PROJECT REPORT

ON
CAPITAL BUDGETING
AT
NATIONAL MINERAL DEVELOPMENT CORPORATION LIMITED

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

CHAPTER-1
INTRODUCTION

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.

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.
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
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.

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:
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

conclusion.
4. Estimation of post project scenario of the company.

arrive

at

the

right

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.

10

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.

11

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
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.

12

CHAPTER-2
COMPANY PROFILE

13

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
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

I nd ia is r ic hl y en do w e d w i th mi n er a ls l ik e co al ( no ne c oo ki ng ),
b au xi te (metallurgical), barites, iron ore, mica, gypsum, chromate (fines a n d

14

l o w 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
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.
15

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.
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.

16

 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.

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

17

district and gravels of Krishna, river basin in AP. Presently the only diamond pipe
under exploitation is at Panna.

COMPANY PROFILE

NATIONAL MINERAL DEVELOPMENT OF NMDC

18

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
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.)

19

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.
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

20

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.

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
21

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.
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

22

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 ISO9001) and Donimalai Iron ore (for ISO - 9002) were akin up. Both the units have
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
,Titanium slag, Ferrite powder.

Markets for NMDC's products:

23

from

Imaret , Iron powder

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
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.

24

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
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.
25

6. Material Management.
7. Marketing.
8. Research and Development.

AWARDS : (RECOGNITION BY OTHERS)

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

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

Industrial Engineering, Navy, Mumbai.

26

the

Indian

Institution

of

CHAPTER-3
THEORETICAL BACKGROUND ABOUT THE TOPIC

THEORETICAL BACKGROUND ABOUT THE TOPIC

27

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.

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 decisionmaking. 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

28

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 'tactical 1 - 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
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; secondhand 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

29

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:
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

30

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
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

31

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
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

32

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

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.
project

decisions

are

It may be noted here that the mutually exclusive

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.

33

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.
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.

34

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
benefits

of measuring

future

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

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

35

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
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

useful

as

profits, which are quire

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

36

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
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:

37

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
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.

38

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-.

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.

39

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 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.

Wor k i n g c a p i t a l e ff e c t .

Wor k i n g c a p i t a l c o n s t i t u t e s a n o t h e r i mp o r t a n t 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

40

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.

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.

41

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:
(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

42

value? Cash benefits here represent CFAT ignoring interest paymentThus, 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
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

43

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:
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

44

of funds.
5) This

is

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.
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 firms 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
value, inflationary (rends, profitability etc.

45

time

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

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

46

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.
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.

47

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
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

48

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.
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

49

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
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

50

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
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,

51

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

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

52

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
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

53

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
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.

54

CHAPTER-4
DATA ANALYSIS

55

DATA ANALYSIS
CALCULATION OF TOTAL SALES OF THE PROJECT

Prod
Capac in
Local Selling A
ity
tonn sales price
Total sales

(B)
Total

Export Selling
sales prices

B
Value Total
prices sales

Years
(in
tonnes}
3
80%

5334 2667

61740

164660580

2667

1260

49

90%

6000 3000

61740

185220000

3000

1260

49

90%

6000 3000

61740

3000

1260

49

90%

6000 3000

61740

185220000
185220000 3000

1260

49

90%

6000 3000

61740

185220000

3000

1260

49

90%

6000 3000

61740

185220000

3000

1260

49

90%

6000 3000

61740

135220000

3000

1260

49

10

90%

6000 3000

61740

165220000

3000

1260

49

11

90%

6000 3000

61740

185220000

3000

1260

49

12

90%

6000 3000

61740

185220000

3000

1260

49

13

90%

6000 3000

61740

185220000

3000

1260

49

14

90%

6000 3000

61740

185220000

3000

1260

49

15

90%

6000 3000

61740

185220000

3000

1260

49

16

90%

6000 3000

61740

185220000

3000

1260

49

17

90%

6000 3000

61740

185220000

3000

1260

49

Total sales of the project

56

(A+B)
Total
sales

E (A+B)
Total

16466058 329320000
0
18522000 370440000
0
18522000 370440000
0
18522000 370440000
0
18522000 370440000
0
18522000 370440000
0
18522000 370440000
0
1S522000 370440000
0
18522000 370440000
0
18522000 370440000
0
185220 370440000
000
18522000 370440000
0
18522000 370440000
0
18522000 370440000
0
18522000 370440000
0

55154480000

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

S.No
PARTICULA
RS
YEARS
3
1Raw
91
Materials
2 Power
167

4
104

5
104

6
104

7
8
104 104

9
104

183

188

188

188 188

188

10 11 12 13 14
104 10 104 104 104
4
133 13 188 133 183
3

15
104

16
104

183

133

60

60

60

934

934

3 Royalty
4Selling
Expenses

80

90

90

90

90

90

90

212

240

120

120

120 6O

60

5Spares,
Consumables
TOTAL

93
830 934 934 934 934 934 934 934 4 934 934 934
1380 1556 1436 1436 1436 1376 1376
128 12 128 128
6
86 6
6 1286

S.No.
3
PARTICULARS/YEA
RS

1 Salaries & Wages

116 11
6

116

116 116 115 11

6

57

10

11
6

60 60

60 60

11 12

13

11 116 116
6

1286 1286
14 15

16

T
L
11 116 116 1
6
1

2 Electricity

21

21

21

21

21

21

21

21 21

21

21 21

21

21

3. Repairs & Main

33

33

33

33

33

33

33

33

33 33

33

33 33

33

4- Administrative
Expenses

62

62

62

62

62

62

62

62

62 62

62

62 62

62

TOTAL

232

232 23
2

232 232 232 23

2

23
2

23 232 232
2

23 232 232 2
2
3

CALCULATION OF INTEREST ON CAPITAL AND DEPRECIATION

RS. In Lakhs

No.
3
4
5
6
7
8
9 10
11
12
Particula
rs/years
1
Interest
on
Capital 750 750 750 7SO 750 750 750 750 750 750
2
490 490 490 490 490 490 488 488 488 494
Deprecia

58

13

14

3
4
6
9

15

16

17

750 750 750 750 750

149 192 233 232 232

tion
TOTAL

124 124 124 124 1240 124 123 1238 1238 1244 899 942 983 982 982
0
0
0
0
0
8

CALCULATION OF NET CASH INFLOWS AND NET PRESENT VALUE OF

THE PROJECT

(Rs. In
A
Lakhs)
YEARS
PROFIT
NET
3
286.78
4
439.66
5
517.66
6
517.66
7
517.66
8
556.66

B
DEPRECIATION
& INTEREST ON
1240
cccccccccapitalCAPIT
1240
1240
1240
1240
1240

C (A+B)
NET CASH
INFLOWS
1526.78
1679.66
1757.66
1757.66
1757.66
1796.66
59

E
DISCOUNTING
FACTOR @ 15%
INFLOWS
DISCOUNTED
0.869
1326.77
CASH
0.756
1269.82
0.657
1154.78
0.571
1003.62
0.497
873.557
0.432
776.157

9
10
11
12
13
14
15
16
17

557.96
616.46
616.46
616.46
612.56
836.81
808.86
782.21
782.86
782.86

1238
1238
1238
1244
899
942
983
982
982

1795.96
1854.46
1854.46
1860.46
1511.56
1778.81
1791.86
1764.21
1764.86

0.375
0.326
0.284
0.247
0.214
0.186
0.162
0.141
0.122

673.485
604.554
526.667
459.534
323.474
330.859
290.281
248.754
215.313
10076.394

TOTAL DISCOUNTED CASH INFLOWS

10,000
LESS:

INITIAL INVESTMENT OF THE PROJECT

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

YEA NET CASH

RS3 INFLOWS
1526.8
4
5
6
7
8
9
10
11

1679.7
1757.7
1757.7
1757.7
1796.7
1796
1 8S4.5
1854.S

DISCOUNTING
FACTOR
0.862 @16 %
0.743
0.64
0,552
0,476
0.41
0.353
0.305
0.262

DISCOUNTE
D 1316.1
1248.02
1124.93
970.25
836.665
736.647
633.988
565.623
485.879

60

12
13
14
15
16
17

1860.5
0.226
1511.6
D.195
1778.8
0.168
1791.9
0.145
1764.2
0.125
1764.2
0.107
TOTAL DISCOUNTED CASH INFLOWS

LESS:

420.473
294-762
298.838
259.826
220.525
168.769
9601.29
10000

INITIAL INVESTMENT OF THE PROJECT

-398.79

NPV OF THE PROJECT (DEFICIT)

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

78
=

15+

*1
10078-69-9601 *1

15.16 %

61

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

NET
PROFIT &
3 286.78

DEPRECIATION
1240

CASHFLOW
S
1526.78

CUMULATIVE
1526.8

439.66

1240

1679.66

3206.5

5
6
7
8

517.66
517.66
517.66
556,66

1240
1240
1240
1240

1757.66
1757.66
1757.66
1796.66

4964,2
6721.9
8479.6
10276.3

9
10
11
12
13
14
15
16
17

587.96
616.46
616.46
612.56
836.81
808.86
782.21
782.86
782.86

1238
1238
1238
1244
899
942
983
982
982

1795.96
1854.46
1854.46
1856.56
1735.87
1750.86
1765.21
1764.86
1764.86

12072.3
13326.8
15781.5
17638.1
19374
21124
22889
24654
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+

7, 84 years. The Company get backs the Original

0.84

Investment at 7.84.
`

62

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.

CALCULATION OF BREAK EVEN POINT

a. Capacity
:
b. Utilization
:
c. Sales (Rs.)
:
d. Variable Cost :

6667 tonnes par annum

5334 tonnes per annum
3293.2 lakhs
Rs. (In lakhs)

63

i) Raw Materials
2) Power
3) Royalty
4) Selling exp.
5) Spares, etc
TOTAL :
Contribution cde :
Fixed Cost
1 Salaries & Wages
2 Electricity
3 Repairs & Main.
4 Administrative exp.
TOTAL
g. P/V Ratio (E/C*100
:
h. Break even point:
Assumptions

91
167
80
212
830
1380
1913.2
116
21
33
62
232
58.09%
399 tones

1) Installed Capacity of UPFO - 6667 tonnes per annum

2) Operating Capacity per annum
a) First Year: 80%
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

project will help the company to

which show that the

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

69

Prasanna Chandra