Capital Budgeting Analysis

Outline
Meaning of Capital Budgeting Significance of Capital Budgeting Analysis Traditional Capital Budgeting Techniques
Payback Period Approach Discounted Payback Period Approach Discounted Cash Flow Techniques
Net Present Value Internal Rate of Return Profitability Index Net Present Value versus Internal Rate of Return

Meaning of Capital Budgeting

Capital budgeting addresses the issue of strategic long-term investment decisions. Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not. Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization.

Significance of Capital Budgeting

Considered to be the most important decision that a corporate treasurer has to make. So much is the significance of capital budgeting that many business schools offer a separate course on capital budgeting

Why Capital Budgeting is so Important?

Involve massive investment of resources Are not easily reversible Have long-term implications for the firm Involve uncertainty and risk for the firm

Due to the above factors, capital budgeting decisions become critical and must be evaluated very carefully. Any firm that does not follow the capital budgeting process will not be maximizing shareholder wealth and management will not be acting in the best interests of shareholders. RJR Nabisco s smokeless cigarette project example Similarly, Euro-Disney, Concorde Plane, Saturn of GM all faced problems due to bad capital budgeting, while Intel became global leader due to sound capital budgeting decisions in 1990s.

Techniques of Capital Budgeting Analysis

Payback Period Approach Discounted Payback Period Approach Net Present Value Approach Internal Rate of Return Profitability Index

Which Technique should we follow?

A technique that helps us in selecting projects that are consistent with the principle of shareholder wealth maximization. A technique is considered consistent with wealth maximization if
It is based on cash flows Considers all the cash flows Considers time value of money Is unbiased in selecting projects

Payback Period Approach

The amount of time needed to recover the initial investment The number of years it takes including a fraction of the year to recover initial investment is called payback period To compute payback period, keep adding the cash flows till the sum equals initial investment Simplicity is the main benefit, but suffers from drawbacks Technique is not consistent with wealth maximization Why?

Discounted Payback Period

Similar to payback period approach with one difference that it considers time value of money The amount of time needed to recover initial investment given the present value of cash inflows Keep adding the discounted cash flows till the sum equals initial investment All other drawbacks of the payback period remains in this approach Not consistent with wealth maximization

Net Present Value Approach

Based on the dollar amount of cash flows The dollar amount of value added by a project NPV equals the present value of cash inflows minus initial investment Technique is consistent with the principle of wealth maximization Why? Accept a project if NPV 0

Internal Rate of Return

The rate at which the net present value of cash flows of a project is zero, I.e., the rate at which the present value of cash inflows equals initial investment Project s promised rate of return given initial investment and cash flows Consistent with wealth maximization Accept a project if IRR Cost of Capital

NPV versus IRR

Usually, NPV and IRR are consistent with each other. If IRR says accept the project, NPV will also say accept the project IRR can be in conflict with NPV if
Investing or Financing Decisions Projects are mutually exclusive
Projects differ in scale of investment Cash flow patterns of projects is different

If cash flows alternate in sign problem of multiple IRR

If IRR and NPV conflict, use NPV approach

Profitability Index (PI)

A part of discounted cash flow family PI = PV of Cash Inflows/initial investment Accept a project if PI 1.0, which means positive NPV Usually, PI consistent with NPV PI may be in conflict with NPV if
Projects are mutually exclusive
Scale of projects differ Pattern of cash flows of projects is different

When in conflict with NPV, use NPV

The Vision
The new millennium will bring with it new challenges and greater opportunities. The 21st century will most certainly see the unfolding of a period of extraordinary possibilities and incredible developments bringing about more fundamental changes in the global economy than the last 200 years

The Vision
In this journey, clarity of vision, a readiness to cultivate a global mindset, effectiveness, harnessing of human resources to enhance job and knowledge skills of employees, a strong accent on R & D and innovation and a move away from selling, to innovative marketing in recognition of the fact that the Customer is truly King, are some of the strategies that will help corporates to survive and succeed. However it must be remembered that it is not enough to adopt a set of values and just leave them in place. In order to move with the changing times, values and ideas must be ceaselessly re-examined so as to ensure that they are in tune with the organisation's goals. The India Cements Limited is committed to contribute its might in making the 21st century an "Indian Century".

The Mission
Aiming High: We should be one of the largest Cement Companies in the Country. Our growth in size will be through continuous review of potentials of the existing manufacturing resources, strategic acquisitions and expansions Core Competency: Cement will be our mainstay. However, we shall venture into related fields which afford purposeful synergy. Quality Quest: Product quality, consistency and customer service will be pursued as an act of faith throughout the organisation. Modern Mindset: In an environment which is intensively competitive, we shall be futuristic in outlook and effective in management.

The Mission
Pursuit Of Excellence: The growing size of our business permit us to have an R & D set up of our own. We shall continuously challenge methods, systems, operating parameters. We shall constantly review our manufacturing systems to upgrade quality and value of products. Human Resources: We consider people as our valuable Assets. Our HRD Systems will be totally proactive and tuned to provide excellent working environment and transparent organisational culture for creativity, innovation and participation. Value Addition: ICL will continuously strive to enhance its value to its customers, ShareHolders and Employees. Community Welfare: As the organization grows, as a good Corporate Citizen, we shall be sensitive to the welfare and development needs of the Society around us.

COMPANY PROFILE
The India Cements Ltd was established in 1946 and the first plant was setup at Sankarnagar in Tamilnadu in 1949 . Since then it has grown in stature to seven plants spread over Tamilnadu and Andhra Pradesh. The capacities as on March 2010 have reached 14.05 mtpa. Company Highlights The Company is the largest producer of cement in South India. The Company's plants are well spread with three in Tamilnadu and four in Andhra Pradesh which cater to all major markets in South India and Maharashtra. The Company is the market leader with a market share of 28% in the South. It aims to achieve a 35% market share in the near future. The Company has access to huge limestone resources and plans to expand capacity by de-bottlenecking and optimisation of existing plants as well as by acquisitions. The Company has a strong distribution network with over 10,000 stockists of whom 25% are dedicated. The Company has well established brands- Sankar Super Power, Coromandel Super Power and Raasi Super Power. Regional offices in all southern states and Maharasthra offices/representative in every district.

FINDINGS
The investment is ideal because normally an investment should be recoverable with in 5 years. Average Rate of Return indicates 46.88%.Therefore the project earns a good profit in short span of period. Net Present Value of the project was Rs.1,97,93,184. This indicates high profitability because it was >1. The Profitability Index of the project is also >1 i.e., 1.55.Thus it is constant with the shareholders value maximization principle. The Internal Rate of Return shows 32.69% .These are also ensures a profitable investment.

SUGGESTIONS
Net Present Value method is more suitable for the company for making investment decision. In future the company may follow the capital budget method before making investment decisions. The company may effectively use the available resources for attaining maximum profit. The company has to analyze the proposal for expansion or creating additional capacity.

THE END