CAPITAL BUDGETING

A mini project submitted in fulfillment of the requirement of the

internal assessment

FINANCIAL MANAGEMENT

BY

AAMIR ABDUL ALEEM

AARIF MOHAMED
AARTHI.S.
ABIRAMI.M.

SRM B – SCHOOL

SRM UNIVERSITY, VADAPALANI

MARCH 2011
CONTENTS:

>INTRODUCTION

>CAPITAL BUDGETING AND FINANCIAL MANAGEMENT

>CAPITAL BUDGETING PROCESS

>CAPITAL STRUCTURE AND CASH FLOW

>IMPORTANCE OF CAPITAL BUDGETING

>SCOPE OF CAPITAL BUDGETING DECITION

>CAPITAL BUDGETING TECHNIQUES

Accounting rate of return

Net present value

Profitability index

Internal rate of return

Modified internal rate of return

Equivalent annuity

>CAPITAL BUDGETING IN BHEL

SECTORS IN BSNL

PROCESS OF CAPITAL BUDGETING

ANALYSIS
Introduction:

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 development
projects are worth pursuing. It is budget for major capital, or investment,
expenditures.[1]

Capital budgeting is a required managerial tool. One duty of a financial manager is

to choose investments with satisfactory cash flows and rates of return. Therefore, a
financial manager must be able to decide whether an investment is worth
undertaking and be able to choose intelligently between two or more alternatives.
To do this, a sound procedure to evaluate, compare, and select projects is needed.
This procedure is called capital budgeting.

Capital budgeting is a process used to determine whether a firm’s proposed

investments or projects are worth undertaking or not. The process of allocating
budget for fixed investment opportunities is crucial because they are generally long
lived and not easily reversed once they are made. So we can say that this is a
strategic asset allocation process and management needs to use capital
budgetingtechniques to determine which project will yield more return over a
period of time.

The question arises why capital budgeting decisions are critical? The foremost

importance is that the capital is a limited resource which is true of any form of
capital, whether it is raised through debt or equity. The firms always face the
constraint of capital rationing. This may result in the selection of less profitable
investment proposals if the budget allocation and utilization is the primary
consideration. So the management should make a careful decision whether a
particular project is economically acceptable and within the specified limits of the
investments to be made during a specified period of time.  In the case of more than
one project, management must identify the combination of investment projects that
will contribute to the value of the firm and profitability.  This, in essence, is the
basis of capital budgeting.
 Capital Budgeting and Financial Management:
 Businesses look for opportunities that increase their share holders’ value. In
capital budgeting, the managers try to figure out investment opportunities that are
worth more to the business than they cost to acquire. Ideally, firms should peruse
all such projects that have good potential to increase the business worth. Since the
available amount of capital at any given time is limited; therefore, it restricts the
management to pick out only certain projects by using capital budgeting techniques
in order to determine which project has potential to yield the most return over an
applicable period of time. 
Capital budgeting is the process which enables the management to decide which,
when and where to make long-term investments. With the help of Capital
Budgeting Techniques, management decide whether to accept or reject a particular
project by making analysis of the cash flows generated by the project over a period
of time and its cost. Management decides in favor of project if the value of cash
flows generated by the project exceeds the cost of undertaking that project.
 
A Capital Budgeting Decision rules likely to satisfy the following criteria:
 Must give consideration to all cash flows generated by the project.
 Must take into account Time Value of Money concept.
 Must always lead to the correct decision when choosing among mutually
exclusive projects.
Regardless of the specific nature of an investment opportunity under consideration,
management must be concerned not only with how much cash they are expecting
to receive, but also when they expect to receive it and how likely they are to
receive it.
Evaluating the size of investment, timing; when to take that investment, and the
risk involve in taking particular investment is the essence of capital budgeting.

CAPITAL IS A LIMITED RESOURCE:

In the form of either debt or equity, capital is a very limited resource. There
is a limit to the volume of credit that the banking system can create in the
economy. Commercial banks and other lending institutions have limited deposits
from which they can lend money to individuals, corporations, and governments. In
addition, the Federal Reserve System requires each bank to maintain part of its
deposits as reserves. Having limited resources to lend, lending institutions are
selective in extending loans to their customers. But even if a bank were to extend
 unlimited loans to a company, the management of that company would need to
consider the impact that increasing loans would have on the overall cost of
financing.

In reality, any firm has limited borrowing resources that should be allocated
among the best investment alternatives. One might argue that a company can issue
an almost unlimited amount of common stock to raise capital. Increasing the
number of shares of company stock, however, will serve only to distribute the
same amount of equity among a greater number of shareholders. In other words,
as the number of shares of a company increases, the company ownership of the
individual stockholder may proportionally decrease.

The argument that capital is a limited resource is true of any form of capital,
whether debt or equity (short-term or long-term, common stock) or retained
earnings, accounts payable or notes payable, and so on. Even the best-known firm
in an industry or a community can increase its borrowing up to a certain limit.
Once this point has been reached, the firm will either be denied more credit or be
charged a higher interest rate, making borrowing a less desirable way to raise
capital.

Faced with limited sources of capital, management should carefully decide

whether a particular project is economically acceptable. In the case of more than
one project, management must identify the projects that will contribute most to
profits and, consequently, to the value (or wealth) of the firm. This, in essence, is
the basis of capital budgeting.

Capital Budgeting Process :

Evaluation of Capital budgeting project involves six steps:
 First, the cost of that particular project must be known.
 Second, estimates the expected cash out flows from the project, including
residual value of the asset at the end of its useful life.  
 Third, riskiness of the cash flows must be estimated. This requires
information about the probability distribution of the cash outflows.
 Based on project’s riskiness, Management find outs the cost of capital at
which the cash out flows should be discounted.
 Next determine the present value of expected cash flows.
 Finally, compare the present value of expected cash flows with the required
outlay. If the present  value of the cash flows is greater than the cost, the project
should be taken. Otherwise, it should be rejected.
                                                                                                      OR
  If the expected rate of return on the project exceeds its cost of capital, that
project is worth taking.
Firm’s stock price directly depends how effective are the firm’s capital budgeting
procedures. If the firm finds or creates an investment opportunity with a present
value higher than its cost of capital, this would effect firms value positively.

Capital Structure and Cash Flows:

On one hand, operations of the company may help in forecasting of future cash
flows but in addition to this, future cash inflows and out flows can also be accessed
through company capital structure. A corporation may use different combinations
of equity, debt, or mixture of securities to finance its assets which is termed as
Capital Structure. Company’s capital structure is basically the composition of its
liabilities i.e. how much the company owes to its share holders and how much to
its creditors.
Stake holders can easily judge the management’s mind-set, strategy of running
business and business’s future prospects. A company’s value is affected by the
capital structure it employs, therefore; while deciding capital structure,
management has to consider different important factors like bankruptcy costs,
agency costs, taxes, and information asymmetry.

For example, if a company sells $100 billion in equity and $300 billion in debt, it
is said to be 25% equity-financed and 75% debt-financed. The Company’s ratio of
debt to total financing, 75% in this example is referred to as the company’s
leverage. Capital structure may be highly complex and may include other sources
of finances like short term loans, coalition etc.

 IMPORTANCE OF CAPITAL BUDGETING:

Capital budgeting decisions are among the most crucial and critical business
decisions. The selection of the most profitable assortment of capital investment can
be considered as a key function of management. The need and importance of
capital budgeting can be well illustrated well on the following grounds.

•Heavy investment – Almost all the capital expenditure projects involve heavy
investment of funds. And these funds are accumulated by the firm from various
external and internal sources at substantial cost of capital. So their proper planning
becomes inevitable.
•Permanent commitment of funds – The funds involved in capital expenditure
are not only large but more or less permanently blocked also. Therefore, these are
long-term investment decisions. The longer the time, the greater the risk is
involved.Hence, a careful planning is essential.
•Long-term impacts on profitability – Capital expenditure decision have long
term implications for the firm and influence its risk complexion to a large extent.
These projects exercise a great impact on the profitability of the firm for a very
long time. If properly planned, they can increase not only the size,scale and
volume of sales but firmm’s growth potentiality also.

•Complicacies of investment decisions – The long-term investment decisions are

more complicated in nature. They entail more risk and uncertainty. Further, the
acquisition of capital assets is a continuous process. So the management must be
gifted sample prophetic skill to peep into future.

Worth maximization of shareholders – Capital budgeting decisions are very

important as
their impact on the well-being and economic health of the enterprise is far
reaching. Themain aim of this process is to avoid over-investment and under-
investment in fixed assets.By selecting the most profitable capital project, the
management can maximize the worthof equity shareholders’ investment.

SCOPE OF CAPITAL BUDGETIG DECISION:

•Mechanisation of a process – In order to reduce costs,a firm may intend to
mechanise its existing production process by installing machine. The future cash
inflows on this investment are the savings resulting from the lower operating costs.
The firm would be interested in analyzing whether it is worth to install the
machine.
•Expansion decision – Every company want to expand its existing business. In
order to increase the scale of production and sale, the company may think of
acquiring machinery, addition of building, merger or takeover of another business
etc. this all would require additional investment which should be evaluated in
terms of future expected earnings.
•Replacement decision – A company may contemplate to replace an existing
machine with a latest model. The use of new and latest model of machinery may
possibly bring down operating costs and increase the production. Such replacement
decision will take with help of capital budgeting.
•Choice of equipment – A company needs an equipment to perform a certain
process. Now a choice can be made between semi- automatic or fully- automatic
machine. Capital budgeting process helps a lot in such selections.
•Product or process innovation – The introduction of new product or a new
process will be involve heavy expenditure and will earn profits also in the future.
So, a study of capitalbudgeting will be very useful and the ultimate decision will
depend upon the profitabilityof the product or process.

CAPITAL BUDGETING TECHNIQUES:

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

 Accounting rate of return

 Net present value
 Profitability index
 Internal rate of return
 Modified internal rate of return
 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.
Accounting rate of return:

Accounting rate of return, also known as the Average rate of return, or ARR is

a financial ratio used in capital budgeting. [1] The ratio does not take into account
the concept of time value of money. ARR calculates the return, generated from net
income of the proposed capital investment. The ARR is a percentage return. Say, if
ARR = 7%, then it means that the project is expected to earn seven cents out each
dollar invested. If the ARR is equal to or greater than the required rate of return,
the project is acceptable. If it is less than the desired rate, it should be rejected.
When comparing investments, the higher the ARR, the more attractive the
investment.

Where,

AVERAGE INVESTMENT= (COST-SCRAP)/2

Net Present Value :

Net Present Value measures the difference between present value of future cash
inflows generated by a project and cash outflows during a specific period of time.

With a help of net present value we can figure out an investment that is expected to
generate positive cash flows. 
In order to calculate net present value (NPV), we first estimate the expected future
cash flows from a project under consideration. The next step is to calculate the
present value of these cash flows by applying the discounted cash flow (DCF)
valuation procedures. Once we have the estimated figures then we will estimate
NPV as the difference between present value of cash inflows and the cost of
investment. 

NPV Formula: 

NET PRESENT VALUE INDEX=

(NET PRESENT VALUE/COST OF THE PROJECT)*100
 
  
  NPV=Present Value of Future Cash Inflows – Cash Outflows (Investment Cost) 
 In addition to this formula, there are various tools available to calculate the net
present value e.g. by using tables and spreadsheets such as Microsoft Excel. 

Each potential project's value should be estimated using a discounted cash flow
(DCF) valuation, to find its net present value (NPV). (First applied to Corporate
Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr
Williams: Theory.) This valuation requires estimating the size and timing of all 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(GE).

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.

Decision Rule: 
A prospective investment should be accepted if its Net Present Value is positive
and rejected if it is negative. 

Internal Rate of Return:

Internal Rate of Return is another important technique used in Capital Budgeting
Analysis to access the viability of an investment proposal. This is considered to be
most important alternative to Net Present Value (NPV). IRR is “The Discount rate
at which the costs of investment equal to the benefits of the investment. Or in other
words IRR is the Required Rate that equates the NPV of an investment zero.
NPV and IRR methods will always result identical accept/reject decisions for
independent projects. The reason is that whenever NPV is positive , IRR must
exceed Cost of Capital. However this is not true in case of mutually exclusive
projects.
The problem with IRR come about when Cash Flows are non-conventional
or when we are looking for two projects which are mutually exclusive. Under such
circumstances IRR can be misleading.
Suppose we have to evaluate two mutually exclusive projects. One of the project
requires a higher initial investment than the second project; the first project may
have a lower IRR value, but a higher NPV and should thus be accepted over the
second project (assuming no capital rationing constraint).

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 (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.

MODIFIED INTERNAL RATE OF RETURN:

The modified internal rate of return (MIRR) is a financial measure of

an investment's attractiveness.[1][2] It is used in capital budgeting to rank alternative
investments of equal size. As the name implies, MIRR is a modification of
the internal rate of return (IRR) and as such aims to resolve some problems with
the IRR.

While there are several problems with the IRR, MIRR resolves two of them.
First, IRR assumes that interim positive cash flows are reinvested at the same rate
of return as that of the project that generated them [3]. This is usually an unrealistic
scenario and a more likely situation is that the funds will be reinvested at a rate
closer to the firm's cost of capital. The IRR therefore often gives an unduly
optimistic picture of the projects under study. Generally for comparing projects
more fairly, the weighted average cost of capital should be used for reinvesting the
interim cash flows.
Second, more than one IRR can be found for projects with alternating positive and
negative cash flows, which leads to confusion and ambiguity. MIRR finds only one
value.
MIRR is calculated as follows:

,
where n is the number of equal periods at the end of which the cash flows occur
(not the number of cash flows), PV is present value (at the beginning of the first
period), FV is future value(at the end of the last period).
The formula adds up the negative cash flows after discounting them to time zero
using the external cost of capital, adds up the positive cash flows including the
proceeds of reinvestment at the external reinvestment rate to the final period, and
then works out what rate of return would cause the magnitude of the discounted
negative cash flows at time zero to be equivalent to the future value of the positive
cash flows at the final time period.
Decision Rule of Internal Rate of Return:
If Internal Rate of Return exceeds the required rate of Return, the investment
should be accepted or should be rejected otherwise.

Profitability Index:
Profitability index (PI) is the ratio of investment to payoff of a suggested project. It
is a useful capital budgeting technique for grading projects because it measures the
value created by per unit of investment made by the investor.
This technique is also known as profit investment ratio (PIR), benefit-cost ratio and
value investment ratio (VIR).
The ratio is calculated as follows:

Profitability Index = Present Value of Future Cash Flows / Initial Investment

If project has positive NPV, then the PV of future cash flows must be higher than
the initial investment. Thus the Profitability Index for a project with positive NPV
is greater than 1 and less than 1 for a project with negative NPV. This technique
may be useful when available capital is limited and we can allocate funds to
projects with the highest PIs.

The profitability index, or PI, method compares the present value of future
cash inflows with the initial investment on a relative basis. Therefore, the PI is
the ratio of the present value of cash flows (PVCF) to the initial investment of
the project.
In this method, a project with a PI greater than 1 is accepted, but a project
is rejected when its PI is less than 1. Note that the PI method is closely related to
the NPV approach. In fact, if the net present value of a project is positive, the PI
will be greater than 1. On the other hand, if the net present value is negative, the
project will have a PI of less than 1. The same conclusion is reached, therefore,
whether the net present value or the PI is used. In other words, if the present value
of cash flows exceeds the initial investment, there is a positive net present value
and a PI greater than 1, indicating that the project is acceptable.
PI is also know as a benefit/cash ratio.

Decision Rule:
Rules for the selection or rejection of a proposed project:
If Profit Index is greater than 1, then project should be accepted.
If Profit Index is less than 1, then reject the project.

Payback Period:

Payback period is the first formal and basic capital budgeting technique used to
assess the viability of the project. It is defined as the time period required for the
investment’s returns to cover its cost. Payback period is easy to apply and easy to
understand technique; therefore, widely used by investors.
For example, an investment of $5000 which returns $1000 per year will have a five
year payback period. Shorter payback periods are more desirable for the investors
than longer payback periods.
It is considered as a method of analysis with serious limitations and qualifications
for its use. Because it does not properly account for the time value of money, risk
and other important considerations such as opportunity cost.
Payback period = Expected number of years required to recover a project’s cost.

PAYBACK PERIOD= COST OF THE PROJECT/ANNUAL CASH INFLOW

Payback period in capital budgeting refers to the period of time required for the

return on an investment to "repay" the sum of the original investment. For
example, a $1000 investment which returned $500 per year would have a two year
payback period. The time value of money is not taken into account. Payback period
intuitively measures how long something takes to "pay for itself." All else being
equal, shorter payback periods are preferable to longer payback periods. Payback
period is widely used because of its ease of use despite recognized limitations,
described below.
The term is also widely used in other types of investment areas, often with respect
to energy efficiency technologies, maintenance, upgrades, or other changes. For
example, a compact fluorescent light bulb may be described as having a payback
period of a certain number of years or operating hours, assuming certain costs.
Here, the return to the investment consists of reduced operating costs. Although
primarily a financial term, the concept of a payback period is occasionally
extended to other uses, such as energy payback period (the period of time over
which the energy savings of a project equal the amount of energy expended since
project inception); these other terms may not be standardized or widely used.
Payback period as a tool of analysis is often used because it is easy to apply and
easy to understand for most individuals, regardless of academic training or field of
endeavour. When used carefully or to compare similar investments, it can be quite
useful. As a stand-alone tool to compare an investment to "doing nothing,"
payback period has no explicit criteria for decision-making (except, perhaps, that
the payback period should be less than infinity).
The payback period is considered a method of analysis with serious limitations and
qualifications for its use, because it does not account for the time value of
money, risk, financing or other important considerations, such as the opportunity
cost. Whilst the time value of money can be rectified by applying a weighted
average cost of capital discount, it is generally agreed that this tool for investment
decisions should not be used in isolation. Alternative measures of "return"
preferred by economists are net present value and internal rate of return. An
implicit assumption in the use of payback period is that returns to the investment
continue after the payback period. Payback period does not specify any required
comparison to other investments or even to not making an investment.
There is no formula to calculate the payback period, except the simple and
unrealistic case of the initial cash outlay and further constant cash inflows or
constantly growing cash inflows. To calculate the payback period an algorithm that
is easlily applied in spreadsheets is needed. The typical algorithm reduces to the
calculation of cumulative cash flow and the moment in which it turns to positive
from negative.
Additional complexity arises when the cash flow changes sign several times; i.e., it
contains outflows in the midst or at the end of the project lifetime. The modified
payback period algorithm may be applied then. First, the sum of all of the cash
outflows is calculated. Then the cumulative positive cash flows are determined for
each period. The modified payback period is calculated as the moment in which
the cumulative positive cash flow exceeds the total cash outflow.
 Project L

Expected Net Cash Flow

Project L Project S
Year
0 ($100) ($100)

1 10 (90)

2 60 (30)

3 80 50

PaybackL = 2 + $30/$80 years

= 2.4 years.

PaybackS = 1.6 years.

Weaknesses of Payback:

>Ignores the time value of money. This weakness is eliminated with the
discounted payback method.
>Ignores cash flows occurring after the payback period.

Discounted Payback Period:

The discounted payback period is the amount of time that it takes to cover the
cost of a project, by adding positive discounted cash flow coming from
the profits of the project.

PRESENT VALUE INDEX

=(TOTAL PRESENT VALUE/COST OF THE PROJECT)*100
One of the limitations in using payback period is that it does not take into account
the time value of money. Thus, future cash inflows are not discounted or adjusted
for debt/equity used to undertake the project , inflation, etc. However, the
discounted payback period solves this problem. It considers the time value of
money, it shows the breakeven after covering such costs. This technique is
somewhat similar to payback period except that the expected future cash flows are
discounted for computing payback period.
Discounted payback period is how long an investment’s cash flows, discounted at
project’s cost of capital, will take to cover the initial cost of the project. In this
approach, the PV of future cash inflows are cumulated up to time they cover the
initial cost of the project. Discounted payback period is generally higher than
payback period because it is money you will get in the future and will be less
valuable than money today.
For example, assume a company purchased a machine for $10000 which yields
cash inflows of $8000, $2000, and $1000 in year 1, 2 and 3 respectively. The cost
of capital is 15%. The regular payback period for this project is exactly 2 year. But
the discounted payback period will be more than 2 years because the first 2 years
cumulative discounted cash flow of $8695.66 is not sufficient to cover the initial
investment of $10000. The discounted payback period is 3 years.

Decision Rule of Discounted Payback:

If discounted payback period is smaller than some pre-determined number of years
then an investment is worth undertaking.

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 compare 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.Y

>Present Value of Multiple Cash Flows:

We come across many cases where we have to determine the present value of
series of multiple cash flows. There are two ways we can calculate present value of
multiple cash flows. Either we discount back individual cash flow at a time, or we
can just calculate the present values individually and add them up.
Example:
Suppose if we want $10,000 in one year and $15,000 more in two years. If we can
earn 8% on this money, how much we need to invest today to exactly earn this
much in the future? In other words, what is the present value of two cash flows at
8%.
Present value of $15,000 in 2 years at 8 percent is:
$15000/1.082 =$12860.082
Present value of $100 in 1 years at 8% is:
$10,000/1.08 =$9259.259
The total present value is :
$12860.082+$9259.259=$22119.341

>ADVANTAGES AND DISADVANTAGES OF IRR AND NPV:

A number of surveys have shown that, in practice, the IRR method is more popular
than the NPV approach. The reason may be that the IRR is straightforward, but it
uses cash flows and recognizes the time value of money, like the NPV. In other
words, while the IRR method is easy and understandable, it does not have the
drawbacks of the ARR and the payback period, both of which ignore the time
value of money.
The main problem with the IRR method is that it often gives unrealistic rates of

return. Suppose the cutoff rate is 11% and the IRR is calculated as 40%. Does this

mean that the management should immediately accept the project because its IRR

is 40%. The answer is no! An IRR of 40% assumes that a firm has the opportunity

to reinvest future cash flows at 40%. If past experience and the economy indicate

that 40% is an unrealistic rate for future reinvestments, an IRR of 40% is suspect.

Simply speaking, an IRR of 40% is too good to be true! So unless the calculated

IRR is a reasonable rate for reinvestment of future cash flows, it should not be used

as a yardstick to accept or reject a project.

Another problem with the IRR method is that it may give different rates of

return. Suppose there are two discount rates (two IRRs) that make the present

value equal to the initial investment. In this case, which rate should be used for

comparison with the cutoff rate? The purpose of this question is not to resolve the

cases where there are different IRRs. The purpose is to let you know that the IRR

method, despite its popularity in the business world, entails more problems than a

practitioner may think.

>WHY THE NPV AND IRR SOMETIMES SELECT DIFFERENT PROJECTS:

When comparing two projects, the use of the NPV and the IRR methods may give

different results. A project selected according to the NPV may be rejected if the

IRR method is used.

Suppose there are two alternative projects, X and Y. The initial investment in
each project is $2,500. Project X will provide annual cash flows of $500 for the
next 10 years. Project Y has annual cash flows of $100, $200, $300, $400, $500,
$600, $700, $800, $900, and $1,000 in the same period. Using the trial and error
method explained before, you find that the IRR of Project X is 17% and the IRR of
Project Y is around 13%. If you use the IRR, Project X should be preferred
because its IRR is 4% more than the IRR of Project Y. But what happens to your
decision if the NPV method is used? The answer is that the decision will change
depending on the discount rate you use. For instance, at a 5% discount rate,
Project Y has a higher NPV than X does. But at a discount rate of 8%, Project X is
preferred because of a higher NPV.
The purpose of this numerical example is to illustrate an important distinction:
The use of the IRR always leads to the selection of the same project, whereas
project selection using the NPV method depends on the discount rate chosen.

 PROJECT SIZE AND LIFE

There are reasons why the NPV and the IRR are sometimes in conflict: the size

and life of the project being studied are the most common ones. A 10-year project

with an initial investment of $100,000 can hardly be compared with a small 3-year

project costing $10,000. Actually, the large project could be thought of as ten

small projects. So if you insist on using the IRR and the NPV methods to compare
a big, long-term project with a small, short-term project, don’t be surprised if you

get different selection results. (See the equivalent annual annuity discussed later

for a good way to compare projects with unequal lives.)

 DIFFERENT CASH FLOWS

Furthermore, even two projects of the same length may have different patterns of

cash flow. The cash flow of one project may continuously increase over time,

while the cash flows of the other project may increase, decrease, stop, or become

negative. These two projects have completely different forms of cash flow, and if

the discount rate is changed when using the NPV approach, the result will probably

be different orders of ranking. For example, at 10% the NPV of Project A may be

higher than that of Project B. As soon as you change the discount rate to 15%,

Project B may be more attractive.

>WHEN ARE THE NPV AND IRR RELIABLE?

Generally speaking, you can use and rely on both the NPV and the IRR if two
conditions are met. First, if projects are compared using the NPV, a discount
rate that fairly reflects the risk of each project should be chosen. There is no
problem if two projects are discounted at two different rates because one project
is riskier than the other. Remember that the result of the NPV is as reliable as
the discount rate that is chosen. If the discount rate is unrealistic, the decision
to accept or reject the project is baseless and unreliable. Second, if the IRR
method is used, the project must not be accepted only because its IRR is very
 high. Management must ask whether such an impressive IRR is possible to
maintain. In other words, management should look into past records, and
existing and future business, to see whether an opportunity to reinvest cash
flows at such a high IRR really exists. If the firm is convinced that such an IRR
is realistic, the project is acceptable. Otherwise, the project must be reevaluated
by the NPV method, using a more realistic discount rate.

Real options:

Real options analysis

Real options analysis has become important since the 1970s as option pricing
models have gotten more sophisticated. The discounted cash flow methods
essentially value projects as if they were risky bonds, with the promised cash flows
known. But managers will have many choices of how to increase future cash
inflows, or to decrease future cash outflows. In other words, managers get to
manage the projects - not simply accept or reject them. Real options analysis try to
value the choices - the option value - that the managers will have in the future and
adds these values to the NPV.

Ranked Projects

The real value of capital budgeting is to rank projects. Most organizations have
many projects that could potentially be financially rewarding. Once it has been
determined that a particular project has exceeded its hurdle, then it should be
ranked against peer projects (e.g. - highest Profitability index to lowest
Profitability index). The highest ranking projects should be implemented until the
budgeted capital has been expended.

Funding Sources

When a corporation determines its capital budget, it must acquire said funds. Three
methods are generally available to publicly traded corporations: corporate bonds,
preferred stock, and common stock. The ideal mix of those funding sources is
determined by the financial managers of the firm and is related to the amount of
financial risk that corporation is willing to undertake. Corporate bonds entail the
lowest financial risk and therefore generally have the lowest interest rate. Preferred
stock have no financial risk but dividends, including all in arrears, must be paid to
the preferred stockholders before any cash disbursements can be made to common
stockholders; they generally have interest rates higher than those of corporate
bonds. Finally, common stocks entail no financial risk but are the most expensive
way to finance capital projects.

BHEL:

BHEL is the largest engineering and manufacturing enterprise in India in the

energy-
related/infrastructure sector, today. BHEL was established more than 40 years ago,
ushering inthe indigenous Heavy Electrical Equipment industry in India - a dream
that has been more thanrealized with a well-recognized record of accomplishment
of performance. The company hasbeen earning profits continuously since 1971-72
and paying dividends since 1976-77.
BHEL manufactures over 180 products under 30 major product groups and caters
to coresectors of the Indian Economy viz., Power Generation & Transmission,
Industry,Transportation, Telecommunication, Renewable Energy, etc. The wide
network of BHEL's 14manufacturing divisions, four Power Sector regional centers,
over 100 project sites, eightservice centers and 18 regional offices, enables the
Company to promptly serve its customersand provide them with suitable products,
systems and services -- efficiently and at competitiveprices. The high level of
quality & reliability of its products is due to the emphasis on design,engineering
and manufacturing to international standards by acquiring and adapting some ofthe
best technologies from leading companies in the world, together with
technologiesdeveloped in its own R&D centers.
BHEL has already attained ISO 9000 and all the major units/divisions of BHEL
have beenupgraded to the latest ISO- 9001: 2000 version quality standard
certification for qualitymanagement. All the major units/division of BHEL have
been awarded ISO- 14001certification for environmental management system and
OHSAS- 18001 certification foroccupational health and safety management
systems.
BHELhas
•Installed equipment for over 90,000 MW of power generation -- for Utilities,
Captive and Industrial users.
•Supplied over 2,25,000 MVA transformer capacity and other equipment operating
in Transmission & Distribution network up to 400 kV (AC & DC).
•Supplied over 25,000 Motors with Drive Control System to Power projects,
Petrochemicals, Refineries, Steel, Aluminum, Fertilizer, Cement plants, etc.
•Supplied Traction electrics and AC/DC locos to power over 12,000 kms Railway
network.
•Supplied over one million Valves to Power Plants and other Industries.

BHEL including Transmission, Transportation, Telecommunication &

Renewable Energy -and Overseas business this enablesBHEL to have a strong
customer orientation, to be sensitive to his needs and respond quickly to the
changes in the market.
BHEL's vision is to become a world-class engineering enterprise, committed
to enhancing stakeholder value. The company is striving to give shape to its
aspirations and fulfill the expectations of the country to become a global player.
The greatest strength ofBHEL is its highly skilled and committed 43,500
employees.Continuous training and retraining, career planning, a positive work
culture and participative style of management – all these have engendered
development of a committed and motivated workforce setting new benchmarks in
terms of productivity, quality and responsiveness.

BHEL - CONTRIBUTION TO VARIOUS CORE SECTOR:

Power, Transmission & Distribution Sector
In the T&D sector, BHEL both leading equipment- manufacturer and a system-
integrator, BHEL- manufactured T&D products have a proven track record in India
and abroad.In the area of T&D systems, BHEL provides turnkey solutions to
utilities. Substation and shunt compensation installations set up by BHEL are in
operation all over the country. EHV level series compensation schemes have been
installed in KSEB, MSEB and POWERGRID networks. Complete HVDC systems
and state-of-the-art flexible AC transmission systems (FACTS) can be delivered by
BHEL. In the area of power distribution, BHEL provides turnkey solution for
improving systems efficiency and reducing losses through RPM of sub-stations,
SCADA and metering solutions, IT solutions etc.
•Industry Sector
Since its inception in 1982, the industry sector business has grown at an impressive
rate and today, contributes significantly to BHEL’s turnover. BHEL, today,
supplies all major equipment for the industries: AC/DC machines, alternators,
centrifugal compressors, special reactor columns, heat exchangers, pressure
vessels, gas turbine based captive, co-generation and combined-cycle power plants,
DG power plants, steam turbine and turbo-generators, complete range of steam
generators for process industries, solar photovoltaic systems, electrostatic
precipitators, fabric filters, etc. BHEL also provides solution for water
management system, coal and ash handling plants. The industries that serve
include steel, aluminum, fertilizers, refinery, petrochemicals, chemicals,
automobiles, cement, sugar, paper, mining, textile, etc.
Transportation Sector
In the transportation field, BHEL product range covers: AC locomotives, AC/DC
dual-voltage locomotives, diesel-electric shunting locomotives, traction motors and
transformers, traction electrics and controls for AC, DC and dual voltage EMUs,
diesel-electric multiple units, diesel power car and diesel electric locomotives,
battery powered vehicles and solution for urban transportation system including
electric trolley buses, LRT & MRTs.
A high percentage of the trains operated by Indian railways is equipped with
traction equipment and controls manufactured and supplied by BHEL.
THE CAPITAL BUDGETING PROCESS IN BHEL:
The important steps involved in the capital budgeting process are :-

• Project-generation

• Evaluation;

• Project-selection; and

• Project execution.
These steps are necessary, but more may be added to make the process more
effective. JoelDean has described ten specific elements in an orderly investment
programme which are asfollows:
•Creative search for profitable opportunities – The first stage in the capital
expenditure
programme should be the conception of a profit making idea. It may be rightly
called theorigination of investment proposals. To facilitate the origination of such
ideas, a periodicreview and comparison of earnings, costs, procedures and product
line should be made bythe management on a continuous basis.
•Long- run capital plans – When a specific proposal is made to management, its
consistency with the long-range plans of the company must be verified. It requires
the
determination of over-all capital budgeting policies before hand based upon the
projections
of short and long-run developments.
•Short- range capital budget – Once the timelines and priority of a proposal have
been
established, it should be listed on the one-year capital budget as an indication of its
approval.
•Measurement of project worth – This stage involves the tentative acceptance of
the
proposal with other competitive projects within the selection criteria of the
company. Smallprojects under a certain rupee amount could be approved by the
departmental head. Largerprojects should be ranked according to their profitability.
For project evaluation, differenttechniques may be used, such as, payback period,
accounting rate of return and discountedcash flow techniques.
Screening and selection – This stage involves the comparison of the proposal
with other projects according to criteria of the firm. This is done either by financial
manager or by a capital expenditure planning committee.
•Establishing priorities – Then comes the stage of establishing the priorities.
When the accepted projects are put in priority, it facilitates their acquisition or
construction ,avoid costly delays and serious cost overruns.
Final approval – Once the financial manager has reviewed the projects, he will
recommend a detailed programme, both of capital expenditures and of source of
capital to meet the meet them, to the top management. Possibly, the financial
manager will present several alternative capital-expenditure budget to the top
management, it will finally approve the capital budget for the firm.
•Forms and procedures – This is a continuous phase that involves the preparation
of reports for every other phase of the capital expenditure programme of the
company.
•Retirement and disposal – This phase marks the end of the cycle in the life of a
project. It involves more than the recovery of the original cost plus an adjustment
for replacement programmes. The old assets should be sold and realized sale price
should be used for replacement financing.
•Evaluation – An important step in the process of capital budgeting is an
evaluation of theprogramme after its implementation. Such evaluation has also the
advantage of forcing departmental heads to more realistic in their approach and
careful in actual execution of the projects.
ANALYSIS:

Turnover for the year has touched a new high for the fourth year in succession
thereby reaching the figure of Rs. 14410 Cr against Rs. 10336 Cr in 2004-05, an
increase of 39.0 %.
•Value addition for the year 2005-06 stood at Rs. 4254 Cr against Rs. 5459 Cr for
theyear 2004-05, registering an increase of 28.3 %.
•Profit before tax for the year stood at Rs. 2484 Cr and is higher by 57.0 % as
comparedto the Rs. 1582 Cr in 2004-05.
•Profit after tax at Rs. 1621 Cr has increased by 70.0 % over the previous years of
Rs.953 Cr.
•Net worth increased by Rs. 7278 Cr to Rs. 6027 Cr.
•Debt-Equity Ratio improved from 0.09 in 2004-05 to 0.08 in 2005-06.