital Budgeting techniques used by Firm’s

Investment Decision ARR IRR NPV PBP Others

20 15 18 2
1 New Project
(74.1) (55.6) (66.7) (7.4)
Expansion of existing 1 10 13 18
2
operation (3.7) (37) (48.1) (66.7)
2 7 10 7 1
3 Merger / Acquisition
(7.4) (25.9) (37) (25.9) (3.7)
5 7 14
4 Replacement of Assets
(18.5) (25.9) (51.9)
4 1 6 1
5 Leasing of Assets
(14.8) (3.7) (22.2) (3.7)
1 6 10 12 1
6 Modernization
(3.7) (22.2) (37) (44.4) (3.7)
Process or Product 6 7 10 2
7
improvement (22.2) (25.9) (37) (7.4)
Any other (please specify)
such as canteen, housing 1 1
8
colony , staff welfare (3.7) (3.7)
scheme etc.
# As there are multiple responses the total per cent may exceed 100 %. / Figure in parenthesis
are in %

One can observe that IRR (74.1%), PBP (66.7%) and NPV(55.6%) respectively are the most
preferred techniques for evaluating new capital budgeting projects. While for expansion,
replacement of assets, modernization and process or product improvement, PBP is preferred over
other techniques. The respondents prefer even NPV (37%) for modernization as well as mergers
and acquisition.
The respondents of the present study were asked to mention frequency of the use of different
capital budgeting methods which indicates that PBP (74.1%) and NPV (59.3%) are always used
by the firms for evaluating their projects capital expenditures followed by IRR (55.5%).
 37

Frequency of the use of Capital Budgeting Techniques

80

70
60

50

40
30

20
10

0
IR PBP NPV ARR PI
R TECHNIQUES

Always Sometimes Rarely

Often Never

Figure 5.3

The survey included many questions on methods to understand the status of current capital budgeting
practices. The respondents were asked to indicate the usage of multiple capital budgeting methods for
appraising major investments. They were required to indicate the relative importance attached to each
technique by entering against the technique listed below: 1 for the item to which they attach most
importance; 2 for the next most important item; and so on. They have been instructed not to enter rankings
against techniques that are not used by their firm.
 38

Table 5.6

Use of Multiple Capital Budgeting Techniques

Not
Evaluation Technique 1 2 3 4 5
Used

3 12 6 6
Internal Rate of Return (IRR)
(11.1) (44.4) (22.2) (22.2)

18 6 2 1
Payback Period (PBP)
(66.7) (22.2) (7.4) (3.7)

3 6 11 7
Net Present Value (NPV)
(11.1) (22.2) (40.7) (25.9)

18 1 1 4 3
Accounting Rate of Return (ARR)
(66.7) (3.7) (3.7) (14.8) (11.1)

16 4 1 3 3
Profitability Index (PI)
(59.3) (14.8) (3.7) (11.1) (11.1)

# As there are multiple responses the total per cent may exceed 100 %. / Figure in parenthesis are in %

The above table 5.6 shows that IRR and PBP has been given first rank by maximum 44.4% and
66.7% of respondents respectively followed by NPV(22.2%). This is supported by the results of
Petty (1975) which revealed that 74% of the companies’ studied were using more than one
technique for evaluating investment proposals. These results are also consistent with the results of
Gupta, Batra and Sharma (2007) study of Capital Budgeting Practices in Punjab-based Companies
who found out that out of 32 companies 30 companies responded in favour of using more than one
capital budgeting method.
 39

Table 5.7

Cut-off Point

PBP NPV/IRR

Not 5 5
Not Used
Used (18.5) (18.5)
0-2 1 3
0-10%
years (3.7) (11.1)
2-4 13 8
11-15%
years (48.1) (29.6)
4-6 8 8
16-20%
years (29.6) (29.6)
2
27 21-30%
Total (7.4)
(100)
1
> 30%
(3.7)
27
Total
(100)

Figure in parenthesis in the above tables are in %

The results in Table 5.7 of the question related to cut-off points to evaluate the viability of major
capital investments produced some noteworthy results. For PBP 2-4 years is the most common
range as the cut-off point used by almost half of the surveyed firms. The significant number of
companies (18) are not using any cut-off point for ARR, while the equal number of firms (8) using
11-15% and 16-20% as the cut-off point for NPV or IRR. These findings are different than the
findings of Pike (1988) who found out that his two-thirds of firms used a hurdle rate between 15%
and 24% for IRR and NPV with a modal range of 15-19%. The findings of Arnold and
Hatzopoulos (2000) are matching to a certain extent to the present findings where the PBP popular
cut-off was 2-4 years. The modal range for ROCE (ARR) was 16-20% and IRR-NPV the range
was falling into 11-15% and 16-20% respectively. But the researcher would like to reiterate that
these findings can not be directly comparable.
The cash flow estimation is an extremely difficult task in capital budgeting. The respondents were
asked how they treat the following items while estimating cash flows for appraising their capital
budgeting projects. The results are summarized in Table 5.8
 40

Table 5.8 Treatment of Following Items in Estimating Cash Flow

Cash flow item Included Excluded

Current Market value or acquisition value of an existing 23 4
resource to be used in the project (e.g. land) (85.2) (14.8)

Expenses incurred prior to deciding on going ahead with the 12 15

project like R&D, market survey, test marketing, etc. (44.4) (55.6)

16 11
Interest on borrowings
(59.3) (40.7)

21 6
Working capital including changes over the life of the project
(77.8) (22.2)

23 4
Salvage/realizable value from the project at the end
(85.2) (14.8)

14 13
Depreciation
(51.9) (48.1)

18 9
Income tax (Before/After Income tax)
(66.7) (33.3)

As there are multiple responses the total per cent may exceed 100 %. / Figure in parenthesis are
in %

It seems that the respondents have not understood the question properly because certain items like
expenses incurred prior to deciding on going ahead with the project like R&D, market survey, test
marketing, etc., interest on borrowings, depreciation, income tax and so on should be actually
excluded while estimating cash flows but some of survey participants have indicated that they
include it while calculating cash flows. There are certain items like working capital including
changes over the life of the project, salvage/realizable value from the project at the end etc. should
be included in cash flows determination but many participants have shown they exclude it while
estimating cash flows. Therefore, the researcher feels that this question should be ignored for the
analysis.
While estimating the cash flows, it is very important to know the inflation adjustment methods
used for investment appraisal by the firms. The table 5.9 summarizes the results for identifying
the popular methods of inflation adjustments for their investment appraisal.
 41

Table 5.9 Inflation Adjustment Methods

Frequency Percent

Specify cash flow in constant prices and 8 29.63

apply a real rate of return

All cash flows expressed in inflated price 11 40.74

terms and discounted at the market rate of
return

Considered at risk analysis or sensitivity 11 40.74

analysis

No adjustment 4 14.81

Other[pl. specify] 0 0.00

As there are multiple responses the total per cent may exceed 100 %.

As observed in the table, the equal numbers of firms (40.74%) prefer to adjust for inflation by
expressing all cash flows in inflated price terms and discounted at the market rate of return or
considering sensitivity analysis. Very few companies (14.81 %) are not making any adjustment for
inflation in their capital budgeting decisions.
Almost all the respondents of this survey are using DCF techniques for evaluating their capital
budgeting projects so there was a question focused on the method used to determine the minimum
acceptable rate of return or the rate of discount to evaluate the proposed capital expenditure project.
 42

CHAPTER 5 : FINDING AND CONCLUSION

From the above explanation it can be concluded that:

 Capital budgeting helps a company to understand the various risks involved in an
investment opportunity and how these risks affect the returns of the company.
 It helps the company to estimate which investment option would yield the best
possible return.
 A company can choose a technique/method from various techniques of capital
budgeting to estimate whether it is financially beneficial to take on a project or not.
 It helps the company to make long-term strategic investments.
 It helps to make an informed decision about an investment taking into consideration
all possible options.
 It helps a company in a competitive market to choose its investments wisely.
 All the techniques/methods of capital budgeting try to increase shareholders wealth
and give the company an edge in the market.
 Capital budgeting presents whether an investment would increase the company’s
value or not.
 It offers adequate control over expenditure for projects.
 Also, it allows management to abstain from over investing and under-investing.

Despite certain limitations , capital budgeting still remains a necessary exercise for
a company before it invests in any long-term project. Capital Budgeting allows the
management to choose wisely amongst the several investment opportunities
available in the market.

The company can adequately and conveniently calculate suitable returns over
the cost of capital and shareholders’ expected rate of return using the
techniques/methods of capital budgeting. It also tells whether an investment would
increase the company’s value or not and hence it is widely used to evaluate projects
in almost all the fields.
 43

BIBLIOGRAPHY

1. RESEARCH METHODOLOG BY MICHAEL VAZ

2. FINANCIAL MANAGEMENT
3. INTERNET:
 www.google.com
 en.m.wikipedia.org
 efinancemanagement.com
 analystprep.com
 www.edupristine.com
 accountlearning.com
 www.invetopedia.com