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Chapter 1
INTRODUCTION
1.1 Background
Capital expenditure is the list of planned investment expenditure on fixed assets outlays
for different projects. It is a process of selecting viable investment project. We can simply define
capital expenditure as investments to acquire fixed or long lived assets from which a stream of
benefits is expected. It represents an organization's commitment to produce and sell future
products and engage in other activities. Thus capital expenditure decision forms a foundation for
the future profitability of a company.
Capital expenditure activities are made up of two distinct processes: (a) making the decision and
(b) implementing it, which may include performing a post-appraisal. This Practice deals only
with the first process.
The capital expenditure decision is derived from and is closely associated with strategic planning
which is an effort by an organization to define its mission and goals and the policies and
strategies it will follow to attain them.
Capital Budgeting Tools
• Payback Period
• Accounting Rate of Return
• Net Present Value
• Internal Rate of Return
• Profitability Index
Modified Internal Rate of Return
Payback Period
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.
Computation of Payback Period
When the cash inflows are uniform the formula for payback period is cash outflow divided by
annual cash inflow
Indian Institute of Technology Madras
Accounting Rate of Return
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.
Computation of Accounting Rate of Return
The accounting rate of return using total investment.
or
Sometimes average rate of return is calculated by using the following
formula:
Net Profit after Tax
Average Investment
Where average investment = total investment divided by 2
Net Present Value (NPV)
Net present value of an investment/project is the difference between present value of cash
inflows and cash outflows. The present values of cash flows are obtained at a discount rate
equivalent to the cost of capital.
Internal Rate of Return (IRR)
The internal rate of return method is also known as the yield method. The IRR of a
project/investment is defined as the rate of discount at which the present value of cash inflows
and present value of cash outflows are equal.
IRR can be restated as the rate of discount, at which the present value of cash flow (inflows and
outflows) associated with a project equal zero.
Profitability Index (PI)
Profitability ratio is otherwise referred to as Benefit/Cost ratio. This is an extention of the Net
Present Value Method. This is a relative valuation index and hence is comparable across
different types of projects requiring different quantum of initial investments.
Profitability index (PI) is the ratio of present values of cash inflows to the present value of cash
outflows. The present values of cash flows are obtained at a discount rate equivalent to the cost
of capital.
Modified Internal Rate of Return (MIRR):
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. Is basically the same as the IRR, except it assumes that the revenue
(cash flows) from the project are reinvested back into the company, and are compounded by the
company's cost of capital, but are not directly invested back into the project from which they
came.
1.2 Report Objective
The main objective of the study is
To understand about how the financial institutions make capital expenditure
decision.
To understand practically the capital budgeting techniques.
1.3 Limitations
Time constraints
Lack of accurate information from the respondents
Lack of knowledge about capital expenditure to respondents
Lack of reliability
Chapter 2
RESEARCH METHODOLOGY
2.1 Introduction
Information was collected from five financial institutions of Pokhara. The five financial
institutions that were surveyed are NIC Bank Limited, Muktinath Bikas Bank, Garima Bikas
Bank, Kist Bank and Lumbini Finance Company.
2.2 Research Design
A research design is the specification of methods and procedures for acquiring the
information needed to structure to solve problems. The present study is exploratory in nature.
The main aim of this study is to understand the capital expenditure practices in different
institutions of Pokhara. The survey research design has been adopted for this study. The
information were collected from the survey are analyzed according to the need of the study for
the attaining the stated objectives. Also, the analyzed data are presented in graphs using SPSS
package.
2.3 Sources of Data
The data were collected in the form of
i. Primary Data
ii. Secondary Data
i. Primary Data was collected in the form of Questionnaire and personal interview.
ii. Secondary Data was collected from
Internet
Books
Chapter 3
DATA ANALYSIS
3.1 DATA INTERPRETATION
Data Interpretation can be defined as "the application of statistical procedures to analyze specific
observed or assumed facts from a particular study". The collected data from each financial
institution was compared with each other and then observed.
Views on capital expenditure
1. Garima Bikas Bank- it covers decisions to acquire other firms, either through the purchase of their common stock or group of assets that can be used to conduct an ongoing business. It involves the entire process of planning expenditure with returns that are expected to extend beyond one year.
2. Muktinath Bikas Bank- Money spent to acquire and upgrade physical assets.
3. Kist Bank- Long term planning for making financial proposed capital outlay.
4. NIC Bank- Expenditure for acquiring physical assets at the time of establishment and
expansion of bank,
5. LFLC- long term decision for investment in assets.
For example: Tallo Modi Hydropower Project, Parbat
It is a hydropower project. If project wants to take lone from bank to operating its
activities, Project have to make capital structure and projected financial statement which shows
future cash inflow and outflow from this project. After that, calculate the NPV, IRR,
Discounted payback period of projected financial statement and have to submit bank’s credit
analysis committee. Bank’s credit analysis committee also makes project financials statement
and calculates the NPV, IRR, discounted payback period. Credit analysis committee have to tally
both calculated figure, if any deviation found once times they can evaluate project and make a
decision but company’s calculated figure should greater than or equal to bank’s calculated figure
and finally they make decision to invest on this project. Bank used the most appropriate tools to
take final decision which is NPV and IRR because discounted payback period ignores cash flow
after the expiration of the payback period. NPV and IRR may give contradictory result, but NPV
shown to lead to the correct project selection because banks are expected to add greatest
increment in value of the firm. Initial stage, bank doesn’t provide loan fully they provides
installment basis according to debt equity ratio to complete fixed period of task. If debt equity
ratio have 80%, bank provides 48% loan and project should invest 52% equity to complete the
fixed task during the fixed period. This cycle will be continuing up to end the project.
Taking about the capital expenditure fixed assets are included furniture fixture, office
equipment, computer software, leasing, machinery items and vehicles. They are using
deprecation method straight-line and diminishing balance method to depreciation and
amortization according to nature. The table below indicates the same.
Items Depreciation charge Method
Furniture 25% SLM
Leasehold property 5 years written off
Computer software 25% Zero at the end of five year
Fixture(leasehold development) 10% SLM
Computer accessories 25%
Office Equipment 25% SLM
Machinery 15% Diminishing rate
Vehicles 20% Diminishing rate
Computer parts 15% Diminishing rate
Comparative study of five financial institutions in making capital expenditure decision
3.1.1 Origin
Name Type of project
Originator of proposal
Official of
similar salary or
rank status
Proposal origination
Use of proposal
origination
Completion of proposal origination decided by
GBL Investment in loan
Board of directors
noneMgmt sponsored productivity scheme
Memorandum Financial Interaction committee
MBBL Investment in loan
Board of directors
noneFormal suggestion scheme
Memorandum Financial manager
Kist Investment in hydro project
Loan Approved Committee
someMgmt sponsored productivity scheme
Memorandum Operation managers
NIC Investment in loan
Board of directors
noneFormal suggestion scheme
Memorandum Loan head
LFLC Investment in loan
Executive members
noneFormal suggestion scheme
Specific formFinancial Manager
Table 1
From the table 1, it is clear that among the five financial institutions, Kist invests in Hydro
project whereas rest of the financial institutions invests in loan and other development programs
like construction of Blacktopped roads and infrastructure which were mentioned during the
interview.
It is also seen that Board of Directors are originators of proposals whereas in LFLC, executive
members does. Similarly, LFLC uses specific form for proposal origination whereas other
financial institutions use Memorandum for the same.
It is also found that there are various governing body as seen in the table which decides the
completion of proposal origination.
Graph of the above table is also shown.
Fig 1 shows the type of project that financial institutions invest in. Among the five institutions
surveyed, four has responded in favor of investments in loan and one institution in hydro project.
Fig 1
Fig 2 indicates the form used for proposal origination. Here, as stated in the table above four
financial institutions uses Memorandum whereas one of the surveyed institutions uses a specific
form for proposal origination.
Fig 2
3.1.2 Progression
NameAuthorization of
proposal
Duty undertaken Preliminary
investigation
Responsible
person for
proposal study
GBL CEOFinancial
Interaction
Committee
No production of
prototype
machine and
products
Loan manager
MBBLCEO Loan manager Not any Loan Manager
KistCEO Loan manager Not any Loan Manager
NICCEO Loan manager Not any Loan Manager
LFLC CEOFinancial
Manager
Not any Loan Manager
Table 2
From the above table, it is found that CEO authorizes the proposal and Loan Managers are
responsible for proposal study in the surveyed financial institutions.
Financial Interaction Committee undertakes the duty at GBL whereas Loan Managers undertakes
at MBBL, Kist & NIC and Financial Manager at LFLC. Fig 3 indicates the same.
Fig 3
3.1.3 Evaluation
NameFormal
Financial
Evaluation
Evaluation of
capital
expenditure
proposal
No. of years
project
assessed
Assessment of
cost to the
firm of
financing
Method of
evaluation
GBLsubjected
Prices
demanded by
customers
- Cash inflows-
cash outflows
NPV
MBBLsubjected
Working
capital
requirement
- Debt coverage
ratio
NPV, IRR,
Payback period
and ARR
Kist subjectedPrices quoted
by suppliers 2
Return on
Equity NPV and IRR
NICsubjected
Working
capital
requirement
- Debt/Equity
ratio
NPV and IRR
LFLCsubjected
Working
capital
requirement
- Cash inflows-
cash outflows
NPV and IRR
Table 3
From the table 3 it is found that all types of capital expenditure proposals are subjected to formal
financial evaluation at the surveyed financial institutions.
Increase working capital requirements is included for the evaluation of capital expenditure
proposal at MBBL, NIC and LFLC whereas at GBL and Kist, evaluation is included in the form
of prices demanded by customers and prices as quoted by suppliers respectively.
There was no response when asked number of years a project is assessed but in Kist, estimation
of 2 years would require.
Inorder for evaluation method, NPV, IRR and payback period are normally followed.
Fig 4 reflects the way in which the assessment of cost of the firm to the financing the capital
invested.
Fig 4
Fig 5 reflects the method of evaluation used by institutions
Fig 5
3.1.4 Decision Appraisal
NamePractice to appraise
profitability
Review the information
Benefits from decision
appraisal
Changes in approach to
capital expenditure management
GBL Project sizeFinancial committee Profitable return No changes
MBBL Cost of projectFinancial committee
Long term sustainability No use of ARR
Kist Cost of project Financial committee
Profitable returnChanges in the
use of NPV, IRR and Payback
period
NIC Cost of projectFinancial committee Profitable return No changes
LFLC Project sizeFinancial committee Profitable return No ARR
Table 4
Table 4 indicates the information about Decision Appraisal.
It is found that size of the project is the practice followed to appraise the profitability of
investments when they become operational at GBL and LFLC whereas cost of project
determines the practice to appraise profitability among the rest. It is also found common in all
the financial institutions surveyed that financial committee is the one who reviews the
information on decision appraisal. Long term sustainability is the benefit resulted from decision
appraisal at MBBL whereas Profitable return is the benefit resulted in rest of the financial
institutions surveyed.
Figures indicating the practice to appraise the profitability of investments and the benefits that
have resulted from the decision appraisal are shown on the following page.
Fig 6 indicates the practice to appraise the profitability of investments when they become operational.
Fig 6
Fig 7 indicates the benefits that have resulted from decision appraisal.
Fig 7
3.2 MAJOR FINDINGS OF THE STUDY
Capital expenditure covers decisions to acquire other firms, either through the purchase
of their common stock or group of assets that can be used to conduct an ongoing
business. It involves the entire process of planning expenditure with returns that are
expected to extend beyond one year.
If the present value of project's future cash flow is greater than cost of project, than such
project is accepted. The institutions are using NPV for maximizing the wealth which
measures the incremental wealth from undertaking the project. Such project is undertaken
whose NPV is greater than zero.
Under capital budgeting techniques we found that, the institutions are using NPV,
payback period, IRR and even ARR. For making decision, NPV is mostly used as it
shows present value of expected future cash flows.NPV is most preferred as it considers
risk factor.
In most of the institution we found that IRR is preferred after NPV criterion as it is
affected by size of cash flows and consider reinvestment rate.
It was found that profitability index was used by institutions to assess the amount of
profit from investment in assets. It is the ratio of present value of cash inflows and cash
outflows. It also assists in relative comparison of project as it is also a modified NPV.
Chapter 5
RECOMMENDATION
For the organizations:
The institution should use capital budgeting techniques for making major investment
decision and to implement it as it influence profitability.
As founded that capital budgeting techniques is the lifeblood for undertaking major
decision, financial institutions should pertain all the information require for capital
budgeting expenditure.
There should be discussions of quantitative estimates to represent decision model for
administration of the capital expenditure decision process in these institutions.
For the researcher:
Researcher need to prepare on the questionnaire part more so that the same could be
enquired with the interviewee with ease.
It would have been better if various organizations are surveyed instead of only financial
institutions.
REFERENCE
Brigham, E.F (June 2001, 10th edition). Financial Management Theory and Practice.
Florida: Thomson South Western Publication.
http://en.wikipedia.org/wiki/Capital_expenditure
http://EzineArticles.com/3452410
Appendix