REVIEW OF LITERATURE

An efficient allocation of capital is the most important finance function in modern times.
It involves decisions to commit firms funds to long-term assets. Such decisions are tend to
determine the value of company/firm by influencing its growth, profitability & risk.
Investment decisions are generally known as capital budgeting or capital expenditure
decisions. It is clever decisions to invest current in long term assets expecting long-term benefits
firms investment decisions would generally include expansion, acquisition, modernization and
replacement of long-term assets.

Such decisions can be investment decisions, financing decisions or operating decisions.

Investment decisions deal with investment of organizations resources in Long tern (fixed) Assets
and / or Short term (Current) Assets. Decisions pertaining to investment in Short term Assets fall
under Working Capital Management. Decisions pertaining to investment in Long term Assets
are classified as Capital Budgeting decisions.

Capital budgeting decisions are related to allocation of investible funds to different long-term
assets. They have long-term implications and affect the future growth and profitability of the
firm.

In evaluating such investment proposals, it is important to carefully consider the expected

benefits of investment against the expenses associated with it.Organizations are frequently faced
with Capital Budgeting decisions. Any decision that requires the use of resources is a capital
budgeting decisions. Capital budgeting is more or less a continuous process in any growing
concern.

For Example: Purchase of Land is an example of Capital Budgeting decision. Similarly

replacement of outdated equipment with modern machines, purchase of a brand or business,
computerization and networking the organization, investment in research and development of a
product launch of a major promotional campaign etc are all example of Capital Budgeting
decisions.
However, in all cases, the decisions have a long-term impact on the performance of the
organization. Even a single wrong decision may in danger the existence of the firm as a
profitable entity.
IMPORTANCE OF CAPITAL BUDGETING:
There are several factors that make capital budgeting decisions among the critical decisions to be
taken by the management. The importance of capital budgeting can be understood from the
following aspects of capital budgeting decisions.

1. Long Term Implications: Capital Budgeting decisions have long term effects on the risk
and return composition of the firm. These decisions affect the future position of the firm
to a considerable extent. The finance manger is also committing to the future needs for
funds of that project.
2. Substantial Commitments: The capital budgeting decisions generally involve large
commitment of funds. As a result, substantial portion of capital funds is blocked.
3. Irreversible Decisions: Most of the capital budgeting decisions are irreversible
decisions. Once taken the firm may not be in a position to revert back unless it is ready to
absorb heavy losses which may result due to abandoning a project midway.

4. After the Capacity and Strength to Compete: Capital budgeting decisions affect the
capacity and strength of a firm to face competition. A firm may loose competitiveness if
the decision to modernize is delayed.

PROBLEMS & DIFFICULTIES IN CAPITAL BUDGETING:

1. Future uncertainty: Capital Budgeting decisions involve long-term commitments. There
is lot of uncertainty in the long term. The uncertainty may be with reference to cost of the
project, future expected returns, future competition, legal provisions, political situation
etc.
1. Time Element: The implications of a Capital Budgeting decision are scattered over a long
period. The cost and benefits of a decision may occur at different point of time. The cost of a
project is incurred immediately. However, the investment is recovered over a number of
 years. The future benefits have to be adjusted to make them comparable with the cost. Longer
the time period involved, greater would be the uncertainty.
3. Difficulty in Quantification of Impact: The finance manger may face difficulties in
measuring the cost and benefits of projects in quantitative terms.
Example: The new product proposed to be launched by a firm may result in increase or
decrease in sales of other products already being sold by the same firm. It is very
difficult to ascertain the extent of impact as the sales of other products may also be
influenced by factors other than the launch of the new product.

ASSUMPTIONS IN CAPITAL BUDGETING:

The Capital Budgeting decision process is a multi-faceted and analytical process. A number of
assumptions are required to be made.

1. Certainty with respect to cost & Benefits: It is very difficult to estimate the cost and
benefits of a proposal beyond 2-3 years in future.
2. Profit Motive : Another assumption is that the capital budgeting decisions are taken with
a primary motive of increasing the profit of the firm.

The activities can be listed as follows:

Dis-investments i.e., sale of division or business.
Change in methods of sales distribution.
Undertakings an advertisement campaign.
Research & Development programs.
Launching new projects.
Diversification.
Cost reduction.

FEATURES OF INVESTMENT DECISIONS:

 The exchange of current funds for future benefits.
The funds are invested in long-term assets.
The future benefits will occur to the firm over a series of years.

IMPORTANT OF INVESTMENT DECISIONS:

They influence the firms growth in long run.

They effect the risk of the firm.
They involve commitment of large amount of funds.
They are irreversible, or reversible at substantial loss.
They are among the most difficult decisions to make.

TYPE OF INVESTMENT DECISIONS:

Expansion of existing business.
Expansion of new business.
Replacement & Modernization.

INVESTMENT EVALUATION CRITERIA:

Estimation of cash flows.

Estimation of the required rate of return.
Application of a decision rule for making the choice.

Consideration of cash flows is to determine true profitability of the project and it is an

unambiguous way of identifying good projects from the pool. Ranking is possible it should
recognize the fact that bigger cash flows are preferable to smaller ones & early cash flows are
 referable to later ones I should help to choose among mutually exclusive projects that which
maximizes the shareholders wealth. It should be a criterion which is applicable to any
considerable investment project independent of other.There are number of techniques that are
in use in practice. The chart of techniques can be outlined as follows:

Capital Budgeting Techniques:

Traditional Approach Modern Approach

(or) (or)
Non-Discounted Cash Flows Disconnected Cash Flows

Pay Back Period (PB) Net Present Value (NPV)

Accounting Rate of Return (ARR) Internal Rate of Return

Profitability Index (PI)
Discounted Payable Period

NET PRESENT VALUE :

The Net Present value method is a classic economic method of evaluating the investment
proposals. It is one of the methods of discounted cash flow. It recognizes the importance of time
value of money.

It correctly postulates that cash flows arising of different time period, differ in value and
are comparable only when their equivalent i.e., present values are found out.
The following steps are involved in the calculation of NPV:
Cash flows of the investment project should be forecasted based on realistic assumptions.
An appropriate rate of interest should be selected to discount the cash flows, generally
this will be the Cost of capital rate of the company.
The present value of inflows and out flows of an investment proposal, has to be computed
by discounting them with an appropriate cost of capital rate.
The Net Present value is the difference between the Present Value of Cash inflows and
the present value of cash outflows.
Net present value should be found out by subtracting present value of cash outflows from
present value of cash inflows. The project should be accepted if NPV is positive.

NPV = Present Value of Cash inflow Present value of the cash outflow

Acceptance Rule:
Accept if NPV > 0
Reject if NPV < 0
May accept if NPV = 0
One with higher NPV is selected.

INTERNAL RATE OF RETURN METHOD:

 The internal rate of return (IRR) method is another discounted cash flow technique .This
method is based on the principle of present value. It takes into account of the magnitude &
timing of cash flows.

IRR nothing but the rate of interest that equates the present value of future periodic net
cash flows, with the present value of the capital investment expenditure required to undertake a
project.

The concept of internal rate of return is quite simple to understand in the case of one-
period project.

Acceptance Rule:

Accept if r > k
Reject if r < k
May accept if r = k

where r = rate return

k = opportunity cost of capital

PROFITABILITY INDEX (OR) BENEFIT COST RATIO:

 Yet another time-adjusted method of evaluating the investment proposals is the benefit-
cost (B/C) ratio of profitability index PI). It is benefit cost ratio. It is ratio of present value of
future net cash inflows at the required rate of return, to the initial cash outflow of the investment.

Present Value of Cash inflows

PI = -----------------------------------------
Present Value of Cash outflows

Acceptance Rule :

Accept if PI > 1
Reject if PI < 1
May accept if PI = 1

Profitability Index is a relative measure of projects profitability.

PAY BACK PERIODE METHOD:

One of the top concerns of any person or organization investing a large amount of money
would be the time by which the money will come back. The concern making the investment
would want that at least the capital invested is recovered as early as possible. The pay back
 period is defined as the period required for the proposals cumulative cash flows to be equal to
its cash outflows. In other words, the payback period is the length of time required to recover
the initial cost of the project. The payback period is usually stated in terms of number of years.
It can also be stated as the period required for a proposal to break even on its net investment.
The payback period is the number of years it takes the firm to recover its original investment
by net returns before depreciation, but after taxes.
If project generates constant annual cash inflows, the pay back period is completed as follows:

Initial Investment
Pay Back = ------------------------
Annual cash inflow
In case of unequal cash inflows, the payback period can be found out by adding up the
cash inflows until the total is equal to initial cash outlay.

Acceptance Rule:
Accept if calculated value is less than standard fixed by management otherwise reject it.
If the payback period calculated for a project is less than the maximum payback period
set up by the company it can be accepted.
As a ranking method it gives highest rank to a project which has lowest pay back period,
and lowest rank to a project with highest pay back period.

DISCOUNTED PAY BACK PERIOD:

One of the serious objections to pay back method is that it does not discount the cash flows.
Hence discounted pay back period has come into existence. The number of periods taken in
recovering the investment outlay on the present value basis is called the discounted pay back
period.
Discounted Pay Back rule is better as it does discount the cash flows until the outlay is
recovered.
ACCOUNTING RATE OF RETURN (OR)
AVERAGE RATE OF RETURN (ARR) :

It is also known as return on investment (ROI). It is an accounting method, which uses the
accounting information revealed by the financial statements to measure the profitability of an
investment proposal. According to Solomon, ARR on an investment can be calculated as the
ratio of accounting net income to the initial investment i.e. .

Average Net Income

ARR = ---------------------------
Average Investment

Average Income = Average of after tax profit

Average Investment = Half of Original Investment

Acceptance Rule:

Accept if calculated rate is higher than minimum rate established by the management.
It can reject the projects with an ARR lower than the expected rate of return.
This method can also help, the management to rank the proposals on the basis of ARR.
A highest rank will be given to a project with highest ARR, whereas a lowest rank to a
project with lowest ARR.
 CAPITAL BUDGETING METHODS IN PRACTICE
In a study of the capital budgeting practices of fourteen medium to large size companies
in India, it was found tat almost all companies used by back.

With pay back and/or other techniques, about 2/3 rd of companies used IRR and about 2/5th
NPV. IRR s found to be second most popular method.

Pay back gained significance because of is simplicity to use & understand, its emphasis
on the early recovery of investment & focus on risk.

It was found that 1/3rd of companies always insisted on computation of pay back for all
projects, 1/3rd for majority of projects & remaining for some of the projects.
 Reasons for secondary of DCF techniques in India included difficulty in understanding &
using threes techniques, lack of qualified professionals & unwillingness of top
management to use DCF techniques.

One large manufacturing and marketing organization mentioned that conditions of its
business were such that DCF techniques were not needed.

Yet another company stated that replacement projects were very frequent in the company,
and it was not considered necessary to use DCF techniques for evaluating such projects.
techniques in India included difficulty in understanding & using threes techniques, lack
of qualified professionals & unwillingness of top management to use DCF techniques.

PROCESS

CAPITAL BUDGETING PROCESS:

Atleast five phases of capital expenditure planning & control can be identified:

Identification ( or Organization ) of investment opportunities.

Development of forecasts of benefits and costs.
Evaluation of the net benefits.
Authorization for progressing and spending capital expenditure.
Control of capital projects.

INVESTMENT IDEAS:
Investment opportunities have to be identified or created investment proposals arise at
different levels within a firm.

Nature of Idea Level

Cost reduction ------
Replacement Plant Level
Process/Product Development ( 50% in India cover this level)
Expansion Top management
Diversification In India, it is insignificant
New Product Marketing Dept., ( or) Plant Manager

Replacing an old
Machine ( or)
Improving the Factory Level.
Production techniques.

Investment proposals should be generated to employ the firms funds fully well & efficiently.
FORECASTING :

Cash flow estimates should be development by operating managers with the help of
finance executives. Risk associated should be properly handled. Estimation of cash flows
requires collection and analysis of all qualitative and quantitative data, both financial and non-
financial in nature. MIS provide such data.

Correct treatment should be given to :

Additional working capital

Sale proceeds of existing assets.
Depreciation
Financial flows (to be distinguished from operation flows)

EVALUATION :
Group of experts who have no ake to grind should be taken in selecting the methods of
evaluation as NPV, IRR, PI, Pay Back, ARR & Discounted Pay Back.

Pay Back period is used as Primary method & IRR/NPV as Secondary method in
India. The following are to be given due importance.

For evaluation, minimum rate of return or cut-off is necessary.

Usually if is computed by means of weighted Average cost of Capital (WACC)
Opportunity cost of capital should be based on risky ness of cash flow of investment
proposals.
Assessment of risk is an important aspect. Sensitivity Analysis & Conservative for
costs are two important methods used in India.
AUTHORIZATION:
 Screening and selecting may differ from one company to another. When large sums are
involved usually final approval rests with top management. Delegation of approval authority
may be effected subject to the amount of outlay. Budgetary control should be rigidly exercised.

CONTROL AND MONITORY:

A Capital projects reporting system is required to review and monitor the performance of
investment projects after completion and during their life. Follow up comparison of the actual
performance with original estimates to ensure better forecasting besides sharpening the
techniques for improving future forecasts. As a result company may re-praise its projects and
take necessary action.

Indian Companies use regular project reports for controlling capital expenditure reports may be
quarterly, half-yearly, monthly, bi-monthly continuous reporting..

Expenditure to date
Stage and physical completion
Approved total cost
Revised total cost
DECISION MAKING LEVEL:

For planning and control purpose three levels of Decision making have been identified :

Operating
Administrative
Strategic

OPERATING CAPITAL BUDGETING:

Includes routine minor expenditure, as office equipment handled by lower level

management.
ADMINISTRATIVE CAPITAL BUDGETING:

Falls in between these two levels involves medium size investments such as business
handled by middle level management.

STRATEGIC CAPITAL BUDGETING:

Involves large investment as acquisition of new business or expansion in a new time of

business, handled by top management unique nature.

Long Term Capital Budgeting In BHEL

PRE INVESTMNET STAGE:

In a planned economy, as in India, the identification of public sector projects needs to be

done within the overall framework of national the sectoral planning. All projects of every sector
need to be identified scientifically at the time of plan formulation. In actual practice, however, it
is observed that identification stage is the most neglected stage of the project planning.

The five year plans indicate the broad strategy of planning economic growth rate and
other basic objectives to be achieved during the plan period. The macro level planning exercise
undertaken at the beginning of every five year plan indicates broadly the role of each sectors
physical targets to be achieved and financial outlays, which could be made available for the
development of the sector during the plan period.
 The identification of a project in the Five Year Plan is not the sanction of the project for
implementation. It provides only the green signal for the preparation of feasibility report (FR0
for appraisal and investment decision. A preliminary scrutiny of the FR of the project is done in
the Ministry and thereafter copies of the feasibility report are submitted to the appraising
agencies, viz., Planning Commission, Bureau of Public Enterprises and the Plan Finance
Division of the Ministry of Finance.

Thus the organizational responsibility for identifying these projects rests with the
concerned administrative ministry, in consultation with its public enterprises.

The essential steps for project identification and preparation relates to studying (i) imports
(ii) substitutes (iii) available and raw material (iv) available technology and skills (v) inter-
industry relationship (vi) existing industry (vii) development plans (viii) old projects etc.

It may be mentioned that in actual practice, these steps are hardly scientifically studied
and followed by the administrative ministry public sector undertaking at the time of project
identification. The public sector projects many a time come spontaneously on the basis of ideas
and possibilities of demand or availability of some raw materials and not an outcome of
scientific investigation and systematic search for feasible projects.

PROJECT FORMULATION :

The second stage of Project Cycle viz. Project Formulation, is a pre-investment

exercise to determine whether to invest, where to invest, when to invest and how much to invest.
The project/feasibility reports are meant to provide required information for assessing technical,
financial, commercial, organization and economic viability of the project planning in India,
mainly because of relatively late realization of its importance. As a result, the investment
decisions for large projects in the past were taken on half-baked and ill-conceived projects and
time-over runs and cost-over runs of public sector projects have become a regular feature rather
than exception.
In early seventies along with the setting up of the Public Investment Board (PIB) the
Government created a new project Appraisal Division in the Planning Commission. This
Division prepared and circulated Guidelines for preparing Feasibility Reports of Industrial
Projects in 1974.
This guidelines, unlike earlier manual, indicates all the information and data required to be
presented and analysed in the feasibility report, so as to enable the appraisal agency to carry out
(i) technical analysis to determine whether the specification of technical parameters are
realistic, (ii) financial anaylsis to determine whether the proposal is financially viable, (iii)
commercial analysis to determine soundness of the product specifications, marketing plans and
organization structure and (iv) economic analysis, to determine whether a project is worthwhile
from the point of view of nation and economy as a whole.

The guidelines describes in details, the information required to be given and analysed on
the following issues : (a) general information of the sector, (b) objective of the proposal, (c)
alternative ways, if any of attaining the objectives and better suitability of the proposed project,
(d) project description gestation period, costs, technology proposed, anticipated life of the
project etc., (e) demand analysis, total demand / requirements of the country, including
anticipated imports and exports and share of the proposed project, (f) capital costs and norms
assumed, activity wise and year wise, (g) operating costs and norms, (h) revenue and benefits
estimation etc.

PROJECT APPRAISAL :
The appraisal of the project follows the formulation stage. The objective of the appraisal
process is not only to decide whether to accept or reject the investment proposal, but also to
recommend the ways in which the project can be redesigned or reformulated so as to ensure
better technical, financial, commercial and economic viabilities.

The project appraised which is an essential tool for judicious investment decisions and
project selection is a multi-disciplinary task. But many a times this is considered doubt, have
played an important role in contributing systematic methods for forecasting the future and
evolving appraisal methods to quantify socials costs and benefits, but they alone can not carry
out complete appraisal of an investment proposal.
 The need for project appraisal and investment decisions based on social profitability
arises mainly because of the basic characteristics of developing countries limited resources for
development and multiple needs objective of planning being Economic Growth with Social
Justice. The project appraisal is a convenient and comprehensive fashion to achieve, the laid
down objectives of the economic development plan. The appraisal work presupposes availability
of a certain minimum among of reliable and up to date data in the country, as well as the
availability of trained persons to carry out the appraisal analysis.

As stated earlier the investment decision of public sector projects are required to be taken within
the approved plan frame work. The Project Appraisal Division (PAD) that prepares the
comprehensive appraisal note of projects of Central Plans was therefore set up in Planning
Commission. The Finance Ministry issues expenditure sanction for all investment proposals
within the frame work of annual budget. The plan Finance Division and the Bureau of Public
Enterprises of the Finance Ministry are also required to examine and give comments on the
investment proposals of public.
 CONCLUSIONS

Every organization has pre-determined set of objective and goals, but reaching
those objectives and goals only by proper planning and executing of the plans
economically.

Within a Short span of its existence, the corporation has commissioned 19502
MW as on 31st March, 2016 with an operating capacity of 19.9%. BHEL today
generate 24.9% of nations electricity. BHEL is presently executing 12 Cement
manufacturing Projects and 6 Gas based cement manufacturing projects with a
total approved capacity of 29,935 MT as on 31st March 2017