Evaluating Various Methods of Capital Budgeting

1. COMPREHENSIVE PROJECT
REPORT
EVALUATING VARIOUS METHODS OF CAPITAL
BUDGETING
BY
JASH PANDIT – IU1555550021

2. Introduction
Methods of Appraisal
Explanation
Objective of study
Literature review
Data Collection
Data Analysis
Conclusion
References
FLOW Of CONTENT

3. WHAT IS CAPITAL BUDGETING?
• Capital investment decisions that involve the purchase of Items such as land,
machinery, buildings, or equipment are among the most important decisions
undertaken by the Business manager. These decisions typically involve the
Commitment of large sums of money, and they will affect the Business over a
number of years. Furthermore, the funds to Purchase a capital item must be paid
out immediately, Whereas the income or benefits accrue over time.
USEFULNESS IN FINANCING PROCESSES:
• The purpose of an economic profitability analysis is to determine Whether the
investment will contribute to the long run Profits of the business. Although
various techniques canBe used to evaluate alternative investments, including the
Payback period and internal rate of return, the most Commonly accepted
technique is net present value, otherwise Known as “Discounted cash flow”
Introduction

4. Risk and Return Fundamentals
• To maximize share price, the financial manager must learn to assess two
key determinants: risk and return. Each financial decision presents certain
risk and return characteristics, and the unique combination of these
characteristics has an impact on share price. Risk can be viewed as it is
related either to a single asset or to a portfolio- a collection, or group, of
asset.
Risk:-
• Risk is the chance of financial loss. Asset having greater chance of loss are
viewed as more risky than those with lesser chances of loss.
Return:-
• The return is the total gain or loss experienced on an investment over a
given period of time. It is commonly measured as cash distribution during
the period plus the change in value, expressed as a percentage of the
beginning of period investment value.

5. Methods of Appraisal
Non-Discounted Cash
Flow Criteria:
a. Pay Back Period (PBP):-
b. Accounting/Average
Rate of Return (ARR):
Discounted Cash Flow
Criteria:
a. Net Present Value (NPV):
b. Internal Rate of Return
(IRR):
c. Profitability Index (PI):

6. Pay Back Period (PBP):-
• It is the number of years required to recover the original cash
outlay invested in a project.
Explaination
0Initial Investment
Payback = =
Annual Cash Inflow
C
C

7. Accounting/Average Rate of Return (ARR):
• This method is also known as the return on investment
(ROI), return on capital employed (ROCE) and is using
accounting information rather than cash flow.
Average income
ARR =
Average investment

8. Net Present Value (NPV):
• The net present value is one of the discounted cash flow
or time-adjusted technique. It recognizes that cash flow
streams at different time period differs in value and can
be computed only when they are expressed in terms of
common denominator i.e. present value.
Steps:
• Decide Appropriate rate for discounting
• Calculate Present Value of Cash Inflow
• NPV = PV of Cash inflows – PV of cash Outflow

9. Internal Rate of Return (IRR):
• The internal rate of return (IRR) is the rate that equates the
investment outlay with the present value of cash inflow received
after one period.
• Internal Rate of Return is the discount rate which makes NPV =
0.
Profitability Index (PI):
• Profitability Index (PI) or Benefit-cost ratio (B/C) is similar to
the NPV approach. PI approach measures the present value of
returns per rupee invested. It is observed in shortcoming of NPV
that, being an absolute measure, it is not a reliable method to
evaluate projects requiring different initial investments. The PI
method provides solution to this kind of problem.

10. OBJECTIVES OF THE STUDY:-
• The primary objective of the present project is to know about
which method are highly useful in Foreign companies and Indian
companies.
• To understand the basic views of this equipment tools. In different
sectors like manufacturing small scale large scale
• To determine the precise tool for calculating rate of return,this
creates a clear picture for a company.
• As there are many tools for evaluating the return rate we must
identify which tool should be used in which project
• Different company uses different methods so for less confusion
company best equipment must be identified and worked.
Objective of Study

11. • To make sure that the evaluating tool used for finding results are
giving the precise results in any situation.
• To identify the errors, if any, in the calculations due to the
budgeting tool and try solving it by using the proper method.
• To see that by using these tools we can get proper results and any
of the company using it for any project can be satisfied by the
outcomes.
• To identified the malware and recover from the data problems by
using methods as per required.
• To recognize NPV and IRR as the best tool for calculating the rate
of returns including all the risks.

12. Foreign reviews.
• 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 atleast $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).1&2
• Fremgen James (1973) surveyed a random sample of 250 business
firms that were in the1969 edition of Dun and Bradsheet‟ 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.
Literature Review

13. • Petty J William, Scott David P., and Bird Monroe M. (1975) examined responses
from109 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.
• Stanley (1990) has studied capital budgeting techniques used by small business firms in
the 1990s. According to Eugene Brigham, in his book „Fundamentals of Financial
Management‟ in the chapter “Capital Budgeting in the Small Business Firms”.
• Capital budgeting may be more important to the smaller firm than its larger counterparts
because of the lack of diversification in a smaller firm. He says that a mistake in one
project may not be offset by successes in others. His intention of the study is to ascertain
where small firms stand today in regard to capital budgeting techniques as opposed to
prior decades. He selected 850 small firms out of which he received 232 usable responses
to the study. As per his findings, a number of patterns relating to capital budgeting by
smaller firms are worthy to note. The firms continue to be dependent on the payback
method as the primary method of analysis.

14. Indian Reviews:-
• 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.37
• 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.

15. • 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.
• 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.

16. • Data Collection is the roadmap for carrying out the
research activity in the project. In my project of
“Evaluating various methods of Capital Budgeting” i have
carried out the research of which method of capital
budgeting is useful for the Foreign companies and Indian
companies.
For this research activity,
• I have conducted some of the practical examples as per
the company does for there project and calculated
illustrations. It secondary data collection method
• Identified the evaluating method which provides with the
precisely understandable outcome determining that a
company should use a tool which gives them proper
information of their risk and return.
Data Collection

17. Data Analysis

18.  Capital budgeting techniques practiced by Indian companies
• In the Indian corporate sector, the use of capital budgeting techniques has
shifted dramatically towards increasing adoption of sophisticated DCF
techniques like NPV, IRR and advanced techniques like NPV with Real
Options, MIRR and Simulation Analysis (Anand, 2002; Singh et al., 2012;
Verma et al., 2009). This does not disregard the usage of old NDCF
techniques especially payback period method, which is still used widely as
a secondary criterion (Gupta et al., 2011).
• An encouraging aspect of the study is that an overwhelming majority
(91%) of companies use the theoretically sound DCF techniques in some
form or the other. The results are in conformance with sound corporate
finance practices. The NDCF techniques are still rigorously used, though,
mainly as a secondary criterion. About 65 companies (84.5%) used a
combination of both NDCF and DCF techniques. These results are very
close to those of Singh et al. (2012).

19. • The seven sampled companies which do not use DCF techniques
disclosed that the most important reason for non usageof these
techniques, is that it is not required as per their business conditions. High
level of complexity and difficulty of these techniques and unwillingness
of top management to implement these are other detrimental factors,
especially in the usage of advanced techniques like NPV with real
options, MIRR, and simulation analysis. Furthermore, many companies
think that they do not require DCF techniques as majority of their
projects are “replacement” projects. In contrast to this the prominent
reasons for the usage of DCF techniques by a vast majority of sampled
companies (70) is their consideration of time value of money as well as
cash inflow throughout the life of the project. Other reasons favouring
their usage appeared to be less influential. Moreover, DCF techniques are
favoured because computational technology have made as made their
calculations much easier (Arnold &Hatzopoulos,2000; Ryan & Ryan,
2002).

20. Consideration of risk by Indian companies
• Our survey results show an increased trend of risk
measurement by a majority of Indian companies. An
overwhelming majority of 97.5% of the companies
measured risk in their projects. Only 2.5% of the companies
did not report measuring risk, those being companies with
capital budget size below INR 50 crore. Indian companies
use a variety of statistical measures to capture different
facets of risk. Standard deviation /coefficient of variation
emerged as the most preferred measure, with 58.7% sampled
companies using it, followed by expected NPV using
probability distribution being used by 25.3% of the
companies. The results remain more or less the same across
all sizes of capital budgets.

21. • The use of measures of range and semi variance is scanty.
There are certain specific macroeconomic risk forces faced by
a business firm which are beyond the control of the business
enterprise such as inflation, interest rate, business cycle, term
structure, commodity price, and foreign exchange risk. Survey
results reveal that nearly 89% companies rate risk of
unexpected inflation as most important, followed by interest
rate risk (85%) and foreign exchange risk (81%).

22. Risk adjusted capital budgeting techniques preferred
by Indian companies
• In today’s risk–prone business environment where companies are
exposed to different types of risks, a wide variety of tools are available
from simple break even analysis to sophisticated advanced techniques
like simulation, for their adjustment. Our survey clearly exhibits that the
most popular technique used for incorporation of risk among Indian
companies is sensitivity analysis. It is used by nearly 56% of respondent
companies “often” or “always” and by 71% of them “sometimes”,
“often”, “always”.

23. • The risk analysis techniques of shorter payback period,
scenario analysis and conservative estimates of cash flows
are used “often” or “always” by 46.7%, 44%, and 40% of the
companies respectively, and by a vast majority of 68%, 81%,
83% of the companies “sometimes”, “often”, “always”. Risk
adjusted discount rates and analysis of project risk through
judgement evaluation are also used by companies, to a
relatively lesser extent. Similarly a small percentage of
companies use Hiller model, calculated bail out factor, utility
theory and even the certainty equivalent approach

24. Three Primary Methods Used to Make Capital
Budgeting Decisions
• Capital budgeting is the process of determining whether or not an
investment is worthwhile. 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. For example, 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. The three
main methods of taking this measurement are Net Present Value
(NPV), Internal Rate of Return (IRR) and Payback Period.
Conclusion

25. Key Findings and Conclusions
Capital budgeting issues
and aspects
Findings and conclusions
Formal capital budgeting
Decision
 Decision at higher/top level of management
 Conducted even for projects of smaller capital outlays.
Capital budgeting
techniques most
preferred
 DCF methods of NPV and IRR
 NDCF technique of payback as a supplement.
 Usage of multiple techniques preferred
NPV-IRR contradiction  Equally divided on the issue.
 Both preferred equally in contradiction.
Reasons for preference
of DCF techniques
 Consider time value of money
 Considers entire stream of cash flows
Reasons for nonpreference
of DCF
 Non-suitability as per business condition
 Complexity in usage
 Non-supportive top management
Cost of capital practices  WACC most preferred for cost capital calculation
 CAPM model (the beta approach) and dividend yield model most
popular for cost ofequity capital

26. Capital budgeting issues
and aspects
Findings and conclusions
Reasons for preference
of NDCF like payback
 Emphasis on liquidity
 Risk consideration
 Simplicity and ease in calculation
Usage of latest advanced
Techniques
Discount rate Preferred
 Sluggish adoption and less use of EVA,MIRR, APV and NPV with
real options
 Use of WACC most prevalent
 Multiple risk adjusted discount rates favoured.
Risk factors  Inflation, interest rates and foreign exchange risks most important
risks
 GDP/business cycle, commodity price and term structure risks also
high in priority.
 Lesser importance to risks of distress, company size or momentum
risk.
Capital budgeting
techniques
incorporating risk
 Sensitivity analysis most popular followed by shorter payback
period, scenario analysisand conservative estimates of cash flows.
 Limited use of risk adjusted discount rates and judgment
evaluations.
 Hiller model, calculated bail out factor, utility theory and certainty
equivalentapproach rarely used.
Latest sophisticated risk
incorporation
Techniques
 Strong reluctance to adopt newer sound techniques of probability
theory, decisiontree analysis, and Monte Carlo simulation.

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capital budgeting evidence from the United Kingdom, Journal of
Business Finance & Accounting, 27(5) & (6), June/July 2000, 0306-
686X, pp 603-626
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practice of corporate finance: Evidence from the field, Journal of
Financial Economics, Vol 60, Nos 2&3, pp187-243
• Block Stanley; Are there any differences in capital budgeting
procedures between industries? An empirical study, The Engineering
Economist, 50, pp 55-67
• Lazaridis Ioannis T., Capital budgeting practices: A survey in the firms
in Cyprus, Journal of small business management 2004 42(4), pp. 427-
433
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