PROJECT REPORT

ON

CAPITAL BUDGETING

AT

NATIONAL MINERAL DEVELOPMENT CORPORATION LIMITED

1

CONTENTS

PAGE No:

CHAPTER-1 03

INTRODUCTION

Introduction of the study

Need for the study

Objectives

Research Methodology

Scope of the study

Limitations

CHAPTER-2 12

COMPANY PROFILE

CHAPTER-3 28

THEORETICAL BACKGROUND ABOUT THE TOPIC

CHAPTER-4 56

DATA ANALYSIS

CHAPTER-5 67

FINDINGS, CONCLUSION&SUGGESTIONS

BIBLIOGRAPHY

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CHAPTER-1

INTRODUCTION

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INTRODUCTION OF THE STUDY

Capital budgeting or investment appraisal is the planning process used to determine

whether a firm's long term investments such as new machinery, replacement

machinery, new plants, new products, and research and development projects are

worth pursuing.

Many formal methods are used in capital budgeting, including the techniques such as

Net present value

Profitability index

Internal rate of return

Modified Internal Rate of Return, and

Equivalent annuity.

These methods use the incremental cash flows from each potential investment, or

project. Techniques based on accounting earnings and accounting rules are sometimes

used - though economists consider this to be improper - such as the accounting rate of

return, and "return on investment." Simplified and hybrid methods are used as well,

such as payback period and discounted payback period.

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Net present value

Each potential project's value should be estimated using a discounted cash flow

(DCF) valuation, to find its net present value (NPV) - (see Fisher separation theorem).

This valuation requires estimating the size and timing of all of the incremental cash

flows from the project. These future cash flows are then discounted to determine their

present value. These present values are then summed, to get the NPV. See also Time

value of money. The NPV decision rule is to accept all positive NPV projects in an

unconstrained environment, or if projects are mutually exclusive, accept the one with

the highest NPV.

The NPV is greatly affected by the discount rate, so selecting the proper rate -

sometimes called the hurdle rate - is critical to making the right decision. The hurdle

rate is the minimum acceptable return on an investment. It should reflect the riskiness

of the investment, typically measured by the volatility of cash flows, and must take

into account the financing mix. Managers may use models such as the CAPM or the

APT to estimate a discount rate appropriate for each particular project, and use the

weighted average cost of capital (WACC) to reflect the financing mix selected. A

common practice in choosing a discount rate for a project is to apply a WACC that

applies to the entire firm, but a higher discount rate may be more appropriate when a

project's risk is higher than the risk of the firm as a whole.

Internal rate of return

The internal rate of return (IRR) is defined as the discount rate that gives a net

present value (NPV) of zero. It is a commonly used measure of investment efficiency.

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The IRR method will result in the same decision as the NPV method for independent

(non-mutually exclusive) projects in an unconstrained environment, in the usual cases

where a negative cash flow occurs at the start of the project, followed by all positive

cash flows. In most realistic cases, all independent projects that have an IRR higher

than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects,

the decision rule of taking the project with the highest IRR - which is often used -

may select a project with a lower NPV.

In some cases, several zero NPV discount rates may exist, so there is no unique IRR.

The IRR exists and is unique if one or more years of net investment (negative cash

flow) are followed by years of net revenues. But if the signs of the cash flows change

more than once, there may be several IRRs. The IRR equation generally cannot be

solved analytically but only via iterations.

One shortcoming of the IRR method is that it is commonly misunderstood to convey

the actual annual profitability of an investment. However, this is not the case because

intermediate cash flows are almost never reinvested at the project's IRR; and,

therefore, the actual rate of return is almost certainly going to be lower. Accordingly,

a measure called Modified Internal Rate of Return (MIRR) is often used.

Despite a strong academic preference for NPV, surveys indicate that executives prefer

IRR over NPV, although they should be used in concert. In a budget-constrained

environment, efficiency measures should be used to maximize the overall NPV of the

firm. Some managers find it intuitively more appealing to evaluate investments in

terms of percentage rates of return than dollars of NPV.

Equivalent annuity method

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The equivalent annuity method expresses the NPV as an annualized cash flow by

dividing it by the present value of the annuity factor. It is often used when assessing

only the costs of specific projects that have the same cash inflows. In this form it is

known as the equivalent annual cost (EAC) method and is the cost per year of owning

and operating an asset over its entire lifespan.

It is often used when comparing investment projects of unequal lifespans. For

example if project A has an expected lifetime of 7 years, and project B has an

expected lifetime of 11 years it would be improper to simply compare the net present

values (NPVs) of the two projects, unless the projects could not be repeated.

The use of the EAC method implies that the project will be replaced by an identical

project.

Alternatively the chain method can be used with the NPV method under the

assumption that the projects will be replaced with the same cash flows each time. To

compare projects of unequal length, say 3 years and 4 years, the projects are chained

together, i.e. four repetitions of the 3 year project are comparing to three repetitions of

the 4 year project. The chain method and the EAC method give mathematically

equivalent answers.

The assumption of the same cash flows for each link in the chain is essentially an

assumption of zero inflation, so a real interest rate rather than a nominal interest rate

is commonly used in the calculations.

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NEED FOR THE STUDY:

Capital Budgeting is an essential element in the preparation of feasibility study as the

potential cost of the project development or the potential income from sales will be a

key factor in your decision as to the viability of project. SEBIC has dedicated staffs

who are experienced financial planners, we can help you develop an initial plan for

your feasibility study or we can liaise with your existing financial consultants in order

to help you make an informed choice.

OBJECTIVES:

MAIN OBJECTIVE:

The main objective of the project is to suggest the company whether to establish

the Ultra Pure Ferric Oxide Plant at Vishakhapatnam or not.

SUB-OBJECTIVES:

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1. To study the financial feasibility of the proposal.

2. To find out the benefits that the company is going to get from

the new project

3. To critically evaluate the project to arrive at the right

conclusion.

4. Estimation of post project scenario of the company.

RESEARCH METHODOLOGY:

The information required for successful completion of the project has been collected

through primary and secondary sources. Primary sources of information are through

interviewing, meetings & etc. with the various officials and employees of NMDC.

Secondary sources of information are the Balance Sheets and other Financial

Statements of the company.

9

SCOPE OF THE STUDY;

The scope of the study covers Costs and benefits received from capital budgeting

decisions occur in different time periods. They are not logically comparable because

of the time value of money.

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LIMITATIONS:

The benefits from investments are received in some future period. The future is

uncertain. Therefore, an element of risk is involved.

Costs incurred and benefits received from capital budgeting decisions occur in

different time periods. They are not logically comparable because of the time value

of money

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It is not often possible to calculate in strict quantitative terms all the benefits or the

costs relating to a particular investment decision

A failure to forecast correctly will lead to various errors which can be corrected

only at a considerable expense

Since the project has been done only for three months, it is dearth of complete

information.

CHAPTER-2

COMPANY PROFILE

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PROFILE OF THE INDUSTRY

Mines are the treasures of the economy. A mineral is any naturally formed

homogenous solid that has a definite chemical composition. It may be a single

element such as Copper, Gold, or Diamond or a compound such as Sodium chloride

or Calcium Carbonate. Mining is the extraction, from the earth or oceans, of

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minerals or certain other minerals, which can be useful to man. Mankind has been

mining and using minerals since before beginning of the recorded history. Old

Stone Age man dug finds out of chalk formations for making weapons and tools

native gold and copper probably were used as early as 8000 BC, and Bronze was

being made by 4000 BC. The first main function of a mining firm is to prospect

and explore the ores for the production of minerals. For mining to be feasible, the

miner must find ore deposits-places where geological processes have created higher

than average concentrations of useful minerals. Prospecting is the process of

looking for mineral deposits. Physical exploration is the process of closely

examining a deposit to determine its size, shape, mineral content and other

characteristics. The second function is drilling and exploiting the mineral

resources.Based on the type of the mineral and the mine the method to will be

selected. The third function is the ore transport and processing.

MINERAL SECTOR IN INDIA

India i s r ichly endowed with minerals l ike coal (none cooking) ,

bauxi te (metallurgical), barites, iron ore, mica, gypsum, chromate (fines and

low grade), dolomite (non-flux grade) and lime stone. While it is deficient in

minerals like asbestos, phosphate, lead, tungsten, tin, platinum group, gold and

diamond.

It possesses large reserves of Iron ore, Extensive deposits of coal, Sizeable quantity

of mineral oil resources, Rich deposits of bauxite and has virtually monopoly of

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mica, all of which hold the potentials of making India economically self-reliant

modern industrial nation. No doubt, the country is still deficient in some minerals

like petroleum, tin, lead, zinc, nickel, etc but the continued exploration of India

under ground mineral wealth is yielding promising results. Thus adding to know

and potential deposits of various minerals.

The mineral resources of India are, however, very unevenly distributed. The

great plains of northern India are almost entirely devoid of any known

deposits of economic materials. On the other hand, Bihar and Orissa areas on the

northern- eastern part of peninsular. India possess large concentration of minerals

deposits, accounting for nearly three fourth of the country's coal deposits and

containing highly rich deposits of iron ore, manganese, mica, bauxite

And radioactive materials deposits are also scattered over the rest of the

peninsular India and in the parts of Assam and Rajasthan. Mines are the source of

treasury' said Kautilya in his Arthashastra over 2001 years ago. However, until and

unless these hidden resources are unlocked and utilized the mineral deposits by

themselves cannot contribute to the economy.

Under the constitution, mineral rights and administration of mining laws are vested

in state governments.

Central government, however, regulated development of minerals under mines and

minerals (regulation & development) act, 1957 and the rules and regulations

formed under this act The statute empowers centre to formulate rules for:-

Grant of prospecting licenses and leasing.

Conservation and development of minerals.

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Modification of old leases.

The Mines & Minerals (regulation & development) Act, 1957 came into force

on lst June 1958. A number of amendments to this are made in further ears.

MINERAL EXPLORATION AND DEVELOPMENT:

A number of organizations are engaged in exploration and development to

mineral resources in India. These include:-

Geographical survey of India(GSl)

Indian Bureau of Mines(JBM)

And a number of public-sector undertaking like-

Hindustan Zinc Limited (HZL) - for Zinc.

Hindustan Copper Limited (HCL) - for Copper.

Bharat Gold Mines Limited (BGML) - for Gold.

National Aluminum Company Limited (NALCO)-for Aluminum.

Bharat Aluminum Company Limited (BALCO) for Aluminum.

Sikkim Mining Corporation - for Copper, Zinc and Lead.

Mineral Exploration Development Corporation Limited (MECL)

- for Exploration.

National Mineral Development Corporation (NMDC)-for Diamond

& Iron ore on production side and various minerals on the exploration,

planning and development side.

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NMDC'S ROLE IN MINERAL SECTOR IN INDIA:

NMDC has rendered yeomen service to the mineral sector in India in the past

four decades. The expertise of the company has been utilized by the nation in

developing its mineral deposits and production of iron ore and diamonds. NMDC is

the largest supplier of iron ore in India and the only producer of diamonds. NMDC

has served the nation only in the areas of copper, lime stone, dolomite and other

raw materials for the steel industry.

Iron ore reserves in India:

India is favorably endowed with iron ore resources, estimated at 2,071crore tones,

of which l, 191crore tones are hematite and 879.9crore tones magnetite ore.

Hematite ore mainly occurs in Bihar, Orissa, Madhya Pradesh, Maharashtra, Goa

and Karnataka. Large reserves of magnetite ore occur along West coast, primarily

in Karnataka, with minor occurrences in Kerala, Tamilnadu.

Diamond:

Total reserves and resources are placed at 10.8 lakh carats. Main diamond bearing

areas in India are Panna belt in MP, Ramallakota and Bangampally in kurnool

district and gravels of Krishna, river basin in AP. Presently the only diamond pipe

under exploitation is at Panna.

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COMPANY PROFILE

NATIONAL MINERAL DEVELOPMENT OF NMDC

NMDC was established in the year 1958. NMDC is the public sector enterprise of

the Govt. of India. It has one subsidiary company-J&K Mineral Development

Corporation, Jammu. Over 40years of experience in large mechanized open cast

mining. It is single largest producer & exporter of Iron ore from India. Synergies

through strategic tie –ups for geological investigations and value addition of

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minerals. R&D center acclaimed as a center of excellence by UNIDO. NMDC

operates India's only diamond mine, which is at Panna, in M.P. NMDC diversified

into the fields of mining limestone and magnesite in Rajasthan, Himachal Pradesh,

and Jammu& Kashmir.

NMDC, a Govt. of India undertaking, under the Ministry of Steel Mine was

registered and incorporated on 15 l Nov ,1958.Initially It was started as Pvt. Ltd.

Company, later on 15 l Dec , 1959,the word limited was added o he corporation

and such resolution was passed in annual general meeting. On 15 th Jan, 1960 with

prior approval of he Govt., the word private was deleted with effect from

pursuant to the resolution passed in terms of sec-21 of companies act, 1956.

Projects of the company:

1. Kinburu iron ore mine in Bihar. (Developed by NMDC but handed over to

Bokaro Steel Plant as captive mine).

2. Meghataburu iron ore mine in Bihar. (Developed by NMDC but handed

over to Bokaro Steel Plant as captive mine).

3. Kudremukh magnetite is project in Karnataka. (Formed as an independent

company, Kudremukh Iron ore Company Ltd.)

4. Bailadila 5(Bacheli, district Bastrar), 14(Kirandul, district Bastar) &llc

(district Bellary) Iron ore mines in MP.

5. Donimalai iron ore mine in Karnataka.

6. Panna diamond mines in MP.

7. Khetri copper project, Rajasthan.

8. Rakha copper project, Rajasthan.

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9. Mussorie rock phosphate project, U.P (Transferred to Pyrites, Phosphates

and Chemicals Ltd.)

Donimalai:

The saga of NMDC includes the pioneering exploration activity, carried for

developing Iron ore mine in Karnataka in various regions take,

Kundremukh, Donimalai, Kumaraswamy, etc. NMDC developed Donimalai

mine in this area to export ore to Japan. Commissioned in Oct' 1977. Present

reserve is 60 Million Tons.

Saga of Bailadila group of mines:

The story of NMDC is woven around the dreamy hills and deep jungle of Bastar

in Madhya Pradesh known as Dandakaranya from the epic period. The Bailadila

iron ore range. The hump of an ox' in the local dialect was remote, in accessible and

replete with wild life. The range contains 12,000million tones of high-grade iron ore

distributed in 14 deposits. The entire area was brought to the mainstream of

civilization by the spectacular effort of NMDC by opening up two iron ore

mining projects during the lost three decades. Today Bailadala is named to

reckon with the iron ore. Bailadila complex possesses the world's best grade of

hard lumpy ore having over 66% iron contents, free from sulphur and other

deleterious material and the best physical properties need for steel making. The

different mines at Bailadila are:

Bailadila 14 With capacity of 18 million tones Commissioned in April 1968.

Bailadala with a capacity of 106million tones Commissioned in June l988.

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Bailadala 5 with a reserve of 137 million tones Commissioned in

the year 1977.

New projects:

In order to take the advantage of boom cycle, which is expected in the mid term of

2-3 years, in steel industry where the economy is now going through a state

recession, NMDC has planned to take the new challenges by developing new

projects in Bailadila sector:

Bailadila 10 & 11A deposit

Bailadila deposit- 11/B.

Bailadila - 14 Blue Dust mining scheme.

Kumaraswamy - B&C blocks as an integrated complex of

domination mine in Hospice sector, Karnataka.

Projects in AP:

NMDC has taken up several projects in AP, which are in various stages of

development. The erection work on the hi-tech project being put up at

Visakhapatnam for commercial production of UPFO is complete and the plant is

under trial runs and likely to go on stream by Sept'1999.

A MOU among NMDC, Indian Rare Earths Limited and APMDC was entered

into for the development of Bhimunipatnam Beach sand by 2 Joint Ventures (JV).

The first JV envisages mining of beach sands and also separation of constituent

minerals.

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The second JV proposes setting up down stream industry based on limonite

concentrate from the beach sand.

NMDC has also taken up a detailed investigation and efforts are on to

participate in tender action of APMDCL for exploration and exploitation of

diamonds in AP, Gold in both AP& Karnataka. The process for gold is now in

initial stage. The R & D center of NMDC at Hyderabad can take up any

assignment in the field of beneficiation & mineral processing.

Foreign Ventures:

In order to capture the opportunities by taking advantage of its expertise in the

field of mineral exploration and mining, the company is in the process of

venturing into the development of high value minerals like Gold, Diamond, etc.,

in some of the favorable African countries like Namibia, Tanzania, Madagascar,

etc .

As part of this exercise, the company had signed a MOU with OMNIS of

Madagascar and has set upon doing detailed geographical investigation or gold

in that country. Present indications are encouraging, but final decision on

investment and mining will be taken after analyzing the data collected. Field data

are also being collected from certain areas in Namibia for assessing suitably for

the company to enter into exploration and mining of diamond and gold. Depending

on the final analysis, a joint venture company may have to be formed.

ISO - certification:

In keeping with the modern trend, NMDC decided to get ISO - 9000 certification

for its individual units. To begin with the R&D center at Hyderabad (for ISO-

9001) and Donimalai Iron ore (for ISO - 9002) were akin up. Both the units have

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obtained the certification. The company is now planning to go ahead with the ISO

certification of Bailadila mines and UPFO plant in Vishakapatnam.

Product Profile of NMDC:

1. Single largest producer of Iron ore in India.

2. The only large scale mechanized Diamond miner in India.

3. Operas Silica sand, SMS grade Limestone, and Magnetic mines.

4. Setting up low Phos Pig Iron PLANT BASED ON Romelt Technology.

5. Setting up plan for the production of Ultra Pure Ferric-Oxide.

Commercialization of R & D's pilots plan scale operations for production of the

ultra pure and pigment grayed ferric oxide is on hand.

Products of NMDC:

The products that are being explored and developed by NMDC include:

Iron ore, Diamonds, low Silica lime stone, Tungsten and Graphite, Utile, zircon,

garnet, Monazite, limonite, Titanium Dl-oxide from Imaret , Iron

powder ,Titanium slag, Ferrite powder.

Markets for NMDC's products:

Exports: 50% of the NMDC's products are export-oriented. In accordance with

the government policy, the export of high grades iron ore produced by NMDC, is

canalized by MMTC (Material and Minerals Trading Corporation.).

Domestic markets : The remaining 50% of the products are for domestic setting.

Vizag Steel Plant occupies around 30-35% of the share in domestic sales. The

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other domestic customers are- ESSAR, Nippon Denro, Vikram, SUL, NACL,

LANCO, Usha Ispat Jmdal, and Kundremukh Iron ore Company Ltd.

The diamond produced by NMDC is sold entirely in domestic market through

auction.

Industrial Relations:

The overall industrial relations situation was peaceful and cordial. During the year

2002- 2003. There were no strikes, lockouts, etc, during the period.

Focus on R & D centre :

NMDC has a state-of-art R&D centre at Hyderabad. It can take up any assignment

in the field of ore beneficiation and mineral processing. It has been declare

"centre of excellence" in the expert group meeting under the aegis of UNIDO.

It has ISO-9001 certification.

The technical capabilities include:

Mineralogy. Batch ore dressing Mineral beneficiation pilot plant Agglomeration

Pyro and Hydrometallurgy. Bulk solids flow ability. New product development.

Analytical chemistry. Electronic data processing.

Supported by the in-house R&D works, NMDC is going in for value addition to

the 'waste' minerals. The R&D centre has developed many value-added products.

Customer satisfaction:

Constant efforts are made at NMDC for providing utmost Customer

satisfaction by qualitative, timely and assured supplier of ores from various mines.

Apart from the guarantee of quality of ore, assured timely supply of the

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consignment to customer has been primary motive of "service to the customer"

offered by this company.

Social Responsibilities :

NMDC has developed social infrastructure facilities and basic necessities

roads, hospitals, drinking water, electricity transport, post offices, banks, schools

and other amenities in the remote areas at its project sites. These have been provided

not only to the employees of NMDC but have also been extended to local

population. As a responsible steps for all round peripheral development bringing

about a change in the socio economic conditions of the regions.

Strengths of NMDC:

NMDC's expertise, know how and skill built up over 30 years in. The field of

mineral development covers several vital areas.

1. Investigation and exploration.

2. Preparation of feasibility reports.

3. Planning and engineering.

4. Construction, erection and commissioning.

5. Product Management.

6. Material Management.

7. Marketing.

8. Research and Development.

AWARDS : (RECOGNITION BY OTHERS)

NMDC has received several awards for its excellent performance, which includes:

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Top Performing Public Sector Enterprise Award', under MoU

system from Indian Institute of Industrial Engineering.

Top Export Award' from CAPEXIL

Abheraj Baldota Environmental Award' from Federation of Indian

Mineral Industries etc.

All India Industry Promotion Award', 1992-93, gold medal, for large

foreign earnings.

Excellence Award' 2004-2005, by the Indian Institution of

Industrial Engineering, Navy, Mumbai.

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CHAPTER-3

THEORETICAL BACKGROUND ABOUT THE TOPIC

THEORETICAL BACKGROUND ABOUT THE TOPIC

Capital Budgeting decisions pertain to fixed/long-term assets which by definition

refer to assets which are in operation, and yield a return, over a period of time,

usually exceeding one year. They therefore, involve a current outlay or series of

outlays or series of cash resources in return for an anticipated flow of future benefits.

In other words, the system of capital budgeting is employed to evaluate expenditure

decisions that involve current outlays but are likely

To produce benefits over a period of time longer than one year. These benefits

may be either in the form of increased revenues or reduced costs.

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From the preceding discussion may be deduced the following basic features of

capital budgeting:

(i) Potentially Target anticipated benefits;

(ii) A relatively high degree of risk; and

(iii) A relatively long time period between the initial outlay and the anticipated

returns. The term capital budgeting is used interchangeably with capital expenditure

decision, capital expenditure management, long-term investment decision,

management of fixed assets and so on.

IMPORTANCE:

Capital Budgeting decisions are of paramount importance in financial decision-

making. In the first place, such decisions affect the profitability of the firm. They

also have a bearing on the competitive position of the enterprise mainly because of

the fact that they relate to fixed assets.

The fixed assets represent, in a sense, the true earnings assets of the firm. They enable

the firm to generate finished goods Thai can ultimately be sold for profit. The current

assets are not generally earning assets. Rather, they provide a buffer that allows the

firms to make sales and extend credit true, current assets are important to

operations, but without fixed assets to generate finished products that can be

converted into current assets, the firm would not be able to operate. Further, they are

'strategic1 investment decisions as against 'tactical1 - which involve a relatively small

amount of funds. Therefore, such capital investment decisions may result in a

major departure from what the company has been doing in the past. Acceptance of a

strategic investment will involve a significant change in the company's expected

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profits and in the risks to which these profits will be subject. These changes are

likely to lead company.

Thus, capital budgeting decisions determine the future destiny of the company.

An opportune investment decision can yield spectacular returns. On the

other hand, an ill-advised and incorrect decision can endanger the very survival

even of the large firms, A few wrong decisions and the firm may be forced into

bankruptcy.

Long-term Effect: A capital expenditure decision has its effect over a long time span

and inevitably affects the company's future cost structure. The < scope of current

manufacturing activities of a firm is governed largely by capital expenditure

decisions provide the framework for future activities. Capital investment decisions

have an enormous bearing on the basic character of a firm.

Irreversibility: Capital investment decisions, once made, are not easily reversible

without much financial loss to the firm because there may be no market for; second-

hand plant and equipment and their conversion to other uses may not be financially

viable.

Substantial outlays: Capital investment involves costs and the majority of the

firms have scarce capital resources. This underlines the need for thoughtful, wise

and correct investment decisions as an incorrect decision would not only result in

losses but also prevent the firm from earning profits from other investment which

could not be undertaken for want of funds.

DIFFICULTIES:

While capital expenditure decisions are extremely important, they also pose

difficulties, which stem from three principal sources:

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Measurement problems: Identifying and measuring the costs and benefits of a

capital expenditure proposal tends to be difficult. This is more so when a capital

expenditure has a bearing on some other activities of the firm like cutting into the

sales of some existing product) or has some intangible consequences like improving

the morale of workers).

Uncertainty: A capital expenditure decision involves costs and benefits that

extend far into far into future. It is impossible to predict exactly what win happen

in the feature. Hence, there is usually a great deal of uncertainty characterizing

the costs and benefits of a capital expenditure decision.

Temporal Spread: The costs and benefits associated with a capital expenditure

decision are spread out over a long period of time, usually 10 20 years for industrial

projects and 20-50 years for infrastructural projects. Such a temporal spread

creates some problems in estimating discount rates and establishing equivalences.

PHASES OF CAPITAL BUDGETING

Capital budgeting is a complex process, which may be divided into five broad

phases: Planning, Analysis, Selection, Implementation and Review. Planning: The

planning phase of a firm's capital budgeting process is concerned with the articulation

of its broad investment strategy and the generation and preliminary screening of

project proposals. The investment strategy of the firm delineates the broad areas or

types of investments the firm plans to undertake. This provides the framework,

which shapes, guides and circumscribes the identification of individual project

opportunities. Once a project proposal is identified, its need to be examined. To

begin with, a preliminary project analysis is done. A prelude to the full blown

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feasibility study, this exercise is meant to assess (I) whether the project is prima facie

worthwhile to justify a feasibility study and (ii) what aspects of the project are

critical to its viability and hence warrant an in depth investigation.

ANALYSIS:

If the preliminary screening suggests that the project is prima facie worthwhile, a

detailed analysis of the marketing, technical, financial, economic, and ecological

aspects is undertaken. The questions and issues raised in such a detailed analysis

are described in the following section. The focus of this phase of capital budgeting

is on gathering, preparing, and summarizing relevant information about various

project proposals which are being considered for inclusion in the capital budget.

Baaed on the information developed in this analysis, the stream, of costs and benefits

associated with the project can be defined.

Financial Analysis:

Financial Analysis seeks to ascertain whether the proposed project will be financially

viable in the sense of being able to meet the burden of servicing debt and whether the

proposed project will satisfy the return expectations of those who provide the

capital. The aspects, which have to be cooked into while conducting financial

appraisal, are:

Investment outlay and cost of the project

Means of financing

Cost of capital

Projected profitability

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Break-even point

Cash flows of the project

Projected financial position

Level of risk

Investment judged in terms of various criteria of merit

KINDS OF CAPITAL BUDGETING DECISIONS

Capital budgeting refers to the total process of generating, evaluating, selecting and

following up on capital expenditure alternatives. The firm allocates or budgets

financial resources to new investment proposals. Basically, the firm may be

confronted with three types of capital budgeting decisions:

(i) The accept-reject decision

(ii) The mutually exclusive choice decision and

(iii) The capital rationing decision.

Accept-reject Decision:

This is a fundamental decision in capital budgeting, if the project is accepted,

the firm would invest in it; if the proposal is rejected, the firm does not invest in

it. In general, all those proposals which yield a rate of return greater than a certain

required rate of return or cost of capital are accepted and the rest are rejected. By

applying this criterion, all independent projects are accepted. Independent projects

are projects that do not compete with one another in such a way that the acceptance

of one precludes the possibility of acceptance of another. Under the accept-reject

decision, all independent projects that satisfy the minimum investment

criterion should be implemented. Mutually

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Exclusive Project Decisions:

Mutually exclusive projects are those which compete with other projects in such a

way that the acceptance of one will exclude the acceptance of the other projects.

The alternatives are mutually exclusive and only one may be chosen.

Suppose, a company is intending to buy a new folding machine. There are

three competing brands, each with a different initial investment and operating

costs.

The three machines represent mutually exclusive alternatives, as only one of

these can be selected. It may be noted here that the mutually exclusive

project decisions are not independent of the accept-reject decisions. The

project(s) should also be acceptable under the latter decision. In brief, in our

example, if all the machines are rejected under the accept-reject decision, the

firm should not buy a new machine. Mutually exclusive investment decisions

acquire significance when more than one proposal is acceptable under the

accept-reject decision, then; some technique has to be used to determine the

best one. The acceptance of this best alternative automatically eliminates the

other alternatives.

Capital Rationing Decision:

In a situation where the firm has unlimited funds, all independent

investment proposals yielding return greater than some predetermined level are

accepted. However, this situation does not prevail inmost of the business firms in

actual practice. They have a fixed capital budget.Larger number of investment

Proposals compete for these limited funds. The firms must, therefore, ration them.

33

The firm allocates funds to Projects in manner that it maximizes long-run returns.

Thus, capital rationing refers to a situation in which a firm has more acceptable

investments than in can finance. It is concerned with the selection of a group

investment proposal acceptable under accept-reject decision.

Capital rationing employs ranking of the acceptable investment projects. The

projects can be ranked on the basis of a predetermined criterion such as the rate of

return. The projects are ranked in the descending order of the rate of return.

DATA REQUIREMENT:

IDENTIFYING RELEVANT CASH FLOWS

Capital budgeting is concerned with investment decisions which yield minima

kiwi r a period of time In future, the foremost requirement for evaluation of

any capful Investment proposal is to estimate the future benefits accruing

from the Investment proposal, two alternative criteria are available to quantify

the benefits:

(I) accounting Pirelli and

(II) Cash flows.

The basic differences between them are primarily. Theoretically due to the

Inclusion of certain non-cash expenses in the profit and fuss account, for

Instance, depreciation.

Therefore the accounting profit is to be adjusted for non-cash expenditure to

determine the actual cash Inflow i.e. Cash flow approach of measuring future

benefits of a project is superior to the accounting approach as cash flows are

34

theoretically better measures of ten net economic benefits of costs associated

with a proposed project.

Lit the first place, while considering an investment proposal, a firm - Inflected

in estimating its economic value. This economic value is determined by the

economic outflows colts) and Inflows (benefits) related with the investment

project. Only cash flow represents the cash transactions. The firm must pay for

the purchase of asset ultra cash.

This cash outlay represents a foregone opportunity to use cash in

sums relit productive alternatives. Consequent, the firm should

measure the future net benefits in cash term a. on the other hand, under

the accounting practices, the cost of the investment is allocated over Its

economic useful life in the nature or depreciation rather than .

At the time when costs are actually incurred. The accounting treatment

clearly does not reflect the actual cash transactions associated with the

project. Since investment analysis is concerned with finding out

whether future economic inflows are sufficiently large to warrant the

Initial investment, only the cash flow method is appropriate for

investment decision analysis.

Secondly, lea use of cash flows avoids accounting ambiguities, mere are

various ways to value inventory, allocate costs, calculate depreciation

and amortization various other expenses. Obviously, different net

income will hi1 arrived at under different accounting procedures. But

there is only one set of cash flows associated with project. Clearly, the

35

cash flow approach to project evaluation is better than the net Income

flow approach. Thirdly, the cash flow approach takes romance of time

value of money whereas the accounting approach ignores it. Under

the usual accounting

practice, revenue la recognized as being generated when the product IS sold, not

when the cash la collected from the sale; revenue may remain a paper figure for

months or years before payment of the Invoice is received. Expenditure, too, is

recognized as being made when incurred and net when the actual payment is made.

Depreciation is deducted from the gross revenues to determine the before-tax

earnings. Such a procedure ignores. The increased flow of funds potentially

available for other uses. In ether words, accounting profits, which are quire

useful as performance measures often, are less useful as decision criteria.

Therefore, from the viewpoint of capital expenditure management, the cash flow

approach can be said to be the basis of estimating future benefits from investment

proposals. The data required for the purpose would be cash revenues and i t

expenses.

Incremental cash flow:

The second aspect of the data required for capital budgeting relates to the basis on

which the relevant cash outflows and inflows associated with proposed capital

expenditure are to be estimated. The widely prevalent practice is to adopt

Incremental analysis. According to Incremental analysis, only differences due to

the decision need to be considered. Other factors may be Important but not to the

decision at hand. For purposes of estimating cash flows in the analysis of

Investments, incremental cash films that is, those Cash flows, which are reedy

attributable to the Investment, are taken Into account. It is for this reason that fixed

36

overhead costs, which remain the same whether the proposal is accepted or

rejected, are not considered. However, if there is an increase in them due to the new

proposal, they must be considered.

Cash flow estimates:

For capital budgeting cash flows have to be estimated. There are certain Ingredients of

cash flow streams. Tax effect; it has boom observed that cash flows to be considered

for purposes of capital budgeting are net of taxes, special consideration needs 10 hi'

given to tax effects on cash flows if the firms is incurring losses and, therefore,

paying no taxes. The tax laws permit, to carrying losses forward to be set off against

future income. In such cases, therefore, the benefits of tax savings would accrue in

future years.

Effect on other projects:

Cash flows effects of the project under consideration, If it la not economically

independent, on other existing projects of the firm must betaken into consideration.

For instance, if a company is considering.

The production of new product which competes with existing products in the

product line, It Is likely that as a result of the new proposal, the cash flows related to

the old product will be affected. Assume that there is a decline of RE. 5,000 In the

actual flow from the existing product. This should be taken into consideration while

estimating that cash streams from the new proposal. In operational terms, the cash

37

flow from the product should be reduced by Rs. 5000. This is in conformity

with the general rule of the incremental cash flows, which involves identifying

changes in cash flows as a result of undertaking the project being evaluated. Clearly,

the cash flow effects or the project should not be evaluated in isolation, if it affects

other projects) in any way.

Effect of Indirect Expenses:

Another factor, which merits special consideration in estimating flows, is the

effect of overheads. The indirect expenses are allocated to the different products or

the basis of wages paid, materials used, floor space occupied or some other similar

common factor The question that arises is should such allocation of overheads be

taken into account In the cash flows? The answer hinges upon whether the amount of

overheads will change as a result of the investment decision. If yes, it should not be

taken into account. If, however, overheads will not change as a result of the

investment decision, they are not relevant.

A company allocates overheads on the basis of the floor space used. Assume it

intends to replace an old machine by a new one. Further assume that the new

machine would occupy lass space so that there would be a reduction the overhead

charged to it. Since there is no effect ort cash flow a change m the overhead is

not relevant to the cash flow streams of the machine being acquired. But If the

surplus space is used for an alternative use, arid If any cash flow Is generated, It

will be relevant to the calculations Thus, the deciding factor Is whether them if

any alternative LIM* The alternative use rule Is a corollary of the Incremental cash

flow mil-.

38

Effect of Depreciation:

Depreciation, although a non-cash item of cost, is deductible expenditure in

determining taxable income, depreciation provisions are prescribed by the

Companies Act, 1956 for accounting purpose and the Income tax act, 1961 for

taxation purposes. The purpose of the provisions of depreciation contained in the

companies1 act is that computation of managerial remuneration, dividend payment

and disclosure in financial statements. Since companies In India are regulated by the

companies act, they should provide depreciation in the books of accounts in

accordance with schedule XIV of the Act which prescribes the rate of depreciation

for various types of depreciable assets on written down value basis as well as

straight-line basis. 11 also permits companies to charge on any other basis provided

it has the effect of writing off 95 percent of the original cost of the asset on the

expiry of specified period and has the approval of Mio government. In actual

practice, however, companies follow the provisions of the Income Tax Act

with the basic objectives of its tax -deducibility.

The provisions or Income Tax Act relating to depreciation are contained in

section 32. The section provides envisages three Important conditions for following

depreciation, namely, (i) the asset is owned by the, (ii) the asset is used the

assesses for the purpose of business and (iii) the is in the form of buildings,

furniture, machinery and plants including ships, vehicles, books, scientific

apparatus, surgical equipments and so on. The amount of annual depreciation on

an asset is determined by (a) the actual coat of the asset and its classification in

the relevant block of assets, The actual cost means the cost of acquisition of

39

asset and the expenses incidental thereto which are necessary to put the asset

in a unable state, for instance, freight, and carriage inwards, installation

charges and expenses Incurred to facilitate the use of the asset like expenses

on the training of the operator or an essential construction work.

Working capital e ffec t.

Working capi tal const i tutes another important ingredient of

the cash flow stream which the directly related to an Investment

proposal The term working capital is used here In net sense, that is,

current assets minus current liabilities (net working capital) if an

investment is expected to increase sales, it is likely that there will be an

increase in current assets in the form (accounts receivable, Inventory and

cash. But part of this Increase in currents assets will be offset by an

increase in current liabilities in the form of increased accounts and notes

payable. Obviously, the sum equivalent to the difference between

these additional current assets and current liabilities will be needed to

carry out the investment proposal. Sometimes, it may constitute. A

significant part of the total Investment in a project. The increased working

capital forms part of the initial cash outlay. The additional net

working capital will, however, be returned to the firm at the end of

project's life. Therefore, the recovery of the working capital becomes part

of the cash inflows stream in the terminal year. The initial investment In,

and the subsequent recovery of, working capital do not balance out each

other due to the time value of money.

40

The increase In the working capital may not only be in the- zero time

period, that is at the time of Initial Investment- There can be continuous

Increase In the working capital as sales increase In later years. This

increase in working capital should be considered as cash outflow of the

year in which additional working capital is required.

EVALUATION TECHNIQUES

This section discusses the important evaluation techniques for capital

budgeting. Included in the methods of appraising an investment proposal

are those which are objective, quantified and based on economic cost and

benefits.

The methods of appraising capital expenditure proposals can be classified

into two broad categories:

41

(i) Traditional and ( i i ) time-adjusted. The latter are more popularly

known as discounted cash flow (DCF) techniques as they take the time

factor into account. The first category includes

(i) Average rate of return method and

(ii) Pay back period method

The second category includes

(i) Present Value method

(ii) Internal rate of return method

(iii) Net terminal value method and

(iv) Profitability index.

TRADITIONAL TECHNIQUES

Pay-back method:-

The pay-back period method is a traditional method of capital budgeting.

It is the simples and, perhaps, the most widely employed, quantitative

method for appraising capital expenditure decisions. This method

answers the question: How many years will it take for the cash benefits to

pay the original cost of an investment, normally disregarding salvage

value? Cash benefits here represent CFAT ignoring interest payment-

Thus, the pay back method measure the number of years required for the

CFAT to pay track the original outlay required in an investment proposal

This method is also known as the payout period, is one of the most

important and traditional techniques used for evaluating the general

projects requiring small amounts. Simply stated, the payback refers to the

time period within which the cost of investment can be covered by the

revenues, it is the length of time required for the stream of cash proceeds

42

produced by an investment to equal the initial expenditure incurred. There

are two ways of calculating the Pay back period. The first method can

be applied when the cash flows stream is in the nature of annuity for

each year of the project's life, flat is, cash flows after tax are uniform. In

such situation, the initial cost of the investment is divided by the constant

annual cash flow:

Pay-Back period = Investment. Constant annual cash flow. The second

method is used when a project's cash flows are not uniform but vary

from year to year. In such situation, pay back period is calculated by the

process of cumulating cash flows till the time when cumulative cash

flows become equal to the original investment outlay.

Accept-Reject Criterion:

The pay back period can be used as a decision criterion to accept or reject

investment proposals. One application of this technique is to compare

the actual pay back with a predetermined pay back that is the pay back set

up by the management in terms of the maximum period which the initial

investment must be recovered. If the actual pay back period is less than

the predetermined pay back, the project would be accepted; if not, it would

be rejected. Alternatively, the pay back can be used as a ranking method.

When mutually exclusive projects are under consideration, they may be

ranked according to the length of the pay back period, thus, the project

having the shortest pay back may be assigned rank one. Followed in that

order so that the project with the longest pay back would be ranked last.

Obviously, projects with shorter pay back period will be selected.

Evaluation:

43

A widely used appraisal criterion the pay back period seems to offer the

following advantages. It is simple, both in concept and application. It does

not use involved concepts and tedious calculations and has few hidden

assumptions.

1) It is rough and ready method for dealing with risk. It favors projects,

which generate substantial cash inflows in earlier years, and discriminates

against projects, which bring substantial cash inflows in later years but

not in earlier years. Now, if the risk tends to increase with futurity in

general, this may be true the pay back period criterion may be helpful in

weeding out risky projects. Similarly, it serves well for projects

characterized by a high degree of cataclysmic risks,

3) Since it emphasizes earlier cash flows, it may be sensible criterion

when the firm is pressed with problems of liquidity or during periods

when financing costs are very high. It weighs all returns equally,

ignoring even distant returns; this method has an inherent hedge against

economic depression.

4) It enables a firm to choose an investment which yields quick return

of funds.

5) This is a sensible criterion which emphasizes early cash

inflows especially when the project is hard pressed with the problem of

liquidity.

6) This method reduces the possibility floss on account of obsolesce

because it prefers investment in relatively shorter projects.

Dies-advantages of Pay Back Period:

1) Ignores the returns after the pay back period.

44

2) Ignores time value of money where cash flows are simply added

without is counting them at a suitable, cut-off rate. It completely ignores

the magnitude and timing of cash inflows.

3) Ignores the total life of the project. Pay back method considers

only the recovery period of investment

4) Measures project's capital recovery, not profitability. Pay

back emphasizes earlier capital recovery and ignores totally the

profitability of the project.

1) Inconsistent with the firm’s objective. As James Porterfield contends

it would be consistent with the firm's objective of share values were a

function of pay back periods of investment projects.

2) This is suitable only to small projects consuming less investment and

time

7) The results are not purely reliable as it does not cover all aspects time

value, inflationary (rends, profitability etc.

AVERAGE RATE OF RETURN

The average rate of return method of evaluating proposed capital

expenditure is also known as the accounting rate of return method. It is

based upon accounting information rather than cash flows. There is no

unanimity regarding the definition of the rate of return. There are a number

of alternative methods for calculating the ARR. The most common usage

of the average rate of return

45

(ARR) expresses it as follows;

Average annual profits after taxes

ARR= __________________________ *100

Average investment over the life of the project

The average profits after taxes are determined by adding up the after-tax

profits expected for each year of the project's life and dividing the result by

the number of years, in the case of annuity, the average after-tax profits

are equal to any year's profits.

The average investment is determined by dividing the net investment by

two. This averaging process assumes that the firm is using straight tine

method of depreciation, in which case the book value of the asset declines

at a constant rate from its purchase price to zero at the end of its

depreciable life. This means that, on the average, firms will have one-

half of their initial purchase prices in the books. Consequently, if the

machine should be divided by two in order to ascertain the average net

investment, as the salvage money will be recovered only at the end of the

life of the project. Therefore, an amount equivalent to the salvage value

remains tied up in the project throughout its lifetime. Hence, no

adjustment is required to the sum of salvage value to determine the

average investment.

46

Accept - Reject Rule: with the help of the ARR, the financial decision

maker can decide whether to accept or reject the investment proposal. As

an accept-reject criterion, the actual

ARR would be compared with a predetermined or a minimum required

rate of return or cut-off rate. A project would qualify to be accepted if

the actual ARR is higher than the minimum desired ARR. Otherwise; it is

liable to be rejected.

Evaluation of ARR:

In evaluating the ARR, as a criterion to select/reject investment projects, its

merits and drawbacks need to be considered. The most favorable attribute

of the ARR method is its easy calculation. What is required is only the

figure of accounting profits after taxes which should be easily obtainable.

Moreover, it is simple to understand and use. In contrast to this, the

discounted flow techniques involve tedious calculations and are

difficult to understand. Finally, the total benefits .associated with the

project is taken into account while calculating the ARR. Some methods,

pay back for instance, do not use the entire stream of incomes.

Discounted Cash Flow (DCF}/Time-Adjusted (TA) Techniques:

The distinguishing characteristics of the DCF capital budgeting techniques are that

they take into consideration the time value of money while valuating the costs and

benefits of a project. In one form or another, all these methods require cash flows

to be discounted at a certain rate, that is, the cost of capital. The cost of capital (KJ is

the minimum discount rate earned on a project that leaves the market value

47

unchanged. The second commendable feature of these techniques is that they take

into account all benefits and costs occurring during the entire life of the project.

Present Value (PV)/Discounted Cash Flow (DCF)

General Procedure:

The present value or the discounted cash flow procedure recognizes that cash flow

streams at different time periods differ in value and can be compared only when they

are expressed in terms of a common denominator that is, present values, it, thus

takes into account the time value of money. In this method, all cash flows are

expressed in terms of their present values.

NET PRESENT VALUE METHOD (NPV)

Net Present Value is described as the summation of the present values of

cash proceeds in each year minus the summation of present values of the net

cash outflows In each year.

Rationale for the NPV method:

The NPV method has a straightforward rationale. An NPV of zero signifies that the

benefits of the project are just enough to recoup the capital invested and (b) earn

the required return on the capital invested; A positive NPV implies that the project

earns an excess return. Since the return to the providers of debt capital is fixed, the

excess return accrues solely to equity shareholders, thereby augmenting their wealth.

Features of the Net Present Value Method:

Two features of the net present value method may be emphasized:

1. The net present value method is based on the assumption that the

intermediate cash inflows of the project are re-invested at a rate of return equal

to the cost of capital.

48

2. The net present value; of a simple project steadily decreases as the discount

rate increases. The decrease in net present value, however, is at a decreasing rate.

Evaluation:

Conceptually sound, the net present value criterion has considerable

merits

1) It takes into account the time value of money.

2) It considers the cash flow stream in its entirety.

3) It squares neatly with the financial objective of maximization of the wealth of

the shareholders. The net present value represents the contribution to the wealth

of shareholders.

4) The net present value of various projects, measured as they are in today's

rupees, can be added. The additively property of net present value ensures that a

poor project will not be accepted just because it is combined with a good project.

Given the above merits, the net present value criterion is conceptually unassailable.

Its practical application, however, seems to be marred by the following:

a) The ranking of projects on the net present value dimension is influenced by the

discount rate.

b) It is difficult to calculate as we as understand and use in

comparison with the pay back method or even the ARR method.

This, of course, is a minor flaw.

c) A more serious problem associated with the present value method

involves the calculation of the required rate of return to discount the

cash flows.

d) Another shortcoming of the present value method is that it is an

absolute measure. Prima facie between two

49

Projects, this method will favor the project, which has higher present value. But

is likely that project may also involve a larger initial outlay, thus, in case of

projects involving different outlays, the present value method may not give

dependable results.

INTERNAL RATE OF RETURN

The second discounted cash flow or time adjusted method for appraising capital

investment decisions is the internal rate of return (IRR) method. This technique is

also known as yield on investment, marginal efficiency

Capital, marginal productivity of capital, rate of return, time-adjusted rate of return

and so on. Like the present value method, the IRR method also considers the time

value of money by discounting the cash streams. The basis of the discount factor,

however, is different in both the cases. In the case of the net present value method,

the discount rate is the required rate of return and being a predetermined rale,

usually the cost of capital; its determinants are external to the proposal under

consideration. The IRR, on the other hand, is based on facts, which are internal to

the proposal. In other words, while arriving at the required rate of return for

finding out present values the cash flows-inflows as well as outflows are not

considered.

But IRR depends entirely on the initial outlay and the cash proceeds of the project,

which is being evaluated for acceptance or rejection. It is, therefore,

appropriately referred to as internal rate of return.

Accept-Reject Decision: the use of IRR, as a criterion to accept capital investment

decisions, involves a comparison of the actual IRR with the required rate of return

also known as the cut-off rate or hurdle rate. The project would qualify to be

50

accepted it the IRR exceeds the cut-off rate. If the IRR and the required rate of

return are equal, the firm is indifferent as to whether to accept or reject the project

Evaluation:

The IRR method is a theoretically correct technique to evaluate capital expenditure

decisions. It has the advantages which are offered by the NPV criterion such as;

(i) It considers the time value of money and

(ii) It takes into account the total cash inflows and outflows,

Merits:

The IRR method is easy to understand. Business executives and

non-technical people understand the concept of IRR much more readily than the

concept of NPV. They may not be following the definition in terms of the

equation but they are well aware of its usual meaning in terms of the rate of return of

investment.

It does not use the concept of the required rate of return. It itself

provides a rate of return which is indicative of the profitability of the proposal. The

cost of capital, of course, enters the calculations

later on.

Finally, it is consistent with the overall objective of maximizing

shareholders wealth.

Limitations:

It involves tedious calculations.

It produces multiple rates which can be confusing.

In evaluating mutually exclusive proposals, the project with the highest RR

would be picked up to the exclusion of all others. However, in practice, it

51

may not turn out to be the one which is the most profitable and consistent

with the objectives of the firm that is maximization of the shareholder's

wealth.

PROFITABILITY INDEX OR BENEFIT-COST RATIO

Yet another time-adjusted capital budgeting technique is profitability index or

benefit-cost ratio. It is similar to the NPV approach. The profitability index

approach measures the present value of returns per rupee invested, while the NPV is

based on the difference between the present value of future cash inflows and

the present value of the cash outlays. A major shortcoming of the NPV

method is that, being an absolute measure it is not reliable method to

evaluate projects requiring different initial investments. The Profitability

Index method provides a solution to this kind of problem. It is in other

words, a relative measure. It may be defined as the ratio, which is

obtained by dividing the present value of future cash inflows by the

present value of cash outlays.

This method is also known as the B/C ratio because the numerator measures

benefits and the denominator costs. A more appropriate description would be

present value index. Accept-Reject Rule: Using the B/C ratio or the PI, a project

will qualify for acceptance if its PI exceeds one. When PI equals 1. The firm is

indifferent to the project. Evaluation: like the other discounted cash flow

techniques, the PI satisfies almost all the requirements of a sound investment

52

criterion. It considers all the elements of capital budgeting, such as the time value

of money, totality of benefits and so on. Conceptually, it is a sound method of

capital budgeting. Although based on the NPV, it is a better evaluation technique

than NPV in a situation of capital rationing. This method however is more difficult

to understand. Also, it involves more computation than the traditional methods

but less than IRR.

THE PROPOSAL

The proposal is to establish a Ultra Pure Ferric Oxide Plant at

Vishakhapatnam. The investment on the project is estimated at about Rs.10, 000

lakhs

THE CONCEPT

The company is operating several mining projects all over India and it is exploring

foreign markets. Ultra Pure Ferric Oxide is one of the basic input materials for the

manufacture of high quality soft ferrite components used in the T.V,

Telecommunication, Computer Peripherals, Power Supply, and Frolics etc. R & D

Centre of NMDC could produce the Ultra Pure Ferric Oxide on laboratory scale to

meet the specifications of soft ferrites. Hence NMDC is planning to go for a

commercial plant for production of Ultra Pure Ferric Oxide to meet the demand of

Soft Ferrite Industry in India and Abroad. The Production is 80% in the first year and

90% for the next 14 years. Total capacity of the Plant at 100% Capacity is 6667

tonnes. Half of the production is exported.

PLANT LOCATION

53

Considering the availability of Raw Materials and their ease of

transportation, Visakhapatnam, on the east coast of Andhra Pradesh has been

selected for locating the Ultra Pure Ferric Oxide Plant. Blue dust will be transported

from the Bilabial Deposit -14 mines of NMDC, 2 to 4 times a year, either by road or

train. Other raw materials such as HCL, LPG, additives and other chemicals that are

required for the plant are available in the Vizag local market.

Visakhapatnam is well connected by road, train and air to all parts of the country. It

is also a major port city. The product can also be transported very easily to

domestic buyers as well as to the sea port for export.

The land required for the plant (4.3 Hectares) is also available for setting up the Plant

in the industrial area of Andhra Pradesh Industrial Infrastructure Corporation Ltd.

Necessary infrastructure facilities like electricity and water exist at the proposed

site.

CHAPTER-4

54

DATA ANALYSIS

DATA ANALYSIS

CALCULATION OF TOTAL SALES OF THE PROJECT (B)Total

(A+B) Total sales

Years Capacity

Prod in tonn

Local sales

Selling price

ATotal sales

Export sales

Selling prices

Value prices

BTotal E sales

(A+B)Total

(in tonnes}

3 80% 5334 2667 61740 164660580 2667 1260 49 164660580

329320000

55

4 90% 6000 3000 61740 185220000

185220000

3000 1260 49 185220000

370440000

5 90% 6000 3000 61740 3000 1260 49 185220000

370440000

6 90% 6000 3000 61740 185220000 3000 1260 49 185220000

370440000

7 90% 6000 3000 61740 185220000 3000 1260 49 185220000

370440000

8 90% 6000 3000 61740 185220000 3000 1260 49 185220000

370440000

9 90% 6000 3000 61740 135220000 3000 1260 49 185220000

370440000

10 90% 6000 3000 61740 165220000 3000 1260 49 1S5220000

370440000

11 90% 6000 3000 61740 185220000 3000 1260 49 185220000

370440000

12 90% 6000 3000 61740 185220000 3000 1260 49 185220000

370440000

13 90% 6000 3000 61740 185220000 3000 1260 49 185220000

370440000

14 90% 6000 3000 61740 185220000 3000 1260 49 185220000

370440000

15 90% 6000 3000 61740 185220000 3000 1260 49 185220000

370440000

16 90% 6000 3000 61740 185220000 3000 1260 49 185220000

370440000

17 90% 6000 3000 61740 185220000 3000 1260 49 185220000

370440000

Total sales of the project 55154480000

CALCULATION OF VARIABLE COST OF THE PF (Rs. in Lakhs)

S.No PARTICULARSYEARS 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

TOTAL

1Raw Materials

91 104 104 104 104 104 104 104 104

104 104 104 104 104 104 1547

2 Power 167 183 188 188 188 188 188 133 133

188 133 183 183 133 183 2799

3 Royalty 80 90 90 90 90 90 90 620 4Selling Expenses 212 240 120 120 120 6O 60 60 60 60 60 60 60 60 60

1412 1

56

5Spares, Consumables 830 934 934 934 934 934 934 934

934 934 934 934 934 934 934

13906

TOTAL 1380 1556 1436 1436 1436 1376 1376 1286

1286

1286

1286 1286 1286 1286 1286

20284

S.No. PARTICULARS/YEARS

3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 TOTAL

1 Salaries & Wages 116 116 116

116 116 115 116

116

116

116 116 116

116 116 116 1740

2 Electricity 21 21 21 21 21 21 21 21 21 21 21 21 21 21 315

3. Repairs & Main 33 33 33 33 33 33 33 33 33 33 33 33 33 33 33 495

4- Administrative Expenses

62 62 62 62 62 62 62 62 62 62 62 62 62 62 62 930

TOTAL 232 232 232

232 232 232 232

232

232

232 232 232

232 232 232 3480

CALCULATION OF INTEREST ON CAPITAL AND DEPRECIATION

57

RS. In Lakhs

No. Particulars/years

3 4 5 6 7 8 9 10

11 12 13 14 15 16 17 TOTAL

1 Interest on Capital 750 750 750 7SO 750

750

750

750

750 750 750 750 750 750 750 11,2502 Depreciation

490 490 490 490 490 490 488 488

488 494 149 192 233 232 232 5936

TOTAL 1240

1240

1240

1240

1240 1240

1238

1238 1238 1244 899 942 983 982 982 17186

CALCULATION OF NET CASH INFLOWS AND NET PRESENT VALUE OF

THE PROJECT

58

(Rs. In

Lakhs)A B C (A+B) D E

YEARS

NET

DEPRECIATION NET CASH DISCOUNTING

DISCOUNTED PROFIT & INTEREST ON

cccccccccapitalCAPIT

INFLOWS FACTOR @ 15%

CASH

INFLOWS 3 286.78 1240 1526.78 0.869 1326.774 439.66 1240 1679.66 0.756 1269.825 517.66 1240 1757.66 0.657 1154.786 517.66 1240 1757.66 0.571 1003.627 517.66 1240 1757.66 0.497 873.5578 556.66 1240 1796.66 0.432 776.1579 557.96 1238 1795.96 0.375 673.48510 616.46 1238 1854.46 0.326 604.55411 616.46 1238 1854.46 0.284 526.66712 616.46 1244 1860.46 0.247 459.53413 612.56 899 1511.56 0.214 323.47414 836.81 942 1778.81 0.186 330.85915 808.86 983 1791.86 0.162 290.28116 782.21 982 1764.21 0.141 248.75417 782.86 982 1764.86 0.122 215.313

782.86

TOTAL DISCOUNTED CASH

INFLOWS

10076.394

10,000

Since the Net Present Value of the Project is positive the project can

be accepted The Npv= 76.394

CALCULATION OF INTERNAL RATE OF RETURN

YEARS

NET CASHINFLOWS

DISCOUNTINGFACTOR @16 %

DISCOUNTED

59

3 1526.8 0.862 1316.1

4 1679.7 0.743 1248.025 1757.7 0.64 1124.936 1757.7 0,552 970.257 1757.7 0,476 836.6658 1796.7 0.41 736.6479 1796 0.353 633.988

10 1 8S4.5 0.305 565.62311 1854.S 0.262 485.87912 1860.5 0.226 420.47313 1511.6 D.195 294-76214 1778.8 0.168 298.83815 1791.9 0.145 259.82616 1764.2 0.125 220.52517 1764.2 0.107 168.769

TOTAL DISCOUNTED CASH INFLOWS

9601.29LESS:

INITIAL INVESTMENT OF THE PROJECT

NPV OF THE PROJECT (DEFICIT)

10000

-398.79

When the Depreciation factor is 15% the project yields a Net present Value

of Rs. 78 Lakhs and when the discounting factor is 16% the Project yields

Deficit NPV of Rs, 398.71 Lakhs. Therefore, it can be concluded that the LRR

lies between 15% & 16%. The project yields deficit npv of rs 398.71lakhs

Therefore, it can be concluded that the IRR lies between 15%& 16 %.

INTERNAL RATE OF RETURN

60

78

= 15+ ––––––––––––––––––––––––––––– *1

10078-69-9601 *1

= 15.16 %

The Cost of Capital is 15% and the Internal Rate of Return is 15.16%

therefore the project can be accepted.

CALCULATION OF PAY-BACK PERIOD

NETPROFIT &

DEPRECIATION CASHFLOWS

CUMULATIVE

3 286.78 1240 1526.78 1526.8

4 439.66 1240 1679.66 3206.5 5 517.66 1240 1757.66 4964,2 6 517.66 1240 1757.66 6721.9 7 517.66 1240 1757.66 8479.6 8 556,66 1240 1796.66 10276.3

9 587.96 1238 1795.96 12072.3 10 616.46 1238 1854.46 13326.8 11 616.46 1238 1854.46 15781.5 12 612.56 1244 1856.56 17638.1 13 836.81 899 1735.87 19374 14 808.86 942 1750.86 21124 15 782.21 983 1765.21 22889 16 782.86 982 1764.86 24654 17 782.86 982 1764.86 26419

Pay-Back Period is the Period in which the Project returns the Initial investment, Rs.

10,000 Lakhs.

Pay-Back Period = 7+ 1520.4/1796.7

= 7 + 0.84

61

= 7, 84 years. The Company get backs the Original

Investment at 7.84.

PROFITABILITY INDEX OR BENEFIT COST RATIO

Profitability Index can be found out is applying the following

formulae.

Profitability Index Present Value of cash inflows

= ___________________________

Present Value of cash outflows

Present Value of cash inflows = 10078 lakhs

Present Value of cash outflows = 10000 lakhs

10078

10078 Profitability Index = ––––––––––––––––

10000

= 1.007

The profitability index or the Benefit-Cost Ratio measures the relative

ratios of benefit and cost; the above calculation shows that the benefits

are more than the costs A project can be accepted only when the ratio is

more than one.

62

CALCULATION OF BREAK EVEN POINT

a. Capacity : 6667 tonnes par annum

b. Utilization : 5334 tonnes per annum

c. Sales (Rs.) : 3293.2 lakhs

d. Variable Cost : Rs. (In lakhs)

i) Raw Materials 91

2) Power 167

3) Royalty 80

4) Selling exp. 212

5) Spares, etc 830

TOTAL : 1380

Contribution cde : 1913.2

Fixed Cost

1 Salaries & Wages 116

2 Electricity 21

3 Repairs & Main. 33

4 Administrative exp. 62

TOTAL 232

g. P/V Ratio (E/C*100 : 58.09%

h. Break even point: 399 tones

Assumptions

1) Installed Capacity of UPFO - 6667 tonnes per annum

2) Operating Capacity per annum

a) First Year: 80%

63

b) Second Year: 90%

3) Turn over at 100% capacity utilization (Rs, in lakhs)

a) UPFO 6667 tonns per annum @Rs.61740 per tonne 4116.2

b) UPFO at 80% capacity 5334 tonnes@Rs.61740 3293,2

c) UPFO at 90% capacity 6000tonnes @Rs.61740 3704.4

4) Interest Interest is calculated on total debt i.e., Rs.5, 000 lakhs @15% p.a.

over the life of the project. It is assumed to be fixed @ Rs.750 lakhs p.a.

5) Income Tax Income Tax is assumed to be 35% i.e., current corporate rate.

6) Value of $ is assumed to be Rs.49 i.e., current market rate.

7) All the costs (Fixed and Variable) have been escalated @25%

8) The 15% of depreciation factor is considered for the project.

64

CHAPTER 5

FINDINGS CONLUSSIONS&SUGGESTION

65

FINDINGSS

The Pay back period of the project is 7.84 years, which means that the project

is going to yield the investment back in 7.84 years.

The Net Present Value of the Project calculated at the Company's cost of

capital is positive which means that the project will generate revenues for

the company.

The Profitability Index or Benefit-cost ratio of the project is 1.007, so the

project is profitable according to the profitability index method too.

The Internal Rate of Return calculated for the project is 15.16%; it is more

than the company's cost of capital. The company's cost of capital is 15%.

66

CONCLUSIONS

The condition of capital Budgeting is Internal Rate of Return Is always higher

than the Interest Rate. This project is satisfied the condition, the cost of capital

is 15% and the Internal rate of return is 15.60%. So that it concluded that the

project accepted.

The project LRR is lies between 15% & 16%. Because of in the 15% of

discount the project Npv is 78 and in the 16% Npv is 398.71.

The Interest concluded on total debt calculation of 5000 lacks @ 15 % per

Annum.

The project pay back period is just lengthily. That is 7.84 years, because of

some times the mineral assumptions are missing or it cannot reach the

expected level. So that the pay back period of this project lengthy.

67

SUGGESTIONS

The project has been appraised from both the traditional and modern

techniques of appraisal tools. The results of which show that the

project will help the company to strengthen its position. So it is

suggested to take up the project

The Net Present Value is positive, so it is suggested to go for the

project.

The Internal Rate of Return is calculated at 15.16%, which is above the cost

of capital of the company. So when the project is yielding more than the

cost of capital, it is wise to go for the project

68

BIBLIOGRAPHY

Financial Management - Khan & Jain

Project Management & Control - P.C.K.Rao

Projects: Planning, Analysis,

Selection, implementation &Review - Prasanna Chandra

69