INTRODUCTION TO PROJECT AT ECIL

CAPITAL BUDETING

Introduction to project:

The term Capital Budgeting refers to long term planning for proposed
capital outlay and their

Financing . It includes raising long-term funds and their utilization. It may be

defined as a firm’s formal

process of acquisition and investment of capital. Capital budgeting decisions are

one of the most

important decisions, which affect both long and short run existence of a business.
It has the major

impact on the shareholders wealth in the long run. The project work has
recognized the above two

phases and conducted this study. The study aims at identifying the extent to which
capital budgeting

techniques and its related practices are used by the ECIL, and identifying
reasonable justifications

behind the use of such pattern. To evaluate the above, techniques such as PBP,
ARR, NPV, PI, and IRR

are used. The study also shows the practices related to capital budgeting
techniques such as: cost of

capital estimation methods, risk analysis techniques, and cash flow forecasting
techniques, which are

not widely used by the ECIL within the domination of subjective judgment.

The term Capital Budgeting refers to long term planning for proposed capital

outlay and their financing. It includes raising long-term funds and their utilization. It

1
may be defined as a firm’s formal process of acquisition and investment of capital.

Capital Budgeting may also be defined as “The decision making process by which a

firm evaluates the purchase of major fixed assets. It involves firm’s decision to

invest its current funds for addition, disposition, modification and replacement of

fixed assets. It deals exclusively with investment proposals, which an essentially

long term projects and is concerned with the allocation of firm’s scarce financial

resources among the available market opportunities.

Some of the examples of Capital Expenditure are

• Cost of acquisition of permanent assets like land and buildings.

• Cost of addition, expansion, improvement or alteration in the fixed assets.

• R&D project cost, etc.

ECIL was setup under the Department of Atomic Energy, with a view to generate

a strong indigenous capability in the field of professional grade electronics.

Many industries these days require concepts of electronics in their production

process. Electronics is assuming increasing importance in the monitoring and

control of production of many industries like Engineering, Chemical and

Metallurgical industries. In India, the electronics industry has growth in many strides

both in public and private sectors.

A part from this, in the field of industrial electronics , the government of India has

taken initiations in 1960”s ton set up a industrial units in public sectors in order to

produce industrial electronics system with indigenous technology to meet the

nation’s requirement in static areas. Electronics occupies a key position in modern

science and technology. It has a vital role to play in the field of Atomic Energy,

communication, defense education, Space technology and entertainment. Because

2
of its dynamic character, its pervasive nature and its significant impact on science,

industry and society, Electronics is today in the vanguard of the technology process.

Technology process is both very rapid in this field.

An intensive promotional effort to both production and research and development

is therefore essential to ensure a rapid growth in this field. In this direction, the

government of India and its agencies with the aim of developing and promoting

industrial Electronics system with indigenous know-how to attain Self-sufficiency in

Atomic energy programmed started ELECTRONICS CORPORATION OF INDIA

LIMITED on 11th April 1967.

In any growing concern, capital budgeting is more or less a

continuous process and it is carried out by different functional areas of

management such as production, marketing, engineering, financial management

etc. All the relevant functional departments play a crucial role in the capital

budgeting decision process of any organization, yet for the time being, only the

financial aspects of capital budgeting decision are considered to discuss. The role of

a finance manager in the capital budgeting basically lies in the process of critically

& in-depth analysis and evaluation of various alternative proposals, then to select

one out of these alternatives. As already stated, the basic objectives of financial

management is to maximize the wealth of the share holders, therefore the

objectives of capital budgeting is to select those long term investment projects that

are expected to make maximum contribution to the wealth of the shareholders in

the long run.

3
Objectives of project:

• To study the capital budgeting techniques and their related practices that used

by ECIL.

• To study the reasons behind the selection of existing capital budgeting

techniques by the ECIL rather than others.

• To evaluate the effect of the capital budgeting technique used on the ECIL’s

performance.

• To measure the present value of rupee invested by ECIL.

• To understand an item wise study of the ECIL of financial performance of the

company.

• To summarize and make suggestions if any, for improving the financial positions

of ECIL.

• To study the financial aspects for future expansion of ECIL.

• To offer suggestion if required for the better investment proposal to ECIL.

Scope of project:

The scope of this project will not only be limited to understanding the finacial

capital budgeting practices employed in ECIL , but it will also analyze the finacial

decisions taken by these units using standed capital techniques there by analyzing

the various projects undertaken by the ECIL.

1. To know the how money is acquired and from what sources.

2. In what way individual capital project alternatives are identified and evaluated

by ECIL.

4
3. How minimum requirements of acceptability are set.

4. How final project selections are made by ECIL.

Methodology:

To achieve a fore said objective the following methodology has been

adopted. The information for this report has been collected through the primary

and secondary sources.

PRIMARY SOURCES:

It is also called as first handed information the data is collected through the

observation in the organization and interviews with officials. Information is

collected by circulating questionnaires to the officials of the finance department. A

part from these some information is collected through the personal interviews and

suggestions collected from required personals.

SECONDARY SOURCES:

These secondary data is the existing data which is collected by others that is

sources are financial journals, annual reports of the ECIL or ECIL website, and other

concerned publications.

Limitations of project:

• Lack of time is another limiting factor the schedule period 6 weeks are not

sufficient to make the study independently regarding Capital budgeting in ECIL.

5
• The busy schedule of the officials in the ECIL is another Limiting factor. Due to

the busy schedule of officials may restrict me in collecting the complete

information about organization.

• Availability of confidential financial data is a constraint

• There is no scope of gathering current information, as the auditing has not been

done by the time of the project work.

• The study is carried basing on the information and documents provided by the

organization with the various employees and based on the interaction with the

various employees of the respective departments.

COMPANY PROFILE

ABOUT ECIL

A. ECIL HISTORY

6
"Let us work up the embers of national pride latent in all of us and build

up our morale so that we can confidently aim high and achieve greater

goals"

Dr. A.S.Rao,

Founder MD of ECIL

Ayyagari Sambasiva Rao, the founder managing director of the Electronics

Corporation of India Limited (ECIL), died on Friday at Nims Hospital, after a

prolonged illness, family sources said. He was 89. He is survived by his wife, four

sons and three daughters.

A.S.Rao, was born in Mogallu of West Godavari district in the year 1914, obtained

his engineering degree from Stanford University in 1947 and joined the Department

of Atomic Energy as a nuclear physicist to work with the likes of Homi J Bhabha. He

was the director of radiation health protection and electronics groups at Bhabha

Atomic Research Centre (Barc) and later played a key role in setting up ECIL in the

city in 1967 when the DAE decided to go commercial in its electronics research.

ECIL was setup under the Department of Atomic Energy on 11th April, 1967 with a view to

generate a strong indigenous capability in the field of professional grade electronics. The initial

accent was on total self-reliance and ECIL was engaged in the Design, Development,

7
Manufacture and Marketing of several products with emphasis on three technology lines viz.

Computers, Control Systems and Communications. Over the years, ECIL pioneered the

development of various complex electronics products without any external technological help

and scored several 'firsts' in these fields prominent among them being country's

• First Digital Computer

• First Solid State TV

• First Control & Instrumentation of Nuclear Power Plants

• First Earth Station Antenna

• First Computerized Operator Information System

• First Radiation Monitoring & Detection Systems

• First Automatic Message Switching Systems

• First Operation & Maintenance Center For E-108 Exchange

The company played a very significant role in the training and growth of high

caliber technical and managerial manpower especially in the fields of Computers

and Information Technology. Though the initial thrust was on meeting the

Control & Instrumentation requirements of the Nuclear Power Program, the

expanded scope of self-reliance pursued by ECIL enabled the company to develop

various products to cater to the needs of Defense, Civil Aviation, Information &

Broadcasting, Telecommunications, Insurance, Banking, Police, and Para-Military

Forces, Oil & Gas, Power, Space Education, Health, Agriculture, Steel and Coal

sectors and various user departments in the Government domain. ECIL thus evolved

as a multi-product company serving multiple sectors of Indian economy with

emphasis on import of country substitution and development of products & services

that are of economic and strategic significance to the country.

8
 A. VISION, MISSION & OBJECTIVES

a. Vision

To contribute to the country in achieving self reliance in strategic

electronics.

b. Mission

ECIL's mission is to consolidate its status as a valued national asset in the area of

strategic electronics with specific focus on Atomic Energy, Defence,

Security and such critical sectors of strategic national importance.

c. Objectives

• To continue services to the country's needs for the peaceful uses Atomic

Energy. Special and Strategic requirements of Defense and Space, Electronics

Security Systems and Support for Civil Aviation sector.

• To establish newer technology products such as Container Scanning Systems

and Explosive Detectors.

• To explore new avenues of business and work for growth in strategic sectors

in addition to working for realizing technological solutions for the benefit of

society in areas like Agriculture, Education, Health, Power, Transportation,

Food, Disaster Management etc.

• To progressively improve shareholder value of the company.

• To strengthen the technology base, enhance skill base and ensure succession

planning in the company.

9
 • To re-engineer the company to become nationally and internationally

competitive by paying particular attention to delivery, cost and quality in all

its activities.

• To consciously work for finding export markets for the company's

products.

A. BOARD OF DIRECTORS

In terms of Sec 617 of the Companies Act, 1956, ECIL is a Government

Company. Presently, the entire paid up capital of the Company is held by

the President of India, including 3 shares held by his nominees. The Board,

as on 31.03.2010 comprises of nine Directors - Chairman & Managing Director,

three Whole-time Director and five Non-Executive Directors. The Board meets at

regular intervals and is responsible for the proper direction and management of the

Company.

B. JOINT VENTURES

Electronics Corporation of India Limited (ECIL) entered into a collaboration with

OSI Systems Inc. (www.osi-systems.com) and set up a Joint Venture "ECIL-RAPISCAN

LIMITED". This Joint Venture manufacture the equipments manufactured by

RAPISCAN, U.K and U.S.A with the same state of art Technology. Requisite

Technology is supplied by RAPISCAN and the final product is manufactured at ECIL

facility.

ECIL-RAPISCAN have supplied many X-RAY BAGGAGE/CARGO INSPECTION

SYSTEMS (XBIS) of this Technology to high profile Indian Customers like Customs,

Airports Authority, Parliament House, Defence, Air lines, State Police etc.

ECIL-RAPISCAN exported XBIS to Tribhuvan International Airport, Kathmandu,

10
Nepal, X-Ray generators to USA and Malaysia. ECIL-RAPISCAN continue to receive

large number of orders from existing as well as new customers. This is basically due

to our strength in

• Latest International Technology,

• Quality Assurance,

• The exhaustive spares inventory to meet the spares requirement.

• Strong Manufacturing and After Sales Service set up in 10 different centers

located all over India.

VIRTICLES

a. OVERVIEW

ECIL, established in 1967 under the Department of Atomic Energy had the

primary objective of productionising the products developed at BARC, Mumbai in

order to support the Country’s Nuclear Power and other Atomic Energy

Programmes. Concurrently, it has endeavored to create a strong indigenous /

production base in the Country for professional grade electronics spanning from

small passive components to large and complex computer based systems.

Though the initial thrust was on meeting the C&I requirements of NPP, the

expanded scope of self-reliance pursued by the Company enabled it to develop

various special purpose products and systems to cater to the needs of Defence,

Civil Aviation, Information & Broadcasting, Telecommunications, Space, Security,

Oil & Ga Power, Education and several other user departments in the

Government domain s.

11
 The Company has thus evolved over the years as a multi-product Company

serving multiple sectors of Indian economy with emphasis on Import Substitution

and development of products and services that are of economic and strategic

importance to the Country spanning the strategic sectors of Atomic Energy,

Defence, Space, Security, IT & eGovernance.

b. AEROSPACE

ECIL Played a pioneering role in supporting the ambitious programs of ISRO. ECIL’s

Antenna Products Division has its lineage that dates back to 1968, when ARVI

Satellite Communication (ASCOM) group was constituted by drawing experts from

various organizations to execute the design, develop, manufacture, install, test and

commission the country’s 1st INTELSAT Class-A Earth Station Antenna at ARVI, Pune

for providing the gateway for overseas communications for the traffic originating

around Mumbai region.

ASCOM Group has designed the 97ft Earth Station Antenna with a king post

Elevation over Azimuth pedestal, servo system and antenna control unit. The

station was installed and commissioneds in 1968. The Feed was imported. The

control and servo system was developed by BARC. After the completion of the

above project, Microwave Antenna System Engineers Group {MASEG (ISRO)} was

formed to further the R&D activities on Microwave and satellite earth station

antennas for providing communication facilities in the country.

The MASEG group got merged with ECIL in 1972, and Antenna Products Division

12
was formed in ECIL with the aim of taking up commercial production of Microwave

and Earth station antennas.

In 1975, ECIL delivered another 97ft Earth Station Antenna with king post

pedestal (similar to ARVI Antenna) at Lachhiwala in Dehradun for providing the

International gateway to the traffic originating from Delhi region. The expertise

gained during the execution of above two projects has firmed up the knowledge

base at ECIL to take up design and production of various types of communication

antennas.

Communication antennas per se can broadly be classified into 3 types.

1. For Terrestrial Communication

a. Troposcatter antennas

b. Line of Sight (LoS ) antennas

2. for Satellite Communication

c. Ground/Earth Station Antennas

Troposcatter Antennas :

Large Bill Board antennas focus a high power radio beam at the

troposphere mid way between the transmitter and receiver. A

certain portion of the signal is refracted and received at a similar

antenna at the receiving station.

Earth Station Antennas :

On the earth station front, ECIL continued its progress and delivered and installed 3

Nos. of 8m earth station antennas at Port Blair, Kavaretti and Aizwal with indigenous

design to bring the far flung areas of Northeast into country’s telecom network.

13
When the INSAT programme was initiated, ECIL

developed and delivered 2 Nos. of reflectors required for

14m diameter Antennas for TTC application at MCF,

Hassan with control system by jointly working with BARC.

During the same period, ECIL also successfully absorbed

the limited know-how from NEC, Japan in productionising

medium sized Earth station antennas of diameter 11M,

7.5M and 4.5M.Several of these antennas were delivered

to various users like DOT, ONGC, NTPC and MCF.

In 1987, ECIL successfully designed, developed,

manufactured and installed the 11M diameter full motion

antenna for TTC application at MCF, Hassan. The 32m

diameter Wheel & Track antenna was installed at ARVI,

Pune which was executed jointly in collaboration with

NEC, Japan. During this period, ECIL acquired know-how

for the indigenous realization of a 32M Wheel & Track

antenna employing the beam wave guide feed from NEC,

Japan.

A full fledged Design Center exists, where more than 30 engineers work in the

Antenna design involving various disciplines of Structural, Mechanical, Microwave

and Control systems aspects. The center is well equipped with various software like

NASTRAN, PATRAN, SIMULINK, Auto CAD, CATIA for Structural and Mechanical

designs, WASPNET for RF design etc. to provide cost effective solutions, many pre

and post processing support routines for verifying design compliance with regard to

surface accuracy, pointing error, system performance predictions, both for

14
 structural and RF are available in the design center.

C.DEFENCE

ECIL has played a pioneering role in spurring the growth of Electronics Industry in the

country. Spanning miniature components to mammoth systems and encompassing

control, communication & computer technologies, today, ECIL is a multi-product, multi

disciplinary and multi technology organization providing cutting-edge technology

solutions in the strategic areas of Atomic Energy, Defence, Space and Electronic

Security systems.

Multidisciplinary capability

ECIL’s expertise harnesses electronics & communication technologies to

meet India’s defence needs on land, sea and air. Some of the areas in which

ECIL has contributed significantly to the Defence Sector are:

15
 1. Secure and Jam- resistant communications

2. Electronic Warfare Systems & Simulators

3. COMINT & Interception Systems

4. Antenna, Satellite Communication Systems (SATCOM Systems), networks

5. Stabilized platforms for air-borne Radars

6. CI systems & Missile support Systems

7. Encryption and Secrecy Systems

8. Electronic Fuzes for artillery and Navy

9. Precision Electro-Mechanical components, sensors & Inertial Navigation

Systems

A. NUCLEAR
Electronics Corporation of India was created essentially to meet the Control &

Instrumentation requirements of the Nuclear Power Programme of India by

productionising the R&D efforts in the Bhabha Atomic Research Centre (BARC).

Right from its inception in 1967, it has been totally supporting all the plans,

programmes and endeavours of the Department of Atomic Energy in the chosen

areas of Electronics, Instrumentation, IT and Security. ECIL significantly

facilitated India’s Nuclear Energy Programme to reach greater heights. Today

the company is proud to claim that all the operating Nuclear Power Plants in

the country are supported by the Instrumentation and Control Systems

engineered & manufactured by ECIL for the safe and reliable operation of the

Reactors. These offerings cover diverse Reactor technologies with the I & C

16
footprints in the entire Nuclear Fuel Cycle, starting from Ore extraction to the

Spent-fuel management. It is a matter of pride that the company made the

country self-sufficient in this vital area of electronics, which is significant in the

context of technology denials clamped on the nation from time to time. ECIL

thus contributed towards creating a strong and dependable indigenous

Technology base in the Nuclear Power area.

B. I.T AND eGOV

The first age : Mainframe Computing

A computer system consists of 3 basic functions – presentation, which manages the

way users interact with the system; application, which supports the logic of what to

do with the data and data management, which supports the storage of information.

The second age : Client Server Computing

New applications with graphics and user interfaces required decentralized

processing at the user end. Client Server computing distributed the work required

to perform these functions among two or more computers. A server is akin to the

mainframe, in that it coordinates activities of all clients and handles

communications, but the processing is done largely at each client’s end.

The Third age : Network Centric Computing

We are now moving to a environment where connectivity between computers and

even other devices has pervaded computing. The network was born out of the C/S

concept – it is now possible to connect computers of different makes and yet enable

them to work together. The popularity of the largest network of them all, the

Internet has established Network Centric computing as the next wave in computing.

17
With a totally different scenario in the country in Information Technology, at

present ECIL is focusing on applications in the following technologies:

• 3-tier architecture

• Web technologies

• ERP

• Data Warehousing and Data Mining

• Network Security

• e-Governance ECIL apart from its own internal R&D efforts has also been

acquiring know-how from various R&D establishments and outsourcing R&D

work to some of the academic institutions.

CAREERS

a. TECHNICAL EXPERTS

Right from inception, ECIL has been a Technology-driven Company. Starting with

supporting the Country's Atomic Energy Programme, the Company pioneered a

number of technologies and introduced a number of products for the first time in

the Country. In the formative years, ECIL was able to attract the best brain to

facilitate the pursuit of its endeavors.

The global village creator’s aftermath of liberalization, privatization and

globalization attracted many well trained technologists and managers from the

Company and as a result the reservoir of the competencies started depleting.

18
Attrition has become global phenomena and the worst hit is the Electronics & IT

field. Customer requirements are also changing dynamically and many of them,

especially in the areas of Strategic Electronics, are expecting Total solutions. In a

highly competitive market environment, with outsourcing as a business inevitability,

every operation needs to hire the services of Experts in select areas. Today, atleast

a multi-disciplinary organization like ECIL, it is very difficult, if not impossible to

have the required expertise within the organization. The age of the organization and

also the retirement profile also aggravates the situation.

Therefore, top management of the Company decided to hire the services of

experts in the areas of relevance to the Company, to supplement the efforts of the

Project Teams in the Strategic Business Units and other service functions. The

required expertise is sought in those areas, which are depleted due to

superannuation and some specialized areas which are non-existent to required

levels within Company and also essential. As a Policy, ECIL appoints experts in the

following levels:

• Senior Technical Experts

• Technical Experts

b. HUMAN RESOURCE

ECIL was setup under the Department of Atomic Energy in the year 1967 with a

view to generating a strong indigenous capability in the field of professional grade

electronics. The present employee strength of the company is about 5100 (3000

officers and 2100 workmen). The company, which started as a manufacturing

company wedded to indigenization and self-reliance had a majority of human

19
resources deployed in manufacturing operations. The post-liberalization era posed a

number of challenges to the company especially in the area of HR, Due to the right

sizing and restructuring compelled by the market forces. With the help of

Government of India, the company offered attractive Voluntary Retirement schemes

to the employees which invited reasonable response. The company has also intiated

a number of programmes to retrain and redeploy the existing manpower so as to

ensure gainful employment and achievement of targets.

c. OUR CULTURE

We Embrace diversity, Diversity is a cornerstone of our culture.

Being an organization with a global foot print, you will notice our employees come

from the most diverse of backgrounds: be it location, race, educational background,

faith, all working towards one common goal. This diversity manifests to boundless

energy, which percolates to all levels across the organization.

MANAGEMENT SYSTEM

a. QUALITY MANAGEMENT SYSTEM

Standards And Quality Assurance Group (SQAG) at ECIL is a Corporate Quality

Assurance Service Facility. While the individual business groups have their

own Quality Control / Quality Assurance sections, this corporate facility

caters to the common requirements.

• Faculty for training personnel in Product divisions on ISO awareness and on

Internal Quality Audits, Helping in developing their quality system

documentation, planning, conducting and managing internal quality audits

20
 and reporting of audit results.

• A well equipped and NABL accredited Calibration and Measurements

Laboratory equipped with standards traceable to National Standards and

catering to the calibration requirements of the Product divisions in the field of

electro-technical measurements.

• An Environmental Test laboratory meant for both component / unit / system

evaluation. It has Dry / Damp heat chambers, Walk in chambers, Dust / Rain

chambers, Vibration and bump test facilities.

• A Technical information Centre.

Equipped with such facilities with service as its motto SQAG has adapted and

declared its quality policy as "To render reliable and professional services in

the fields of Quality Assurance, Testing and Calibration to the satisfaction

of its CUSTOMERS."
Standards and Quality Assurance Group (SQAG) is a Corporate Services Group

catering to the needs of all Production divisions in the following areas.

1. Standards

2. Quality Assurance

3. Environmental and Calibration Services

4. Industrial Engineering
a. ENVIRONMENT MANAGEMENT SYSTEM

In recent times, environmental concern is increasing among Public as they

are facing air pollution, traffic congestion, and land pollution due to dumping

the waste (including electronic waste) in open lands without proper disposal.

This feeling is predominantly high at national and international level. All

21
environmental Scientists are alerting the nations from time to time by

bringing awareness and cautioning the ecological imbalances in the world. In

this direction, all nations have responded in their own way. As usual,

Internal Organization for Standardization (ISO) also showed their concern by

constituting a Technical Committee and assigned the responsibility of

formulating a standard with a view to certifying the organizations against

that standard. This certification results in practical realization of prevention

of pollution and conservation of energy. To this effect, ISO brought out a

standard on Environmental Management System – ISO 14001 in 1996. Later

on it was revised in the year 2004 which is in practice.

Top Management felt that, even though pollution in electronic industry is at

low level which will not affect anybody, the environmental management

system should be implemented in ECIL to demonstrate to customers,

suppliers, employees and Society that no pollution will be created by the very

existence of the company through any act of theirs. It was therefore decided

in August, 2004 to implement the EMS in the company. It was also concluded

that one certificate should be obtained for the whole company covering all

activities of all divisions.

PRODUCTS

a. TELECOM DIVISION

Products Major

custome

22
 rs
Surveillance Systems - GSM, CDMA, Satellite & Wire line DAE

monitoring Systems MOD

Encryption systems - Wireless Encryption - Radios, CDMA, GSM Wire
NTRO
line Encryption- Voice / Data / fax / IP / STM / Bulk
Design & Implementation of Access Control Systems & Integrated NPCIL

Security Systems MHA

Design & implementation of Network Solutions on turnkey basis
Law Enforcing

agencies

PSUs

b. INSTRUMENTS AND SYSTEMS DIVISION

23
 Sectors of operation /
Product
major customers
Directorate of Logistics,

Airports, Banks, Govt.

X ray baggage inspection system
Departments, Courier

Services.
Steel, Coal Cement,
Nuclear Industrial Instruments Electronic Toll Collection,
industry, BARC/ DAE
Weigh in motion
Transport sector
Agricultural departments,
Spectrophotometers
BARC, Research institutes
Upgraded EVM Election Commission
Energy meters & Energy Management System Electricity boards
Ship Installed Radiac Systems XBT Probes Defense (Navy)
CCTV, Access Control, Perimeter protection System, Fire DAE, NPCIL, Defense, PSUs,

Alarm system, Gate Systems, Explosive detector DFMD Railways, central and state

etc as stand alone system, UVSS, Bollards, Tyre Killers, govt. establishments,

Road Blockers and vehicle scanning Temples etc.

c. CONTROL AND AUTOMATION DIVISION

Major products Customer

1.Simulators Power Plants
2. C & I for PHWRs NPCIL
3. B1-B2 Project BARC
4. CC & I Panels BHEL
5. HV & Pulsed P/s ITER & FAIR
6. Sensors BHEL & other power stations
7. C&I PFBR BHAVINI

d. CUSTOMER SUPPORT DIVISION

24
COOPERATE SOCIAL RESPONSIBILITIES

The Company has initiated measures to adopt CSR as a tool for systematic growth.

All measures, initiated in this regard in accordance with the ‘Guidelines and CSR’

issued by the Department of Public Enterprises are well integrated in the business

processes of the Company rather than being mere ‘stand-alone’ activities.

a. SOCIETAL APPLICATIONS OF TECHNOLOGY: Community Development

The Company has been addressing inclusively contemporary technological

solutions for the benefit of society, more so to the rural masses, particularly

the poor that reflect its commitment to CSR activities.

A few relevant ones are enumerated below.

➢ High technology Health Care Solutions :

• Digital Radiology System, Tele-radiology Consultancy and Tele-medicine

• Hospital Management System.

➢ Education :

• Tele- education, Rural IT education

➢ Agriculture:

• Farmer-friendly Market Yard Systems

In addition, as a significantly beneficial application of technology for the citizen

of the Nation, the Company has executed the pilot phase of Multipurpose National

Identity Card (MNIC) Project.

a. IMPLEMENTATION OF ENVIRONMENTAL MANAGEMENT AND OTHER

SYSTEMS

The Company achieved EMS Certification as per ISO-14001:2004. The beneficial

outcome includes:

25
  Increasing the green belt in and around the factory premises

 Tree plantation by VIPs visiting ECIL and development of lawns etc.

 Installation of solar power in place of conventional heating mechanisms in areas like

Canteen and Guest House.

Installation of effluent treatment processes on scientific lines for disposal of used

hazardous chemicals and other effluents

a. Encouraging Academic Pursuits

As part of Industry-Academia synergy efforts, the Company has instituted specific

measures that would encourage academic pursuits and result in competency

building.

A few such important measures are :

MoU with premier Institutes like Institute of Public Enterprise and Universities like

JNTU, Osmania University etc. for supporting academic pursuits including M.Tech

(sponsored) programmes. Providing Project work facility for Graduates / Post

Graduates / Engineering Studen

26
 News and Events

➢ Awards

1. BEST HOUSE KEEPING AWARD for SERVO SYSTEMS DIVISION (SSD) presented by

Shri Y S Mayya, C&MD on 15th August 2010 to Shri R Mahendran, Offtg. Head -SSD.

2. Mr. Y.S.Mayya, Chairman & Managing Director, ECIL receiving MoU Excellence

Award for the Year 2007 -08 from the Honorable Prime Minister of India Dr.

Manmohan Sing

3. Mr. Y.S.Mayya, Chairman & Managing Director, ECIL receiving SCOPE Excellence

Award for the Year 2007 -08 from the Honorable Prime Minister of India Dr.

Manmohan Singh

4.Shri S Hanumantha Rao, Director (Personnel) & Chairman, OLIC of ECIL is

receiving the Rajbhasha Shield for 2006-07 from Major General (Retd) Rajneesh

Gosai, C&MD of BDL at the Annual Function and 26th Half Yearly meeting of TOLIC

(U) and others can also be seen.

➢ ECIL Headquarters and its Branches

ECIL offices network are:

a. ECIL has 6 Regional maintenance centers they are,

• DELHI, KOLKATA, MUMBAI, HYDERABAD, CHENNAI, BANGLORE.

b. It has 84 Service centers.

27
 c. Hyderabad as head office of ECIL.

THEORETICAL BACKGROUND ON CAPITAL

BUDGETING.
Capital budgeting is the planning process used to determine whether An organisation's

long term investments such as new machinery, replacement machinery, new plants, new

products, an research development projects are worth pursuing. It is budget for major capital, or

investment, expenditures.

• Capital Budgeting is a project selection exercise performed by the business enterprise.

• Capital budgeting uses the concept of present value to select the projects.

• Capital budgeting uses tools such as pay back period, net present value, internal rate of

return, profitability index to select projects.

CAPITAL BUDGETING

Definitions

“Capital budgeting is long term planning for making and financing proposed capital

outlays”.

28
T.Horngreen

“Capital budgeting is concerned with allocation of the firm’s scarce financial

resources among the available market opportunities. The consideration of

investment opportunities involves the comparison of the expected future streams of

earnings from a project with immediate and subsequent streams of expenditure for

it”.

A systematic approach to capital budgeting implies:

a) the formulation of long-term goals

b) the creative search for and identification of new investment opportunities
c) classification of projects and recognition of economically and/or statistically dependent
proposals
d) the estimation and forecasting of current and future cash flows
e) a suitable administrative framework capable of transferring the required information to the
decision level
f) the controlling of expenditures and careful monitoring of crucial aspects of project
execution
g) a set of decision rules which can differentiate acceptable from unacceptable alternatives
is required.

Features of Capital Budgeting:

The important features, which distinguish capital budgeting decisions in other Day-to-day

decisions, are

• Capital budgeting decisions involve the exchange of current funds for the

benefits to be achieved in future.

• The futures benefits are expected and are to be realized over a series of

years.

• The funds are invested in non-flexible long-term funds.

29
 • They have a long terms are significant effect on the profitability of the

concern.

• They involve huge funds.

• They are irreversible decisions. They are strategic decisions associated with

high degree of risk.

Importance of Capital Budgeting:

The importance of capital budgeting can be understood from the fact that an unsound

investment decision may prove to be fatal to the very existence of the organization.

The importance of capital budgeting arises mainly due to the following:

1. Large investment:

Capital budgeting decision, generally involves large investment of funds. But the funds

available with the firm are scarce and the demand for funds for exceeds resources. Hence, it is

very important for a firm to plan and control its capital expenditure.

2. Long term commitment of funds:

Capital expenditure involves not only large amount of funds but also funds for long-term or an

permanent basis. The long-term commitment of funds increases the financial risk involved in the

investment decision.

3. Irreversible nature:

The Capital expenditure decisions are of irreversible nature. Once, the decision for acquiring a

permanent asset is taken, it becomes very difficult to dispose of these assets without incurring

heavy losses.

30
 4. Long terms effect on profitability:

Capital budgeting decision has a long term and significant effect on the profitability of a concern.

Not only the present earnings of the firm are affected by the investments in capital assets but also

the future growth and profitability of the firm depends up to the investment decision taken today.

Capital budgeting decision has utmost importance to avoid over or under investment in fixed

assets.

5. Difficulties of investment decision:

The long terms investment decisions are difficult to be taken because uncertainties of future and

higher degree of risk.

6. Notional Importance:

Investment decision though taken by individual concern is of national importance because it

determines employment, economic activities and economic growth.

Kinds of Capital Budgeting:

Every capital budgeting decision is a specific decision in the given situation, for a given firm

and with given parameters and therefore, an almost infinite number of types or forms of capital

budgeting decisions may occur. Even if the same decision being considered by the same firm at

two different points of time, the decision considerations may change as a result of change in any

of the variables. However, the different types of capital budgeting decisions undertaken from

time to time by different firms can be classified on a number of dimensions. Some projects affect

other projects the firm is considering and analyzing. At the other extreme, some proposals are

pre-requisite for other projects. The projects may also be classified as revenue generating

projects or cost reducing projects. In general, the projects can be categorized as follows:

31
1. From the point of view of firm's existence: The capital budgeting decisions may be

taken by a newly incorporated firm or by an already existing firm.

a) New Firm: A newly incorporated firm may be required to take different decisions such

as selection of a plant to be installed, capacity utilization at initial stages, to set up or not

simultaneously the ancillary unit etc.

b) Existing: Firm: A firm which is already existing may also be required to take various

decisions from time to time to meet the challenges of competition or changing

environment. These decision may be :

i. Replacement and Modernization Decision: This is a common type of a capital

budgeting decision. All types of plant and machineries eventually require replacement. If

the existing plant is to be replaced because the economic life of the plant is over, then the

decisions may be known as a replacement decision. However, if an existing plant is to be

replaced because it has become technologically outdated (though the economic life may

not be over), the decision may be known as a modernization decision. In case of a

replacement decision, the objective is to restore the same or higher capacity, whereas in

case of modernization decision, the objective is to increase the efficiency and/or cost

reduction. In general, the replacement decision and the modernization decisions are also

known as cost reduction decisions.

ii. Expansion: Some times, the firm may be interested in increasing the installed production

capacity so as to increase the market share. In such a case, the finance manager is

required to evaluate the expansion program in terms of marginal costs and marginal

benefits.

32
 iii. Diversification: Some times, the firm may be interested to diversify into new product

lines, new markets, production of spare parts etc. In such a case, the finance manager is

required to evaluate not only the marginal cost and benefits, but also the effect of

diversification on the existing market share and profitability. Both the expansion and

diversification decisions may also be known as revenue increasing decisions.

Assumptions in Capital Budgeting:

The capital budgeting decision process is a multi-faceted and analytical process. A number of

assumptions are required to be made. These assumptions constitute a general set of conditions

within which the financial aspects of different proposals are to be evaluated. Some of these

assumptions are:

1. Certainty with respect to cost and benefits: It is very difficult to estimate the cost and

benefits of a proposal beyond 2-3 years in future. However, for a capital budgeting

decision,It is assumed that the estimates of cost and benefits are reasonably accurate

and certain.

2. Profit motive: Another assumption is that the capital budgeting decisions are taken with

a primary motive of increasing the profit of the firm. No other motive or goal influences

the decision of the finance manager.

3. No Capital Rationing: The Capital Budgeting decisions in the present chapter assume

that there is no scarcity of capital. It assumes that a proposal will be accepted or rejected

on the strength of its merits alone. The proposal will not be considered in combination

with other proposals to consider the maximum utilization of available funds.

Basic steps of Capital Budgeting

1. Estimate the cash flows

2. Assess the risky ness of the cash flows.

33
 3. Determine the appropriate discount rate.

4. Find the PV of the expected cash flows.

5. Accept the project if PV of inflows > costs. IRR > Hurdle Rate and/or payback

< policy

The classification of investment projects

a) By project size
Small projects may be approved by departmental managers. More careful analysis and
Board of Directors' approval is needed for large projects of, say, half a million dollars or
more.
b) By type of benefit to the firm
• an increase in cash flow
• a decrease in risk
• an indirect benefit (showers for workers, etc).
c) By degree of dependence
• mutually exclusive projects (can execute project A or B, but not both)
• complementary projects: taking project A increases the cash flow of project B.
• substitute projects: taking project A decreases the cash flow of project B.
d) By degree of statistical dependence
• Positive dependence
• Negative dependence
• Statistical independence.
e) By type of cash flow
• Conventional cash flow: only one change in the cash flow sign
e.g. -/++++ or +/----, etc
• Non-conventional cash flows: more than one change in the cash flow sign,
e.g. +/-/+++ or -/+/-/++++, etc.

The analysis stipulates a decision rule for:

I) accepting or
II) rejecting
investment projects.

METHODS AND TECHNIQUES OF CAPITAL BUDGETING

There are many methods for evaluating the profitability of investment proposals. The various

commonly used methods are

34
Traditional methods:

1. Payback period method (P.B.P)

2. Accounting Rate of return method (A.R.R)

3. Discounted Payback

Time adjusted or discounting techniques:

1. Net Present value method (N.P.V)

2. Internal rate of return method (I.R.R)

3. Profitability index method (P.I)

4. Modified Internal Rate of Return (MIRR)

5. Equivalent Annual Annuity

1) Net Present Value:

Is also known as the discounted cash flow technique or NPV is the amount the

shareholder’s wealth would increase if the firm selected the project – if this number

is positive then the firm should select the project. Using the following formula we

can find the NPV of the two projects.

The NPV method is a modern method of evaluating investment proposals. This

method takes in to consideration the time value of money and attempts to calculate

the return on investments by introducing time element. The net present values of

all inflows and outflows of cash during the entire life of the project is determined

separately for each year by discounting these flows with firms cost of capital or

predetermined rate. The steps in this method are

1. Determine an appropriate rate of interest known as cut off rate.

35
 2. Compute the present value of cash outflows at the above-determined

discount rate.

3. Compute the present value of cash inflows at the predetermined rate.

4. Calculate the NPV of the project by subtracting the present value of cash

outflows, from present value of cash inflows.

Decision rule:
If NPV is positive (+): accept the project
If NPV is negative(-): reject the project

The NPV method is used for evaluating the desirability of investments or projects.

where:
Ct = the net cash receipt at the end of year t
Io = the initial investment outlay
r = the discount rate/the required minimum rate of return on investment
n = the project/investment's duration in years.

Advantages:

• It recognizes the time value of money and is suitable to apply in a situation

with uniform cash outflows and uneven cash inflows.

• It takes in to account the earnings over the entire life of the project and gives

the true view of the profitability of the investment

• Takes in to consideration the objective of maximum profitability.

Disadvantages:

• More difficult to understand and operate.

36
 • It may not give good results while comparing projects with unequal

investment of funds.

• It is not easy to determine an appropriate discount rate.

1) Internal Rate of Return (IRR):

The IRR is the discount rate that makes the net present value of the project equal to

zero. A project’s IRR should be compared to the company’s cost of capital or “hurdle

rate.” The hurdle rate is the rate that the project must exceed to create positive

shareholder wealth effects. (Assume the hurdle rate (r) is 5%).

The internal rate of return method is also a modern technique of capital

budgeting that takes in to account the time value of money. It is also known as

time-adjusted rate of return or trial and error yield method. Under this method the

cash flows of a project are discounted at a suitable rate by hit and trial method,

which equates the net present value so calculated to the amount of the investment.

The internal rate of return can be defined as “that rate of discount at which the

present value of cash inflows is equal to the present value of cash outflows”.

Rules to follow:

Accept the proposal having the higher rate of return and vice versa.

If IRR>K, accept project. K = cost of capital.

If IRR<K, reject project.

Determination of IRR

• When annual cash flows are equal over the life of the asset.

Initial Outlay

FACTOR = --------------------------- x 100

37
 Annual Cash Inflow

• When the annual cash flows are unequal over the life of the asset:

Pv of cash inflows at lower rate - Pv of cash outflows

IRR = LR + ------------------------------------------------------------------------- (hr-lr)

Pv of cash inflows at lower rate-Pv of cash inflows at higher rate

The steps involved here are:

1. Prepare the cash flow table using assumed discount rate to discount the net

cash flows to the present value.

2. Find out the NPV, & if the NPV is positive, apply higher rate of discount.

3. If the higher discount rate still gives a positive NPV, increase the discount

rate further. Untill it becomes zero.

4. If the NPV is negative, at a higher rate, NPV lies between these two rates.

Advantages:

• It takes into account, the time value of money and can be applied in

situations with even and even cash flows.

• It considers the profitability of the projects for its entire economic life.

• The determination of cost of capital is not a pre-requisite for the use of this

method.

• It provides for uniform ranking of various proposals due to the percentage

rate of return.

• This method is also compatible with the objective of maximum profitability.

38
Disadvantages:

• It is difficult to understand and operate.

• The results of NPV and IRR methods may differ when the projects under

evaluation differ in their size, life and timings of cash flows.

• This method is based on the assumption that the earnings are reinvested at

the IRR for the remaining life of the project, which is not a justified

assumption.

Net present value vs internal rate of return

Independent vs dependent projects
NPV and IRR methods are closely related because:
i) both are time-adjusted measures of profitability, and
ii) their mathematical formulas are almost identical.
So, which method leads to an optimal decision: IRR or NPV?
a) NPV vs IRR: Independent projects
Independent project: Selecting one project does not preclude the choosing of the other.
With conventional cash flows (-|+|+) no conflict in decision arises; in this case both NPV and
IRR lead to the same accept/reject decisions.
Figure 6.1 NPV vs IRR Independent projects

39
If cash flows are discounted at k1, NPV is positive and IRR > k1: accept project.
If cash flows are discounted at k2, NPV is negative and IRR < k2: reject the project.
Mathematical proof: for a project to be acceptable, the NPV must be positive, i.e.

Similarly for the same project to be acceptable:

where R is the IRR.

Since the numerators Ct are identical and positive in both instances:
• implicitly/intuitively R must be greater than k (R > k);
• If NPV = 0 then R = k: the company is indifferent to such a project;
• Hence, IRR and NPV lead to the same decision in this case.
b) NPV vs IRR: Dependent projects
NPV clashes with IRR where mutually exclusive projects exist.
Example:
Agritex is considering building either a one-storey (Project A) or five-storey (Project B) block
of offices on a prime site. The following information is available:
Initial Investment Outlay Net Inflow at the Year End

Project A -9,500 11,500

Project B -15,000 18,000

Assume k = 10%, which project should Agritex undertake?

40
= $954.55

= $1,363.64
Both projects are of one-year duration:

IRRA:
$11,500 = $9,500 (1 +RA)

= 1.21-1
therefore IRRA = 21%

IRRB:
$18,000 = $15,000(1 + RB)

= 1.2-1
therefore IRRB = 20%
Decision:
Assuming that k = 10%, both projects are acceptable because:
NPVA and NPVB are both positive
IRRA > k AND IRRB > k
Which project is a "better option" for Agritex?
If we use the NPV method:
NPVB ($1,363.64) > NPVA ($954.55): Agritex should choose Project B.
If we use the IRR method:
IRRA (21%) > IRRB (20%): Agritex should choose Project A. See figure 6.2.
Figure 6.2 NPV vs IRR: Dependent projects

41
Up to a discount rate of ko: project B is superior to project A, therefore project B is preferred
to project A.
Beyond the point ko: project A is superior to project B, therefore project A is preferred to
project B
The two methods do not rank the projects the same.

1) Modified Internal Rate of Return (MIRR):

The modified IRR assumes that cash flows are reinvested at the

company’s cost of capital. The cash flows are first brought forward to their

future values at the company’s cost of capital. Next the “terminal value”

is calculated by summing all of the future value cash flows. Finally the

terminal value is brought to the present value of the initial investment at

the MIRR rate. (Assume a cost of capital of 5%). Modified IRR (MIRR).

42
The MIRR is similar to the IRR, but is theoretically superior in that it

overcomes two weaknesses of the IRR. The MIRR correctly assumes

reinvestment at the project’s cost of capital and avoids the problem of

multiple IRRs. However, please note that the MIRR is not used as widely

as the IRR in practice.

There are 3 basic steps of the MIRR:

1. Estimate all cash flows as in IRR.

2. Calculate the future value of all cash inflows at the last year of the

project’s life.

3. Determine the discount rate that causes the future value of all cash

inflows determined in step 2, to be equal to the firm’s investment at

time zero. This discount rate is know as the MIRR.

∑ Cash Inflow ( 1 + r )
N −1
N
Cash Outflowt
∑ = t =0
( 1+ r ) ( 1 + MIRR )
t N
t =0

Terminal value
PV of costs =
( 1 + MIRR )
N

= PV of terminal value

1) Profitability Index (PI):

43
The profitability index is the present value of the project’s cash flows divided by the

cost. (Assume a 5% cost of capital) PI tells us how much profit we can earn for

each dollar invested. Profitability ratio is otherwise referred to as Benefit/Cost ratio.

This is an extension of the Net Present Value Method. This is a relative valuation

index and hence is comparable across different types of the projects requiring

different quantum of initial investments.

Profitability index (PI) is the ratio of sent value of cash inflows to the present

value of cash outflows. The present values of the cash flows are obtained at a

discount rate equivalent to the cost of capital.

The profitability index, or PI, method compares the present value of future cash

inflows with the initial investment on a relative basis. Therefore, the PI is the ratio

of the present value of cash flows (PVCF) to the initial investment of the project.

It is also a time-adjusted method of evaluating the investment proposals. PI also

called benefit cost ratio or desirability factor is the relationship between present

value of cash inflows and the present values of cash outflows. Thus

PV of cash inflows

Profitability index = ------------------------------

PV of cash outflows

NPV

Net profitability index = -----------------------------

Initial Outlay

44
Advantages:

• Unlike net present value, the profitability index method is used to rank the

projects even when the costs of the projects differ significantly.

• It recognizes the time value of money and is suitable to applied in a situation

with uniform cash outflows and uneven cash inflows.

• It takes into an account the earnings over the entire life of the project and

gives the true view of the profitability of the investment.

• Takes into consideration the objective of maximum profitability.

Disadvantages:

• More difficult to understand and operate.

• It may not give good results while comparing projects with Unequal

investment funds.

• It is not easy to determine and appropriate discount rate.

• It may not give good results while comparing projects with unequal lives as

the project having higher NPV but have a longer life span may not be as

desirable as a project having some what lesser NPV achieved in a much

shorter span of life of the asset.

1) Payback Period:

The payback period is the expected number of years required to recover the original

investment.

45
 The payback period method has three main flaws: 1) dollars received in different

years are all given the same weight 2) cash flows beyond the payback year are not

considered 3) payback period analysis does not provide an indication of how much

shareholder wealth should increase (like NPV) and 4) payback period analysis does

not indicate how much the project will yield over the cost of capital (like

IRR).Payback period is the time duration required to recoup the investment

committed to a project. Business enterprises following payback period use

"stipulated payback period", which acts as a standard for screening the project.

Rules to follow:

• A project is accepted if its payback period is less than the period specific

decision rule.

• A project is accepted if its payback period is less than the period specified by the

management and vice-versa.

Initial Cash Outflow

Pay Back Period = ------------------------------
Annual Cash Inflows

Advantages:

• It is easy to understand and apply. The concept of recovery is familiar to

every decision-maker.

• Business enterprises facing uncertainty - both of product and technology -

will benefit by the use of payback period method since the stress in this

technique is on early recovery of investment. So enterprises facing

46
 technological obsolescence and product obsolescence - as in

electronics/computer industry - prefer payback period method.

• Liquidity requirement requires earlier cash flows. Hence, enterprises having

high liquidity requirement prefer this tool since it involves minimal waiting

time for recovery of cash outflows as the emphasis is on early recoupment of

investment.

Disadvantages:

• The time value of money is ignored. For example, in the case of project.

• A Rs.500 received at the end of 2nd and 3rd years are given same

weightage. Broadly a rupee received in the first year and during any other

year within the payback period is given same weight. But it is common

knowledge that a rupee received today has higher value than a rupee to be

received in future.

• But this drawback can be set right by using the discounted payback period

method. The discounted payback period method looks at recovery of initial

investment after considering the time value of inflows.

• Another important drawback of the payback period method is that it ignores

the cash inflows received beyond the payback period. In its emphasis on

early recovery, it often rejects projects offering higher total cash inflow.

1) Discounted Payback:

This method is similar to the payback period method except the cash flows are

discounted by the project’s cost of capital. The discounted payback period is the

47
number of years required to recover the investment from the discounted net cash

flows. (Assume a cost of capital of 5%)

Discounted Payback = Number of years prior to full recovery*

Unrecovered cost at start of year *
+
Cash flow during full recovery year *
*considers discounted cash flows

2) Accounting Rate of Return on Investment (ROI):

Firms make capital investments to earn a satisfactory rate of return. Determining a satisfactory

rate of return depends on the cost of borrowing money, but other factors can enter into the

equation. Such factors include the historic rates of return expected by the firm. In the long run,

the desired rate of return must equal or exceed the cost of capital in the marketplace. The

accounting rate of return on investment (ROI) calculates the rate of return from an investment by

adjusting the cash inflows produced by the investment for depreciation. It gives an

approximation of the accounting income earned by the project.

Accounting rate of return is the rate arrived at by expressing the average annual net profit

(after tax) as given in the income statement as a percentage of the total investment or average

investment. The accounting rate of return is based on accounting profits. Accounting profits are

different from the cash flows from a project and hence, in many instances, accounting rate of

return might not be used as a project evaluation decision. Accounting rate of return does find a

place in business decision making when the returns expected are accounting profits and not

merely the cash flows.

48
 This method takes into account the earnings from the investment over the whole

life. It is known as average rate of return method because under this method the

concept of accounting profit (NP after tax and depreciation) is used rather than cash

inflows. According to this method, various projects are ranked in order of the rate

of earnings or rate of return.

Rule to follow:

• The project with higher rate of return is selected and vice – versa.

• The return on investment method can be used in several ways, as

Average Rate of Return Method:

Under this method average profit after tax and depreciation is calculated and then it is divided by

the total capital out lay.

Average Annual profits (after dep. & tax)

Average rate of return = --------------------------------------------------- x 100

Net Investment

Advantages:

• It is very simple to understand and easy to calculate.

• It uses the entire earnings of a project in calculating rate of return and hence

gives a true view of profitability.

• As this method is based upon accounting profit, it can be readily calculated

from the financial data.

Disadvantages:

49
 • It ignores the time value of money.

• It does not take in to account the cash flows, which are more important than

the accounting profits.

• It ignores the period in which the profits are earned as a 20% rate of return in

2 ½ years is considered to be better than 18% rate if return in 12 years.

• This method cannot be applied to a situation where investment in project is

to be made in parts.

1) Equivalent annual annuity:

What do you do when project lives vary significantly? An easy and

intuitively appealing approach is to compare the “equivalent annual

annuity” among all the projects. The equivalent annuity is the level

annual payment across a project’s specific life that has a present value

equal to that of another cash-flow stream. Projects of equal size but

different life can be ranked directly by their equivalent annuity. This

approach is also known as equivalent annual cost, equivalent annual cash

flow, or simply equivalent annuity approach. The equivalent annual

annuity is solved for by this equation:

Equivalent Annuity = PV (Cash Flows) / (present value factor of n-year

annuity)

CAPITAL BUDGETING ANALYSIS

50
Capital Budgeting Analysis is a process of evaluating how we invest in capital assets; i.e. assets that

provide cash flow benefits for more than one year. We are trying to answer the following

question: Will the future benefits of this project be large enough to justify the investment given the

risk involved?

It has been said that how we spend our money today determines what our value will be tomorrow.

Therefore, we will focus much of our attention on present values so that we can understand how

expenditures today influence values in the future. A very popular approach to looking at present

values of projects is discounted cash flows or DCF. However, we will learn that this approach is

too narrow for properly evaluating a project. We will include three stages within Capital

Budgeting Analysis:

 Decision Analysis for Knowledge Building

 Option Pricing to Establish Position

 Discounted Cash Flow (DCF) for making the Investment Decision

Stage 1: Decision Analysis

Decision-making is increasingly more complex today because of uncertainty. Additionally, most

capital projects will involve numerous variables and possible outcomes. For example, estimating

cash flows associated with a project involves working capital requirements, project risk, tax

considerations, expected rates of inflation, and disposal values. We have to understand existing

markets to forecast project revenues, assess competitive impacts of the project, and determine the

life cycle of the project. If our capital project involves production, we have to understand

operating costs, additional overheads, capacity utilization, and start-up costs. Consequently, we

51
 can not manage capital projects by simply looking at the numbers; i.e. discounted cash flows. We

must look at the entire decision and assess all relevant variables and outcomes within an analytical

hierarchy.

In financial management, we refer to this analytical hierarchy as the Multiple Attribute Decision

Model (MADM). Multiple attributes are involved in capital projects and each attribute in the

decision needs to be weighed differently. We will use an analytical hierarchy to structure the

decision and derive the importance of attributes in relation to one another. We can think of

MADM as a decision tree which breaks down a complex decision into component parts. This

decision tree approach offers several advantages:

• We systematically consider both financial and non-financial criteria.

• Judgments and assumptions are included within the decision based on expected values.

• We focus more of our attention on those parts of the decision that are important.

• We include the opinions and ideas of others into the decision. Group or team decision making

is usually much better than one person analyzing the decision.

Stage 2: Option Pricing

The uncertainty about our project is first reduced by obtaining knowledge and working the decision

through a decision tree. The second stage in this process is to consider all options or choices we

have or should have for the project. Therefore, before we proceed to discounted cash flows we

need to build a set of options into our project for managing unexpected changes.

In financial management, consideration of options within capital budgeting is called contingent

claims analysis or option pricing. For example, suppose you have a choice between two boiler

52
 units for your factory. Boiler A uses oil and Boiler B can use either oil or natural gas. Based on

traditional approaches to capital budgeting, the least costs boiler was selected for purchase,

namely Boiler A. However, if we consider option pricing Boiler B may be the best choice because

we have a choice or option on what fuel we can use. Suppose we expect rising oil prices in the

next five years. This will result in higher operating costs for Boiler A, but Boiler B can switch to a

second fuel to better control operating costs. Consequently, we want to assess the options of

capital projects.

Options can take many forms; ability to delay, defer, postpone, alter, change, etc. These options give

us more opportunities for creating value within capital projects. We need to think of capital

projects as a bundle of options. Three common sources of options are:

1. Timing Options: The ability to delay our investment in the project.

2. Abandonment Options: The ability to abandon or get out of a project that has gone bad.

3. Growth Options: The ability of a project to provide long-term growth despite negative values. For

example, a new research program may appear negative, but it might lead to new product

innovations and market growth. We need to consider the growth options of projects.

Option pricing is the additional value that we recognize within a project because it has flexibilities

over similar projects. These flexibilities help us manage capital projects and therefore, failure to

recognize option values can result in an under-valuation of a project.

Stage 3: Discounted Cash Flows

So we have completed the first two stages of capital budgeting analysis: (1) Build and organize

knowledge within a decision tree and (2) Recognize and build options within our capital projects.

We can now make an investment decision based on Discounted Cash Flows or DCF. Unlike

53
 accounting, financial management is concerned with the values of assets today; i.e. present values.

Since capital projects provide benefits into the future and since we want to determine the present

value of the project, we will discount the future cash flows of a project to the present.

Discounting refers to taking a future amount and finding its value today. Future values differ from

present values because of the time value of money. Financial management recognizes the time

value of money because:

1. Inflation reduces values over time: i.e. $ 1,000 today will have less value five years from now

due to rising prices (inflation).

2. Uncertainty in the future: i.e. we think we will receive $ 1,000 five years from now, but a lot

can happen over the next five years.

3. Opportunity Costs of money: $ 1,000 today is worth more to us than $ 1,000 five years from

now because we can invest $ 1,000 today and earn a return.

54