PUNJAB AGRICULTURAL UNIVERSITY

Synopsis Of Research Problem Of Post Graduate Student(MBA)

Name of Student : SHEETAL NAGPAL

Admission No. : L-2018-BS-31-MBA

Major Subject : Business Management

Field Of Specialization : Financial Management

Minor Subject : Economics

Major Advisor : Dr. Babita Kumar

1) Title
CAPITAL BUDGETING TECHNIQUES USED BY SELECTED FIRMS AND BANKS
FOR PROJECT EVALUATION

2) INTRODUCTION
Capital budgeting is the process a business undertakes to evaluate potential major projects or
investments. Construction of a new plant or a big investment in an outside venture are examples
of projects that would require capital budgeting before they are approved or rejected.
As part of capital budgeting, a company might assess a prospective project's lifetime cash
inflows and outflows to determine whether the potential returns that would be generated meet a
sufficient target benchmark. The process is also known as investment appraisal. Ideally,
businesses would pursue any and all projects and opportunities that enhance shareholder value.
However, because the amount of capital any business has available for new projects is limited,
management uses capital budgeting techniques to determine which projects will yield the best
return over an applicable period. Capital budgeting plays a crucial role in a business’s
competitive model.

METHODS OF CAPITAL BUDGETING

Some methods of capital budgeting companies use to determine which projects to pursue include
throughput analysis, net present value (NPV), internal rate of return, discounted cash flow, and
payback period.

Throughput analysis is the most complicated form of capital budgeting analysis but also the most
accurate in helping managers decide which projects to pursue. Under this method, the entire
company is considered as a single profit-generating system. Throughput is measured as an
amount of material passing through that system.

Payback analysis is the simplest form of capital budgeting analysis but it's also the least accurate.
It's still widely used because it's quick and can give managers a "back of the envelope"
understanding of the real value of a proposed project. This analysis calculates how long it will
take to recoup the costs of an investment. Accounting Rate of Return, in this technique, the total
net income of the investment is divided by the initial or average investment to derive at the most
profitable investment. These two are the non-discounted techniques of capital budgeting.

Discounted cash flow (DCF) analysis looks at the initial cash outflow needed to fund a project,
the mix of cash inflows in the form of revenue, and other future outflows in the form of
maintenance and other costs. These costs, except for the initial outflow, are discounted back to
the present date.

Net Present value is calculated by taking the difference between the present value of cash
inflows and the present value of cash outflows over a period of time. The investment with a
positive NPV will be considered. In case there are multiple projects, the project with a higher
NPV is more likely to be selected. Internal Rate of Return (IRR), for NPV computation a
discount rate is used. IRR is the rate at which the NPV becomes zero. The project with higher
IRR is usually selected. Profitability Index is the ratio of the present value of future cash flows of
the project to the initial investment required for the project. An organization needs to use the
best-suited technique to assist it in budgeting.  It can also select different techniques and compare
the results to derive at the best profitable projects. the net present value, internal rate of return
are the discounted techniques of capital budgeting.

Few studies have been conducted on the techniques used by firms for project evaluation, the
firms calculated or use many methods of capital budgeting before undertaking the project. The
banks also access the project on basis of these techniques before granting any finances or loans
to the firms for project. Capital budgeting represents one of the many tools used by banks to
choose investments that will generate the highest rate of return. This study undertaken within the
objective of reviewing or assessing the techniques used by firms in India for evaluating the risk,
profitability of the project. It provides a wide scope for financial managers to evaluate different
projects in terms of their viability to be taken up for investments. Mostly small firms in India
used a payback period method because it is most suitable for small investments or also because
of its simplicity and risk focus.

Furthermore, Peterson states that, to correctly implement these techniques, analysis of following
is required: Its future cash flow, the degree of uncertainty associated with these future cash
flows, The value of these future cash flows considering their uncertainty.

The present study aims to achieve the following specific objectives:

1. To study the Capital Budgeting techniques used by selected firms in evaluating their projects.

2.To Study the Capital Budgeting techniques used banks in assessing their project.

3) Review of literature

To give a direction to this study some relevant and significant research studies have been
summarized as below:
Rappaport and Taggart (1982) examined various methods for incorporating the effect of inflation
into capital budgeting. They provided an analysis which showed the differential impact of using
a gross profit per unit approach, a nominal cash flow approach (where individual forecasts are
incorporated into each component of cash flow) and a real cash flow approach in which a general
price deflator is used to deflate nominal cash flows. They attempt to combine the simplicity of a
gross profit per unit methodology of adjusting for inflation with the more realistic nominal case
flow and real cash flow approaches.

Chadwell-Hatfield et al(1993) looked into the financial criteria used to evaluate projects, capital
budgeting and risk analysis techniques employed by medium and small US manufacturing firm.
In their survey, it was found that a large number of firms did not formally analyze all proposals.
The results also showed that multiple evaluation techniques were preferred in the analysis of
proposals. Techniques that were problematic in theory appealed to managers in practice. They
concluded that their results of the capital budgeting survey were inconsistent with previous
studies and they felt that it was due to the sample they chose.

Mills (1996) has explored the question of the impact of inflation on the capital budgeting
process. It had shown that it was reasonable to expect that the cost of capital will increase at the
same rate as the rate of inflation on an ex ante basis, and that this increase will be a
multiplicative relationship. The IRR method gives the rate of return result. This is especially
important in our current economic climate, where businesses were trying to cut costs and only
invest in those projects which will yield a higher rate of return.

Block (1997) noted that a number of patterns pertaining to capital budgeting were exhibited by
small firms. Payback continued to be the dominant technique employed not due to lack of
sophistication but rather the financial pressures placed on them by financial institutions. In spite
of this, small business has become more sophisticated as over 27% used DCF as the primary
method of analysis as compared to earlier studies. However, this conclusion may be
somewhat misleading as the discount rate was not scientifically calculated.

Edward et al(2001) found that the early 1950s, the academic community has tried to convince
corporate managers that there are sophisticated techniques that can improve the capital budgeting
decision-making process. Over the years, many studies have documented a trend toward
increasing business use of such sophisticated capital budgeting techniques.The simple rate of
return method is another capital budgeting technique that does not involve discounted cash
flows. The method is also known as the accounting rate of return, the unadjusted rate of return,
and the financial statement method.

Sandahl and Sjorgen (2003) this study shows that the public sector companies are most frequent
users of discounted cash flow (DCF) methods. The payback method is the most used in all
industries. The use of the net present value method has increased over the years, although the use
of DCF methods is generally unchanged. Value-based management models have been introduced
in the listed companies. Another conclusion is that tradition is an important factor explaining the
choice of capital budgeting method. Large companies within the manufacturing industry use
DCF methods more often than other companies. In general, the companies seem unconcerned
with the tax consequences of capital budgeting decisions. It would appear as if the public
companies have not adopted capital budgeting practices supporting shareholder value increases.
Gilbert (2005) established to determine the usage of capital budgeting methods and how they are
related to the performance of South African organizations in the manufacturing sector. The study
used of 318 manufacturing organizations as a sample. The study tested the usage of the tools and
their impact of accounting rate of return (ARR), payback method, net present value (NPV) and
the internal return rate (IRR). From this study it was established that 48 of the firms employed
the payback period technique, 25 organizations used purely discounting methods while the rest
of these 318 companies applied a combination of all methods. Even though the management of
these companies had recognized the advantages of using the discounted methods like cost
benefit. Their feedback indicated that they used mostly approximation and shortcuts, but they
have admitted that discounted cash flow methods are very significant and needs to be
considering when making investment decisions.

Prather et al(2009) determined how small rural firms apply capital budgeting techniques. They
surveyed 281 members of the Durant, Oklahoma Chamber of Commerce. Their goal was to
determine whether these small rural firms practice what academics teach. Their survey covered a
variety of discounted cash flow (DCF) and other traditional techniques and also examined the
incidence and treatment of capital rationing. The survey design permitted us to partition results
to examine differences due to firm size, industry, form of business organization, firm age, age
and education level of the primary decision-maker, and whether operations were international or
domestic.

Karim et al (2010) carried out a research on capital budgeting of large firms in Canada. many
large firms in Canada tend to use Discounted Cash Flow techniques (DCF) in evaluating their
investment opportunities. Thus Discounted Cash Flow Techniques are increasingly accepted by
the large firms in America specially NPV and IRR. But this study has not addressed the
alignment of financial objectives of the business strategy with the adoption of investment
appraisal techniques in evaluating the investment opportunities. Further they explained that
usage of non-discounted cash flow techniques has declined though the usage is still in the
system.

Batra and Verma(2017)observed that the volatility of the global economy, changing business
practices, and academic developments had created a need to re-examine Indian corporate capital
budgeting practices. Research was based on a sample of 77 Indian companies listed on the
Bombay Stock Exchange. Results reveal that corporate practitioners largely follow the capital
budgeting practices proposed by academic theory. Discounted cash flow techniques of net
present value and internal rate of return and risk adjusted sensitivity analysis were most used.
Weighted average cost of capital as cost of capital is most favored. Nevertheless, the theory-
practice gap remains in adoption of specialized techniques of real options modified internal rate
of return (MIRR), and simulation. Non-financial criteria are also given due consideration in
project selection.

4) Research methodology

The present study aims to examine the capital budgeting techniques used by banks and selected
companies for project evaluation . For this study a sample of 50 micro small enterprises and 50
large firms will be selected on the basis of capital investments. The financial information
regarding the selected companies would be collected from the company’s annual reports or
questionaires.primary data will be collected through questionnaires filled by firms or managers
of banks. Exploratory research design will be used.

5) References

Batra.R and Verma.S(2017),Capital budgeting practices in Indian companies.29:29-44.

Block.S(1997)Capital budgeting techniques used by small business firms in the1990s.The engr.

economist,42:289-302.

Chadwell-Hatfield.P,B.Goitein,Horwath.P and Webster(1993)A financial criteria, capital

budgeting techniques, and risk analysis of manufacturing firms,“Journal of Appl. Bus. Research,
13:95

Edward.J,Farrangher Robert,T.KleimanAnandi and P.Sahu (2001).A Oakland University,

Michigan York University, The Association between the Use of Sophisticated Capital Budgeting
Practices and Corporate Performance , Published in: The Engineering Economists , 46:300-11.

Gilbert.E.(2005).Capital Budgeting:A case study analysis of the role of formal evaluation

techniques in the decision-making process,56.

Karim.BGeoffrey,G.M.Teressa.M(2010)Improved capital budgeting decision making: evidenced

from Canada , Mngt. Decision, 48:5-12

Mills G (1996). The impact of inflation on the capital budgeting process:Journal of Financ. and
Strategic Decisions ,9:8

Prather, Larry J, Topuz, John C, Benco, Daniel C, Romer, David A.(2009). How small rural
firms apply capital budgeting techniques, Journal of Bus. and Entr.10:1-2.

Rappaport A. and Taggart R A.(1982)evaluation of capital expenditure proposals under

inflation.Financial Mgmt.9:5-14.

Sandahl.G,Sjogren.S(2003),Capital budgeting methods among Sweden's largest groups of

companies. The state of the art and a comparison with earlier studies:International journal of
prod. econ.,84: 51-69.