Chapter 01

Introduction

This chapter consists with the back ground of the study, research issue, objective of

the study, significant of the study, flow of the study and the limitations which are

occurred during the research.

1.1 Background of the study

Rapidly changing technology, innovations and globalization are lead to make more

competition in modern businesses context. The business that can compete with this

competition be able to survive in the market and earn profits. Organizations which are

having more flexible structure and strong financial position be able to compete with

the market changes. Making capital nature expenses for unforeseen future may not be

best solution to the organizations. On the other hand having zero investment also may

not be the best scenario. Therefore organizations should undertake the projects which

may give sustainable competitive advantage to the businesses.

Capital investment decisions normally represent the most important decisions that an

organization makes, since they commit a substantial proportion of a firms resources to

actions that are irreversible. Expansion of business operations, acquisitions,

modernization and replacement of long term assets and sale of a division or business

can be identified as investment. Normally such investment will take more than one

year period and those includes investments in plant and machinery, research and

development, advertising and warehousing facilities.

These types of investments carry huge cash inflows and outflows as well as risk

associated with; therefore managers are evaluating the project before it is accepted. In

1
this case, managers apply different criterion to evaluate investment decisions in which

maximize the wealth of the shareholder’s.

In current practice, managers use Traditional method and Discounted Cash flow

(DCF) analysis to evaluate the investment in financial terms. In which traditional

Method includes Payback method and Accounting Rate of Return (ARR) which make

no adjustment for the time value of money. But in DCF method considers the time

value of money in which reduces the time value of money progressively and it consist

with Net Present Value (NPV) approach and Internal Rate of Return (IRR) method.

This could lead to more popularize investment appraisal techniques among the

managers.

In theory would suggest that DCF method is more superior than the traditional

method, on that NPV is superior than to IRR. Even though in theoretically NPV

technique of investment appraisal is superior in pragmatic ground its rivals are over. It

is proved that survey conducted by Arnold & Hatzopoulos (2000) and Graham &

Harvey (2001). These surveys done in UK and more generally and they have revealed

that techniques less behind for it rivals.

In addition to that Koller (2006) have identified most frequent ten errors in

application of DCF model. He also stated that DCF model should be economically

sound and transparent. Therefore Koller has strongly emphasized without looking at

those issues managers may not be able to end up with good decisions. In this case he

suggests that application of DCF method need to be adjusted and assumptions to be

made accurately. Because accuracy of the decision is relies on such assumptions.

Surveys of capital budgeting practices in the UK and USA reveal a trend towards the

increased use of more sophisticated investment appraisals requiring the application of

DCF techniques. Several writers, however, have claimed that companies are under

2
investing because they misapply or misinterpret DCF techniques. Such claims have

been made on the basis of observations in only a few companies, or anecdotal

evidence, without any supporting statistical evidence. Reports on a recent survey

conducted by the Drury C. & Tayles M. (1997) suggest that many UK firms are guilty

of misapplying DCF techniques. On this survey they have tested the three areas where

misapplication could be taken place. They are selection of investment appraisal

techniques, treatment of Inflation and Uses of discount rate. In addition to that they

have tested the major reason that is cited to explain why the financial appraisal often

fails to justify investment in Advanced Manufacturing Technology’s (AMT). It is

because those benefits which are difficult to quantify are either understated, or

frequently omitted from the financial appraisal. Because of that UK organizations

may be rejecting the profitable investment.

On the other hand, when we are considering the appraisal of AMT project different

researchers established diverse arguments. Kaplan (1986) argued that conventional

DCF method to be used based on the financial data available to appraise the AMT

projects. Meredith & Suresh (1986) also developed the new approach consist with

flexibility, high level of risk and the synergy of Flexible Manufacturing Systems

(FMS) when linked together with other systems. These three levels tested on different

appraisal techniques and try to overcome the problems associate with Kaplan’s

Model. But later Browmich & Bhimami (1991) developed the model in which

quantify all the benefits either financial terms or score value terms.

However DCF approach is still widely used investment appraisal techniques. It is

prove according to the surveys carried out by Lawrance, Gary & Williams (1978)

65% and 56% respondent of Large US firms were applied IRR and NPV respectively

and recent survey carried out by the Pike (1996) reported 75% and 81% UK firms are

3
applying NPV and IRR respectively. According to the study carried out by the

McIntosh (1993) among major valuation firms in Australia and the Sangster (1993)

among largest 500 Scottish companies they have revealed that more than 75% firms

are currently practicing the DCF method.

1.2 Research Issue

According to the literature survey we can see that there is an ongoing debate among

the managers of all industries whether to use DCF analysis or any other method in

capital investment evaluation process. However it was found that DCF analysis is the

more accurate and flexible decision making technique that can be used. But as far as

practical application is concern DCF models cannot be applied as it is. It has to be

developed and to be made the necessary adjustments to minimize errors that can be

occurred in decision making process. Therefore validity of the DCF analysis is

susceptible. So that researcher undertakes research on following issue.

Whether DCF analysis is validated by the Managers of Milk Food industry as an

Investment Decision making Tool

1.3 objectives of the study

To identify, whether DCF analysis is validated by the managers of milk food industry

as an investment decision making tool

1.4 Significance of the study

Investments are the most critical aspect for the success of an organization. So that it

has given the highest importance in financial management. It is because it’s impact

upon the long term future of the business, the amount of scare resources utilized and

4
degree of irreversibility. Misguided decisions can endanger the survival of the

business and cause difficulties in obtaining additional finance from more costly

sources. On the other hand it showed that investment decision is at a high risk.

Therefore investment must be carefully analyzed in a systematic and logical way.

All of the projects will generate financial or non financial benefits to the organization.

To evaluate the financial benefit pre determined appraisal techniques are developed

and existed. But in case of appraising non financial benefits there is no specified

method is developed. Therefore organizations evaluate the non financial benefits

based on the judgments of the specialized persons and their experiences.

When managers are evaluating the financial benefits of the generally accepted

techniques such as Pay back, NPV or IRR most of the calculations based on the

assumptions. Therefore validity and acceptability of such techniques is in doubt.

According to the Sri Lankan context it is a collection of different industries like

Transportation, Telecommunication, Garment, Milk food, Construction, Paddy etc.

Considering the milk food industry it is more competitive and widely spread their

activities all over the country. Therefore organizations which are currently running in

milk food industry make frequent investments to keep their market by way of doing

innovations. In addition to that major organizations which acquired majority of the

market is foreign own companies. They make frequent investment according to the

changes in technology, consumer preference all over the world. Therefore it is

significant to study the decision making process of the milk food industry and there

validity of the decision making techniques.

5
1.5 Flow of the study

Chapter 1 Introduction

This chapter includes the background of the study, research issue, objective of the

study, significant of the study, flow of the study and limitation of the study.

Chapter 2 Literature Review

This includes the literature review of the study.

Chapter 3 Conceptual Frame work and Research Methodology

This chapter consists with conceptual frame work and research methodology. Under

the research methodology empirical setting of the study and the data collection

method is included.

Chapter 4 Data Presentation and Analysis

This chapter consists with profile of the respondents, discussion with the managers

and analysis of data.

Chapter 5 Conclusion

This chapter comprises the conclusion of the study and directions for further

researches.

1.6 Limitation of the study

• Quantitative information is more confidential and more prices sensitive therefore

companies are reluctant to give that information to outsiders

• Milk food industry is comprised with large organizations as well as small scale

organizations such as yoghurt manufactures. Due to the insignificant capacity and

unable to make more financial investment they are dismissed from the research.

6
Chapter 02

Literature Review

Capital budgeting define,

Drury (2000) stated, “ The theory of capital budgeting reconciles the goals of survival

and profitability by assuming that management takes as its goal the maximization of

the market value of the shareholders’ wealth via the maximization of the market value

of ordinary share”.

Capital budgeting decisions may be defined as “the firm’s decision to invest its

current funds most efficiently in the long term assets in anticipation of an expected

flow benefits over a series of years”. (Pandy, 2005)

According to the above definitions of capital budgeting, following features can be

identified,

I. Exchange current funds for future benefits

II. Funds are invested in long term assets and

III. Benefit will occur to the firm over a series of years.

Therefore main objective of the capital budgeting decisions are to maximize the

wealth of the shareholders by,

• Determining which specific investment projects to be undertaken

• Determining the total amount of capital expenditure which the firm should be

obtained

• Determining how this portfolio of projects should be financed.

In capital budgeting process different investment appraisal techniques are used to

evaluate the investments. They are mainly traditional and Discounting Factor (DCF)

methods. In traditional method consist of Payback and Accounting Rate of Return

(ARR) which don’t have the time value adjustment. But in DCF method Net Present

7
Value (NPV) and Internal Rate of Return (IRR) are included and they are adjusting

the time value of money to the cash flows. These techniques give different benefits

and limitations in investment evaluation process, although as per the theoretical view

DCF analysis may give more benefit to the organization.

However successful completion of a project mainly depends on the selection criteria

adopted while choosing the project in the initial phases itself and the choice of a

project must be based on a sound financial assessment and not based on impression.

DCF techniques are being widely used in both public and private sector. This is the

method recommended for evaluating investment proposals. In this method, the

incremental cost and benefits of proposals are discounted by a required rate of return

in order to obtain the net present value of the proposal.

Discounted cashflow (DCF)

DCF focuses on the time value of money, Rs.1 is worth more today than Rs.1 in the

future. The reason being that it could be invested and make a return (yes, even in

times of low interest, so long as interest rates are positive).

So that's the discounting methodology, DCF has two methods.

Net Present Value (NPV)

The annual cash flows are discounted and totaled and then the initial capital cost of

the project is deducted. The excess or deficit is the NPV of the project, it goes

without saying that for the project to be worthwhile the NPV must be positive and the

higher the NPV the more attractive is the investment in the project.

8
Internal Rate of Return (IRR)

The IRR or yield of a project is the rate of return at which the present value of the net

cash inflows equals the initial cost, which is the same as the discount rate which

produces a NPV of zero. For an investment to be worthwhile the IRR must be

greater than the cost of capital.

Due to the following reasons, DCF method is identified as a best method for

investment appraisal processes,

• They give due weight to timing and size of cash flow

• Thy take the whole life of the project in to irregular cash flows do not

invalidate the result obtained.

• Estimate of risk and uncertainty can be incorporated

• Use of discounting methods may lead to move accurate estimating and

• They rank projects correctly in order of profitability and give better criteria for

acceptance or rejection of projects than other method.

Because of that in theoretically said that DCF analysis is best method to evaluate the

investment over its rivals. A survey carried out by the Arnold & Hatzopolous (2000)

and Graham & Harvey (2000) to identify the practical usage of investment appraisal

techniques among the large manufacturing firms of UK had revealed that NPV and

IRR are less behind its rivals in practically. Therefore they have commented that there

is a gap between usages of appraisal techniques in practically and theoretically.

But according to the Koller (2006) have identified the errors which may occur

frequently while application of DCF techniques. He also commented that DCF model

should be economically sound and transparent to get the expected output.

Economically sound means the company’s return and growth are consistent with the

9
company’s positioning and the ample empirical records. Transparent means you

understand the economic implications of the method and assumptions you choose. As

per his comment most DCF models fail to meet the standards of economic soundness

and transparency.

Following are the frequent errors identified by Koller,

• Forecast horizon that is too short. One of the most criticisms is that any

forecast beyond a couple of years is suspect.

• Uneconomic continuing value. The continuing value component of a DCF

model captures the firm’s value for the time beyond the explicit forecast

period which can theoretically extend in to perpetuity.

• Cost of capital. You will rarely see a grate equity investor point to an ability to

judge the cost of capital better than others as the source of meaningful edge.

But you do see many DCF models debilitated by non sensible cost of capital

estimates.

• Mismatch between assumed investment and earnings growth. Companies

invariably must invest in the business in order to grow over and extended

period. Return on investment (ROI) determines how efficiently a company

translates its investments into earnings growth. So that investor must treat the

relationship between investment and growth carefully.

• DCF models commonly underestimate the investment necessary to achieve an

assumed growth rate.

• Improper reflection of other liabilities. Most liabilities, including debt and

many pension programs are relatively straightforward to determine and reflect

in the model. Some other liabilities like employee stock option are trickier to

10
 capture. Not surprisingly most analysts do a very poor job capturing these

liabilities in an economically sound way.

• Discount to private market value. The discount to private market value model

lacks sufficient transparency because it conflates the base and synergy cash

flows.

• Double counting. Models should not count a rupee of value more than once.

Unwittingly, DCF models often double count the same source of value.

• Scenarios. Probably the most often cited criticism of a DCF model is that

small changes in assumptions can lead to large changes in the value.

Because of such errors, they have commented that an investor must ensure the models

are economically sound and transparent to apply DCF models to the real world.

Drury and Tayles (1997) argued uses and limitations of DCF analysis in different

view. They have done a survey on application of DCF method based on 886 UK

manufacturing organizations. On that survey they have identified companies are under

investing because of the misapplication and misinterpretation of DCF techniques.

That survey showed smaller organizations place less emphasis on formal appraisal

techniques and staff responsible for making capital investment decisions are likely to

be involved in the invitation process. Hence they will have detailed “knowledge of the

business” and intuitive managerial judgment.

The survey findings also indicated that non-discounting methods continue to be used

by both smaller and large organizations.

Firms are guilty of rejecting worthwhile investment because of the improper treatment

of inflation in the financial appraisal. Inflation affects both future cash flows and the

cost of capital that is used to discount the cash flows.

11
It must be noted also that inflation is likely to affect different components of cash

flows in different ways. Inflation also affects the cost of capital because investors

require higher monetary returns to compensate for inflation. The correct treatment of

inflation requires that we compare like with like in the financial appraisal. Thus real

cash flows should be discounted at a real discount rate or nominal rate. In order to

ascertain how inflation was dealt with in financial appraisal they asked from the

respondent to specify whether real or money discount rate used to discount the cash

flows. In that case 49% of respondent were understating the IRR by using current or

real cash flow estimates to compute the IRR and then comparing the resulting return

with a normal discount rate. Results were almost similar to largest and smallest

organizations. Therefore it is important to ensure that inflation is dealt with correctly

in financial appraisals.

Another misapplication of DCF analysis is uses of excessive discount rate uses for

investment appraisal. During that period there was a debate on UK companies for

using high discount rates to appraise investment and as a result these companies in

danger of under investing. According to their survey, they have identified

approximately 50% of respondents are using nominal and real discount rate more than

19%. It showed majority of respondents use rate significantly in excess of those

calculated above for average risk projects. These findings show that many companies

in UK were using excessively high discount rates.

In case of Advanced Manufacturing Technological (AMT) investments, different

researchers are having various ideas. Because AMT investments generate more

benefits on financial and non financial terms as well. Benefits like quality

improvement, manufacturing flexibility, higher level of customer service and delivery,

shorter lead times and greater product innovations cannot be quantify are distorted by

12
the DFC analysis. It means that investment in AMT projects are often fails because of

non financial benefits which are difficult to quantify or either understated or

frequently omitted.

Kaplan (1986) argued that conventional DCF method should be used to evaluate

investments based on the financial data available. He also stated that if the net results

of the cash flows results in a negative NPV, then it becomes necessary to estimate

how much the annual cash flows must increase before the investment does give a

positive net present value. Kaplan goes on to argue that the management must then

decide if the value of the intangible benefit will be greater than this figure. If the

answer is yes, then he project would meet the criteria for acceptance. But Meredith &

Suresh’s (1986) argument was financial appraisal methods used by industry to

evaluate investments may be inappropriate on their own for today’s high technology

business environment, since they fail to capture many of the strategical benefits from

important AMT projects. Therefore he suggested three stages appraisal techniques. It

can be identified as 1. Flexibility, 2. High level of risk and 3. Synergy of Flexible

Manufacturing Systems. Flexibility can be identified by way of conventional

investment appraisal techniques and at the second stage company must sue techniques

such as value analysis, portfolio analysis and risk analysis. Final stage requires a more

strategic justification.

Bromwich & Bhimami (1991) had a different approach for the appraisal of AMT

projects. In their approach, they attempted to quantify either financial terms or score

values of benefits of investing in AMT. Still there is no specifically developed

technique to appraise AMT projects. Different researchers have been developed

different models for appraising AMT projects.

13
Even though there are different models, different arguments still managers are compel

to use DCF analysis for their investment decisions.

According to the past survey carried out by Lawrence, Gary & Williams (1978)

inquired about the capital budgeting techniques employed by large US firms and

computation of the discount rate and cash flows. Of those responding firms indicating

that a discount rate is applied. 65% of the respondents were applied IRR and 56%

uses NPV method. Over 86% of the respondents use either IRR or NPV or both.

Another survey carried out by Pike (1996) on capital budgeting practices of large UK

companies between 1975 and 1992 reported a substantial increase in the usage of

discounted cash flow. According to survey he has identified 75% and 81% UK firms

are applying NPV and IRR respectively.

In a recent study carried out by the McIntosh (1993) to ascertain whether or not DCF

technique is used by property investors as an investment decision making tool among

the major property investors in Australia. It was reported that 75% of the respondents

always use DCF and 25% usually use DCF analysis in the valuation of properties over

$25 million.

The survey carried out by the Sangster (1993) among the 500 largest Scottish

companies to ascertain currently used techniques for capital investment appraisal. His

findings indicated that companies are using several appraisal methods together, and

application of discounted cash flow techniques is becoming more sophisticated.

Although the survey does not directly indicate the use of DCF techniques for valuing

property investments, it does suggest that the DCF technique of appraising investment

is an accepted and widely used method by investment appraisers.

14
Due to these research findings we can identify there is an ongoing debate among

managers for using DCF analysis for their investment decisions. And there is an

unfilled gap for the uses of DCF analysis.

15
Chapter 03

Conceptual Framework and Research Methodology

Introduction

This chapter mainly describes under two parts, the conceptual framework of this

research and research methodology. Methodology part explains methodology

followed by the researcher, analysis methods, empirical settings of study, sample of

study and data collection methods.

3.1 Conceptual framework

Nature of
capital Human
Expenditure Factors

Share holders Managers

Company Validity of DCF
Expectation Perceptio
Policies Analysis
n

Reliability of Benefits of
Investment the project
appraisal
Techniques

As shown in above, researcher has developed a frame work to identify the factors

which affect to the validity of the DCF analysis techniques. Factors such as company

policy and the manager’s perception are directly affected to the manager’s validity to

the techniques. There is overwhelming evidence that the importance of these factors

vary among each managers and shareholders. Researcher found out that preference to

16
each factor varies with the demographic factors such as age, gender type of

employment, marital status, and educational level and companies policy requirements

of managers and shareholders.

Working Definitions

• Company policies

Most of the large companies follow the predetermined procedures for each and ever

activity. In case of decision making process also they have practicing proper

procedure manual. Therefore it will restrict the decision making power of the

managers to some extent. According to the return requirement of shareholders and the

reliability of DCF analysis owners may set the company policies. In addition to that

nature of the expense such as adding new spare parts to the vehicle may not apply the

Investment appraisal techniques. Based on such things top management of a company

is set the selected techniques and the decisions which need to be analyze through the

appraisal techniques. Therefore researcher has highlighted company policies are

directly influence the validity of the DCF techniques

According to the nature of the capital expenditure company may formulate their

policies and procedures. Normally asset repairs, purchase of new car are not evaluated

through investment appraisal techniques. On the other hand based on the expectation

of share holders or owners they may set the discount factor or the method should be

used to evaluate the projects. And also reliability of the answer must be more to

accept the project otherwise project may not be accepted. Because of such instances

validity of an investment appraisal technique is lost.

17
 • Managers perception

Different persons perceive different character. This is a human factor therefore it

won’t be fixed it is varying with the personal Characteristics. Personnel characteristics

are depend on the demographic factors such as age, gender, education qualification,

experience, attitudes and so on. There is no stipulated format is developed to measure

the non financial benefits of an investment. Therefore it is measured based on the

judgments of managers. Before accepting the projects company may analyze those

benefits according to the manager’s knowledge and skill. Because of that accepting or

rejecting investment appraisal techniques is depend on the manager’s perception. This

will lead to eliminate another factor which directly influence validity of the decision

making process.

In these instances in a same organization Engineer and Accountant may have different

ideas. If a project is financially not viable but its non financial benefits are better,

Engineer will accept the project. In addition to that personal characteristic such as risk

averse managers, lack of knowledge of investment appraisal techniques may lead to

loose the validity of the DCF techniques.

3.2 Research Methodology

Reseacher has identified this study as the qulitative study. Qualitative research is one

of the two major approaches to research methodology in social sciences. In the social

sciences, qualitative research is a broad term that describes research that focuses on

how individuals and groups view and understand the world and construct meaning out

of their experiences. Further Qualitative research involves an indepth understanding

of human behaviour and the reasons that govern human behaviour and relies on

18
reasons behind various aspects of behaviour. Simply put, it investigates the why and

how of decision making.

In this study the main reason for identifying this research as a qualitative is that, this

study mainly address the problem that “whether DCF analysis is validated by the

managers of Milk food industry”. Validity can be defined as "An account is valid or

true if it represents accurately those features of the phenomena, that it is intended to

describe, explain or theories.” Therefore researcher has tested validity of the DCF

analysis according to the above mention conceptual frame work by collecting

qualitative data from an interview method.

3.2.1 Empirical Settings of the Study

In this study researcher has identified three large milk food manufacturing firms for

the research context. Following figure 3.1 shows the Island wide milk intakes by the

milk food manufacturers in 2005. When selecting those firms to the sample

researcher has concentrated on the firms in this represents the large portion of the

market and the type of the organization. According to the organization type researcher

chosen private, public sector and Quoted company namely Fonterra Brands Lanka

(Pvt) Ltd, Milco (Pvt) Ltd and Nestle Lanka Ltd respectively. Throughout this

research researcher noted the three respondents. Accountant of Fonterra Brands Lanka

Ltd, Finance Manager of Milco (Pvt) Ltd and Accountant of Nestle Lanka Ltd are

recognized as respondent 1, 2 and 3 respectively. Investments made of these three

companies during the last 5 year period are shown in the figure 3.2.

19
Figure 3.1 Island wide milk intakes

Islandwide Milk Intake

Othres & Small
Manufactures, 5.9
,
Maliban, 0

Strassen , 12.3

Milco (Pvt) Ltd, 33.8

Kothmale Holdings, 13.1

Fonterra Brands Lanka (Pvt)
Ltd, 11.2
Nestle Lanka (Pvt), 23.7

Figure 3.2 Investment values of sample selected

Investments of Selected Sample

800,000

700,000

600,000

500,000
Values in Rs.'000

Nestle Lanka (Pvt)

400,000 Fonterra Brands Lanka (Pvt) Ltd
Milco (Pvt) Ltd
300,000

200,000

100,000

0
2001 2002 2003 2004 2005
Years

20
Fonterra Brands Lanka (Pvt) Ltd

Fonterra is a fully own subsidiary of the Fonterra Group of Companies in New

Zealand. Fonterra is the world’s largest manufacturer and exporter of diary products

in New Zealand. This company was established in 1985 under a joint venture in Sri

Lanka and in December 2000 become a wholly owned subsidiary of New Zealand

Dairy Board. The company’s vision statement stated that their vision is “To lead in

Diary” and mission is “Delighting consumers through diary products that are

notorious, innovative and taste great”. This company is in business of importing,

manufacturing and marketing diary based products in the country. The company

employs 600 people who are mostly located at the Biyagama office. Company is the

owners of different types of products there product range is Anchor, Anmum, Anlene,

Ratthi full cream milk powder, Newdale Ratthi yourghts, Wam, Curd, Cheese,

Butter etc with different quantities.

Milco (Pvt) Ltd

The company was incorporated on 9th May, 1996 under the name “ Kiriya Milk

Industries of Lanka (Pvt) Limited. The name of the company was changed as Milco

(pvt) limited with effect from 23rd July, 2001 as per the agreement entered into

between the Government of Sri Lanka and the National Dairy Board of India. Milco is

a fully government owned company.

The principal activities of the company is collecting, packing, distributing and dealing

in milk powder, yogurt, ice cream, cheese and butter. It employs nearly 1000 people

and it’s products are targeted to the South Asian market.

During the last few years they have carried out under mention massive activities with

the expectation of increasing the production, quality and the market share.

21
 • Opened 5 new milk chilling centers in 2002

• Adding 6 new bousers to the existing fleet

• Established new weigh bridges at Polgahawela cattle feed plant and Digana

milk factory

• Formulate and implement a “clean milk” program in collaboration with JICA.

• Installation of a new instant soluble milk powder plant at Ambewela.

• Installation of new powder packing machines and 2 ice cream making machie.

Nestle Lanka (Pvt) Ltd

This is a quoted company in Colombo Stock Exchange. This also a multinational

company and nearly 91% is owned by the Nestle S.A. of Switzerland. The company

produces high quality products at its’ factory in Kurunegala under exclusive

permission from the Trade mark owner, Societe de produits Nestle S.A. Vevey,

Switzerland. World renowned brands such as Nespray, Nestomalt, Cereal, Milo and

Maggi range of products maggi bouillon cubes and Maggi Noodles are manufactured

in Sri Lanka. Currently nestle employes nearly 750 employees in factory at

Kurunegala and office at Colombo 10.

22
3.2.2 Data Collection Method

In this study researcher has adopted interview method to collect information. Because

this is a qualitative research and also to obtain more accurate and deep information

about companies it is necessary to make interviews with the persons who is handling

the capital budgeting of an organization. Size of the sample is too small and it makes

easier to apply the interview method for data collection purpose. By using interview

method researcher ca identify the clear idea of managers and it will not make struggle

with understanding the questions and researcher can obtain more qualitative

information as they want.

In this study researcher uses the questionnaire to interview with managers. This is

developed mainly to gather data about the decision making process and techniques

they are currently practicing.

23
Chapter 04

Data presentation and analysis

Introduction

This chapter explains the information collected for this regards. On this earlier part is

consisting with the data extracted from the selected respondent and their personal

characteristics. Latter part of this chapter included the analysis part of the data gathers

during the research.

4.1 profile of the respondents

First respondent is an accountant of the company and he is responsible for capital

budgeting of the company. He is a young character and he is having BBA degree in

University of Colombo. In his professional career he is a qualified chartered

accountant and also he is doing finals of CIMA. Researcher had a nearly two hour

discussion with the him and he is identified he is a risk averse character because he is

not willing take any risk. In addition researcher has observed that he is the person who

strictly adheres to the company policies and procedures. Because, he has only one

year experience in this firm as an accountant.

The second respondent is a government servant and he is newly promoted as a finance

manager of the Milco (Pvt) Ltd. He is 45years old and he is having BSc degree in

University of Sri Jayewardenepura. He is having experience in 15 years in this

company. He said that he is decision making power is limited to some extent because

of the complicated government rules and regulations. He also noted that big projects

like restructuring organization, establishing new plants require approval for the

parliament.

24
Last respondent of the research is a treasure manager of Nestle (Pvt) Ltd. He is also

43 years old and he a graduated from the foreign university. He is a member of the

CIMA. He is very corporative character and he is having more experience in capital

budgeting area. Since 1988 he is working in this organization in different levels.

However their decisions are taken by the board of executives including Managing

Director, Finance Director, and other functional level directors.

4.2 Discussion with Managers

According to the first question of the questionnaire respondent 1 said they are classify

their expenses mainly capital and revenue expenses. Capital expenses further divided

into two parts called capital expenditure and operative expenditure. Out of this capital

expenditure they are identified as investments which are needed to evaluate by using

investment appraisal techniques. Respondent two and three also have the same

classification of expenses and they also not recognize the capitol nature operational

expenditure to the investment decision making process. Because they said such

expenditure must be incurred to carryout the continuous production.

As per the second question there were no restriction is made for application of

investment appraisal techniques as a percentage of total corporate capital investment

expenditure. But respondent 1 said their MD has the approval limit of $20million and

respondent 3 said their MD has a $50 million approval level.

If we look at the application of appraisal methods respondent 1 should apply the

Payback method, NPV and IRR method for investment evaluation process as per the

group decision making process. But they haven’t calculated the ARR for the projects

in case of that they calculate the EBIT and GP margin. In addition he stated that they

are calculating payback method for discounted cash flows also. But the respondent

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two applies the NPV and ARR for their capital decision making. It is a must and this

is imposed by the National Livestock and development board.. Application of

investment appraisal techniques of respondent 3 is more similar to the respondent

1.They are also apply the NPV, IRR and discounted payback method to evaluate the

investment in financially. This is the requirement of its parent company.

According to the next question to identify the techniques which are currently used for

the evaluation of non financial benefits, respondent 1 said “when we are going to new

project, project initiator must be identified the benefits generated from such projects”.

It shows that project initiator should be included the non financial benefits generated

from the project in the project report. Improvement of efficiency, reduction of wastage

etc should be quantified by the project initiator. He also stated that if a project has

marginally negative NPV and more non financial benefits they are accepting such

projects.

But the respondent 2 had a different view for evaluating non financial benefits of a

project. He said that his organization is paying more attention on non financial

benefits rather than financial benefits. He is more emphasizing the importance of non

financial benefits to a government organization. Likewise other governmental

organization his organizations also have the political influence. Ultimate decision is

taken by the minister. As per the discussion with respondent 2, researcher has revealed

that personal characteristic of Minister’s also effect to their organization decisions.

Unless the project is not financial viable with the approval from the Minister company

will accept those. But if it is a large scale projects such as restructuring the

organization in which people loose their employment, they must obtain the approval

from the parliament. Chairman should passed the sanction from the parliament.

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Respondent 3 has the similar opinion as respondent 1 has in this manner. Here also

MD of the company has given the approval limit of Rs 2500million. But the company

may not accept any projects which are not financially viable. It means that they have

accepted the project which carries positive NPV value.

According to the question No 5 all respondents said that they are going for such

techniques to comply with the company policies and procedures which are developed

by the top management to maximize the wealth of the owners or share holders.

Fonterra and Nestle has the group policy for their subsidiaries all over the world. MD

should adhere to practice such policies with in their organization.

Normally when they are going to evaluate the investment in DCF models they are

always concern the inflation and the cost of capital. All respondents are considering

the WACC as the cost of capital of such project.

Three respondents are concerned different time period for the investment appraisal

process. Respondent 1, 2 and 3 consider the 5years, 6years and 10 years time periods

for investment appraisal process respectively.

While analyzing the project through investment appraisal models, all respondents are

made similar assumptions for prices, usage of materials, inflation etc. In addition to

that respondent 1 ignores the cash flows after 5 years and growth rate is considered as

10% over and year.

When considering the Advance Manufacturing Technological projects respondent 1

and 3 has complied with the stated procedures. But in case of respondent 2,

parliament may decide the investment by considering the social as well as company

non financial benefits.

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4.3 Analysis of data

According to the findings researcher has noted that decision making of an

organization is influence by the type of organization. If an organization is private or

public their decision making process is little different. It is because most of the public

organizations are focus on welfare rather than earning profits. Therefore such

organizations more concern on non financial benefits rather than financial benefits.

But in the other hand private sector organizations are profit oriented therefore owners

are set the standard procedures or benchmark to follow the managers of an

organizations at a minimum risk and high level of profit margins.

In case of investment evaluation process most of the organizations are applying DCF

techniques to appraise the financial viability of the project. It also confirmed by the

different surveys conducted in the different countries. Therefore it proves that milk

food industry in Sri Lanka is also practicing the DCF techniques for investment

appraisal techniques.

In literature review shows that most frequent errors identified by the Koller (2006)

and to over come such errors happening in the decision making process companies

make assumptions and forecast the significantly less time period. And also minimize

the effect of misinterpretation and misapplication of investment appraisal techniques

these companies adopted the inflation adjusted discount rate and make use of WACC

to recognize the company’s cost of capital.

When we consider the validity of investment appraisal techniques it is depend on

whether they are using and identifying DCF technique. If managers are relying on the

result of the DCF method, it will make validity of the DCF techniques. But when we

look at the research findings non governmental organizations pay more attention on

financial appraisal techniques such as NPV, IRR and Payback method but it can’t say

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with full assurance because respondent 1 said they are accepting projects which are

having marginal negative NPV. In such instances validity of the investment appraisal

is lost. When we look at the decision making process of a governmental organization

it is influence by the political leaders and employee unions in Sri Lankan context.

Therefore we can see that application of formal procedure is exists but it may not be

workout as it is. Therefore in such instances also lost the validity of investment

appraisal techniques. But as argument made by the Kaplan (1986) is may not be valid.

In practically organizations considers the financial and non financial benefits as well.

According to the research finding it is noted that major manufacturers of milk food in

Sri Lanka show that not only financial benefits but also non financial aspects are

considered.

When we look at the effects of the company policies and managers perception for the

validity of the DCF technique as per the conceptual frame work we can see that

decision making process in milk food industry in Sri Lanka is largely affected by the

company policies. Up to certain level managers has empowered to make decisions

within the stipulated frame work. And also company policies are affected by the share

holder’s preference, nature of capital expenditure and generally accepted reliable

investment appraisal techniques. As mention in the conceptual frame work managers

perception is affected by their personal characteristics but in this context it has no

impact to the validity of a DCF techniques. On the other hand researcher has observed

that benefits of organizations also have significant influence to loose the validity of

the DCF model.

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Chapter 5

Conclusion

This research is mainly focus by the researcher to identify whether DCF techniques

are validated by the managers of the milk food industry. According to this research

also researcher recognized that discounted cash flow is a powerful devise for

appraising investment projects. And still DCF model is excessively used by the

managers of milk food industry in Sri Lanka.

This research also eliminated that selection of capital investment appraisal techniques

in Milk food industry is affected by policies of multinational companies to the private

sector. Political interference is affected to the public sector investment decision

making in milk food industry in Sri Lanka. It is a new variable identified in this

research.

Therefore research finding showed that most of the organizations are using DCF

techniques for evaluating in investment on its financial perspective. Because it is the

more appropriate technique developed for investment appraisal. Therefore managers

of milk food industry of Sri Lanka also apply and validate this approach as a decision

making tool. In some instances managers are not rely on the DCF methods in decision

making process. But it is insignificant when compared to overall decisions taken by

the managers of milk food industry.

It ensures the managers by making adjustment to the DCF model to overcome

problems of misinterpretation and misapplication. To obtain reliable answer managers

make assumptions.

The various models and approaches highlighted and discussed in this paper to

appraise the investment in AMT all attempt to take into account and the strategic

benefits from the introduction of AMT. However, no single model that has been

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universally accepted and it is to the decision maker to adopt whichever approach is

preferred. In this research has not covered the all the sectors of the manufacturing

industry and all the areas of investment appraisal techniques. There is lot of further

investigation can be done in this area also.

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