CAPITAL BUDGETING

INTRODUCTION

The term capital budgeting refers to long term planning for proposal capital
outlay andtheir financial. It includes raising long term funds and their utilization. It may
be defined as afirm’sformalprocessofacquisitionandinvestmentofcapital.
Capital budgeting may also be defined as “The decision making process by
which afirm evaluates the purchase of major fixed assets “It involves firms decision to
invests its current funds for addition modification and replacement of fixed assets.
Its deals exclusively with investment proposals which are essentially long term projects
and are concerned with the allocation of firms scarce financial resources among
theavailable market opportunities.
Someoftheexamples of capitalexpenditureare.
I. Costof acquisitionofpermanentassetsaslandandbuildings.
II. Costof additions, expansion,improvementas alterationin thefixedassets.
III. R&Dprojectscost,etc.,

Definition:
It is “The process of investment of firms current funds most efficiently in long
termassetswitha viewto earnprofits over a seriesoffears.

“Capital Budgeting is long term planning for financing proposed capital outlays.

.THorngren“ Capital budgeting is concerned with a location of the firms scare financial
resources among the available market opportunities .The consideration of investment
opportunities involves the comparison of the expected future streams of earning from a
project with Immediate and subsequent of expenditure for it.

In any grouping concern, capital budgeting is more as less a continuous

process andit is carried out by different functional areas of management such as
production, marketing engineering, financial management etc all the relevant functional
departments play a crucialrolein the capitalbudgeting decisionareconsidered.

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 In role of a finance manager in the capital budgeting basically lies in the process
ofcritically and in depth analysis and evaluation of various alternatives proposals and
then toselect one out of these. As already stated, the basic objective of financial
management is to maximize the wealth of the share holders, therefore the objectives to
capital budgeting is toselect those long term investment projects the are expected to
make maximum contribution to the wealth of the shareholders in the long run.

FEATURES OF CAPITAL BUDGETING

The important features which distinguish capital budgeting decision in other day to
day decisions are.

 Capital budgeting decision involves the exchange of current funds for the benefits
to be achieved in future.

 The future benefits are expected and are to be realized over a series of year.

 The funds are invested in non-flexible long term funds.

They have a long term and significant effect on the profitability of the concern.

 They involve huge funds they are irreversible decisions .They are strategic decision
associated with high degree ofrisk.
IMPORTANCE OF CAPITAL BUDGETING

The importance of capital budgeting can be understood from the facts that an
unsound investment decision may prove to be fatal to the very existence of the
organization.

The importance of capital budgeting arises mainly due to the following.

1. Large investment:
Capital budgeting decision, generally involves large investment of funds .But
the funds available with the firms are scare and the demand for funds for exceed
resources.Hence It is very important for a firm to plan and controls its capital
expenditure.

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 2. Long term commitment of funds:
Capital expenditure involves not only large amount of funds but also funds for
longterm or a permanent basis. The long-term commitment of funds increases the
financial risk involved in the investment decision.
3. Irreversible nature:
The capital expenditure decision is of irreversible nature.Once,the decision for
difficult to impose of the seassets with out in curring heavy losses.
4. Long term effect on profitability:
Capital budgeting decision has a long term and significant effect on the
profitability ofa concern. Not only the present earning of the firm is affected by the
investment in capitalassets but also the future growth and investment decision taken
today.Capital budgeting decision has almost had importance to avoid over or under
investment in fixed assets.
5. Difference of investment decision:
The long term investment decision are difficult to be taken because
uncertainties of future and higher degree of risk.

6. Importance
Investment decision through taken individual concern is of national importance
because it determines important economic activities and economic growth.

KINDS OF CAPITAL BUDGETING

Every capital budgeting decision is a specific and with given parameters and
there fare almost in finite number of types or forms of capital budgeting decision may
occur. Ever if the samedecision being considered by the same firm at two different
point of time, the decision considerationsmay change as a result of change in any of the
variable. However, the different type of capital budgeting under taken from time to time
by different firms can be classified on a number of dimension. Some projects affect
other projects of the firms is considering and analyzing. At the otherextreme, some
proposals are prerequisite for other projects. The projects may also be classified as
revenue generating or cost reducing projects can be categorized as follow:

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 From the point of view of the firm’s existence:
The capital budgeting decision may be taken by a newly incorporated firm or by
an already existing firm.
Newfirm:
A newly in corporated firm may be required to take different decision such as
selectionof a plant to be installed, capacity utilization at initial stage, to set up or not
simultaneouslytheancillaryunitetc.
a) Existing firm: A firm which is already existing may be required to take various
decisions from time to time meet the challenge of competition or changing
Environment.
i) Replacement and Modernization decision:

This is a common type of a machineries eventually required replacement .If the

existing plant to be replaced because of the economic life of the plant is over, then
thedecision. However, if an existing plant to be replaced because of the economic life
of theplant is over, then the decisions may be known as a replacement decision.
However, if anexisting plant to be replaced because it has become technologically out
dated (through theeconomic life may not be over) the decision any be know as a
modernization decision. In case of are placement decision ,the objective store the same
as higher capacity where as in case of modernization decision, the objectives is to
increase the efficiency and/or costraductions .In general,the replacement decision and
the modernization decision are also know as costraduction decisions.
ii) Expansion
Sometimes, the firms may be interested in increasing the installed production
capacity so as to increase the market share. In such a case, the finance manager
is required to evaluate the expansion programin term of marginal costs and
managerialbenefits.

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 iii) Diversification

Some times ,the firm may be interested to diversity in to new product lines ,new
markets production of spares part etc. in such a case, the finance manager is required to
evaluate the only the marginal cost and benefits, but also the effect of diversification on
theexisting market share and profitability. Both the expansion and diversification
decisions may be also known as revenue increasing decisions.

II. From the point of view of Decision situation

The capital budgeting may also be classified from the point of view of the
decision situation as follows:
i) Dependent project decision
This is a fundamental decision in capital budgeting. It is also called as accept
rejectcriterion. If the project is accepted, the firm invests in it. In general all these
proposals, which field at rate of return greater than certain required rate of return on
cost of capital are accepted and the restare rejected. By applying this criterion all
independent projects with one in such a way that the acceptance of one precludes the
possibility of the acceptance ofanother. Under the accept reject decision all independent
projects that satisfy the minimum investment criterion should be improvement.
ii) Mutually Exclusive project decision
Mutually exclusive project are those, which complete with other projects in
such away that the acceptance of one will exclude the acceptance of the other
projects .The alternatively are mutually exclusive and only one may be chosen.
Suppose a company is intending to buy each with a different initial investment adopting
costs. The three machines represent mutually exclusive alternatives ads only one of
these can be selected. It may berated hear that the mutually exclusive project decisions
are not independent of the acceptrejectdecisions.
iii) Capital rationing decision
In a situation where the firm has unlimited funds all independent investment
proposalsyielding return greater than some pre determined levels are accepted.
However this situation does not prevail in most of the business firms in actual practice.
They have a fixed capital budget.

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 A large number of investment proposals complete for these limited funds, the firm must
there fore ration them. The firm allocates funds to project in a manner that it maximizes
long run returns this rationing refers to a situation in which a firm has more acceptance
investment than it can finance. It is concerned with the accept-reject decision capital
rationing employees ranking of the acceptable investment projects.
The project can be ranked on the basis of a pre determined criterion such as the
rate of return.The project is ranked in the descending order of the rate of return.
Problems and Difficulties in Capital Budgeting:
The problems in capital budgeting decision may be as follows:
a). Future uncertainty:
Capital budgeting decision involves long term commitments. However, there is
lot of uncertainty in the long-term uncertainty may be with reference to cost of the
project, future expected returns, future competition, legal provision, political situation
etc.
b). Time Element :
The implication of a capital budgeting decision is scattered over long period.
The costand benefit of a decision may occur at different point of time. The cost of
project id incurredimmediately. However, the investment is recovered over number of
fears. The future benefit has to be adjusted to make them comparable with the cost.
Long the time period involved ,greater would be the uncertainty.
c). Difficulty in Qualification of impact
The finance manager may face difficulties in measuring the cost and benefits of
projects in quantitative term .For example ,the new product proposed to be launched by
a firm may result in increase or decrease in sale of other products already being sold by
the firm. It is very difficult to ascertain the extent of impact very difficult to ascertain
the extent of impact as the sales of the other than the launch of the new products.

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 Assumption in capital budgeting
The capital budgeting decision process is a multi-faceted and analytical process.
Anumber of assumptions are required to be made. The assumption constitutes a general
set of condition with in which the financial aspects of different proposals are to be
evaluated. Some of the se assumptions are.
1. Certainty with respect to cost and benefits
It is very difficult to estimate the cost and benefit of a proposal beyond 2-3 year
infuture. However, for a capital budgeting decision, it is assumed that the estimate of
cost and benefits are reasonably accurate and certain.
2. Profit motive
Another assumption is that the capital budgeting decisions are take with a
primary motive of increasing the profit of the firm. No other motive or goal influences
the decision of the finance manager.
3. No capital Rationing
The capital budgeting decision in the present chapter assume that is no scarcity
of capital. It assumes that a proposals will be accepted or rejected in the strength of its
merits alone. The proposals will not be considered in combination with other proposals
to the maximum utilization of available funds.
Capital budgeting process
Capital budgeting is complex process as it involves decision relating to the
investment of current funds for the benefits for the benefits to be achieved in future and
the future are always uncertain. However, the following procedure may be adopted in
the process of capital budgeting.
i) Identification of investment proposals:
The capital budgeting process begins with the identification of investment
proposals .The proposals about potential investment opportunities may origin at either
form top management or form any officer of the organization. The departmental head
analysis various proposals in the light of the corporate strategies and submit proposals
to the capital expenditure planning.

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 ii) Screening proposals
The expenditure planning Committee screens the various proposals received
from different departments. The committee reviews these proposals from various angles
to ensure that these are in accordance with the corporate strategies or selection criterion
of the firm and also do not lead departmental imbalances.
iii) Evaluation of various proposal
The next step in the capital budgeting process is to various proposals. The
method which may be used for this purpose such as pay back period method ,rate of
return method,
N.P.Vand I.R.R.etc.
iv) Fixing priorities
After evaluating various proposals, the unprofitable uneconomical proposals
may be rejected and it may not be possible for the firm to invest immediately in all the
acceptable proposals due to limitation of funds. Therefore, it essential to rank the
project/proposals after considering urgent risk and profitability involved in there.
Final Approval and Preparation of Capital Expenditure Budget
Proposals meeting the evaluation and other criterion are approver to be
including in the capital expenditure budget. The expenditure budget lays down the
amount of estimated to be incurred of fixed assets during the budget period.
Implementing proposals
Preparation of a capital expenditure budget and incorporated of a particular
proposal in the budget doesn’t ’authorize to go a head with the implementation of the
project.
A request for the authority to spend the amount should be mode to the capital
expenditure committee ,which reviews the profitability of he project in the changed
circumstances. Responsibilities should be assigned while implementing the project in
orders avoid unnecessary delays and cost over runs. Network technique like PERT and
CPM can be applied to control and monitor the implementation of the project.

Performance Review
The lost stage in the process of capital budgeting is the evaluation of the
performance of the project the evaluation is made by comparing actual and budget
expenditures and also by comparing actual anticipated returns .The unfavorable
variances, if any should be looked

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 In to and the causes of the same be identified so that corrective saction may be taken in
future.
Methods for Techniques of Capital Budgeting
There are many method for the evaluating the profitability of investment
proposals the various commodity used method sare

Techniques of capital budgeting

Traditional Method Modern method

1. Payback period 1.N .P.V
2. Accounting Rate of Return 2.I.R.R

Traditional Methods:-
1. Payback period method(P.B.P)
2. Accounting Rate of return
method (A.R.R)Modern or
Discounting techniques:
1. Net present value method(N.P.V)
2. Internal Rate of Return method(I.R.R)
3. Profitability index method(P.I)
1. Payback period method(PBP)
The number of years required to recover the initial outlay of the investment is
called payback.
PBP = Cashout lay Annualnet cashinflows

This formula can be applicable when the cash inflows are even are equal for a given
period of time.

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 Acceptance rule:

 Accept if PB<Standard pay back

 Reject if PB>standard pay back

Merits Demerits
1. East to understand the and compute 1.Ignores the time
value of money and in expensive to use
2. Emphasizes liquidity 2.Ignores cash flows
occurring after the pay
back period
3 East and crude way to cope with 3. Net a Measure of
profitability Risk
4. Uses cash flows in formation 4.No objective way to determine the
Standard pay back
5. No realation
principle

Discount pay back:

The number of year required in recovering the cash outlay on the present value
basis is the discounted payable period.Exceptusing discounted the demerits of pay back
method.

Accounting rate of return:

An average rate of return found by dividing the average net operating profit by
the average investment. The accounting rate of return is also known as called average
rate of return It is a superior method then pay back period method .This method uses
certain accounting information. In the problem the minimum required rate (or) cost of
capital will be given by using the data given the problem we have to calculate A.R.R
.This calculated
A.R.R. is compared with the minimum required rate.

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 Average rate Of return = Average income x100
Average investment

Acceptance rule:
i. Average if ARR > Minimum rate

ii. Reject if ARR < Minimum rate.

Average Income:
Net income after all deductions during the life of the project by life of the project.

Average Investment:
Original x ½ (or) half the original investment.

Merits Demerits
 Uses accounting date with
 Ignores the time value of money
which executives are familiar.
 East to understand and calculate Does not
use cash flows
 Gives more weight age

II. Discounted cash flow techniques:

For evaluating the projects, most of the organizations are preparing to use
discounted cash flow techniques .The techniques are very qualitative because they have
strong theoretical base while calculating the cash in flows generated by the projects for
different years, their future value is discounted. According to a given discount rate.
This discounted value is considered for calculating and decision making.
Types:
They are three of discounted cash flow techniques are in practice. They are.
i) Net present value method(N.P.V)
ii) Profitability index (P.I)

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 iii) Internal rate of return (I.R.R)

i) Net present value method (N.P.V)

This is the most widely and company used method to evaluate the projects
under this method the given cash in flows are discounted according to the given
discounted factor value either the rupee realization value is given it is multiplied with
the cash in flows. In that respect to year. Later these values are to be added to arrive the
value of total of net present value of cash inflows.
The difference between P.V of cash flows and P.V of ash out flows in equal to
NPV the firms opportunity cost of capital being the discount rate.

Net present Value = P.V. Cash in flows - P.V. Cash out flows

Acceptance rule:
i) Accept if NPC>o(I e NPV is Positive)
ii) Reject if NPV<o(i.e., NPV is negative)
iii) Project may be accepted if NPV=0.

Merits Demerits
 Considered all cash flows -Requires estimates of cash flows
-Which is a tedious task
 \True measure of profitability Requires competition of the
-Opportunity cost
ofcapital which poses
practical difficulties.
 Based on the concept of the time -Sensitive to discount rates value of money

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 ii) ProfitabilityIndex:(P.I)

Another important technique under discounted cash flow techniques is

profitability index method per taking decision by using this method. Per taking decision
by using this method required the net values of both P.V. of cash in flows and P.V. of
cash out flows. It is an expention to N.P.V method. The nature of data used in both the
methods is same, the only differences is in the made of uses of such data.
The ratio is of the present value of the cash flows to he initial out lay is
profitability Index or benefit cost ratio.
 P.I.=P.V of cash in flows
P.V of cost out flows
Acceptance rule:
 Accept if PI>1.0
 Reject if PI<1.0
 Project may be accepted if PI=1.

Merits Demerits
 Considers all cash flows -Requires estimates of the
cash
 Recognizes the time value of money -At times falls Indicate correct choice
Between mutually
exclusive projective
 Relative measure of profitability
 Generally consistent with
the wealth maximization
principle

Capital Budgeting Methods in Practice

 In a study of the capital budgeting practices of fourteen medium to large size

companiesin India. It was found that all companies, except one, used payback with
payback and / orother techniques about two-thirds of companies used IRR and
about two-fifths NPV. IRR was found to these most popular method.

 The reasons for the popularity of payback in order of significance were stated to be

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 PENNACEMENT

Penna Cement Industries Limited (PCIL) was formed in year1991 by Mr.P.PrathapReddy.

First plant was commissioned in 1994 at Talaricheruvu village in Tadipatri Mandal of

Ananthapur district of Andhra Pradesh with initial capacityof 0.2mtpa.

Penna Cement Industries Limited is an ISO9001:2008Company.

Penna is well positioned for continued growth and market dominance because of its
vibrant leadership.Under the able leadership of founder promoter,Mr. P. Prathap
Reddy,the management has taken significant steps to renew and refresh the core
business of cement manufacturing for tomorrow ,making the company achieve greater
heights.

OurPlants

Penna Cement has operational plants and with plans for setting up grinding units and
packingunits at various locations which have strategic value. With total installed
capacity of 7 mtpa,Penna looks a head to serve its customers..

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 PENNA CEMENT INDUSTRIES LIMITED

RatingsAssigned

Facilities/Instruments Amount(Rs.crore) Ratings' Remarks

Long-termBankFacilities 572.41 ‘CAREA’ Re-affirmed
is,dinedIron,Rs.678.87crow)
(SingileA)
ShorttermRank Facilities 40.00 ‘CAREA1’ Re-affirmed

(AOne)
TotalFacilities 612.41

Rating Rationale

The ratings continue to draw strength from the experienced promoters, established track
record of the company,location advantage of manufacturing facilities ,healthy financial
position, firm raw material sourcing arrangement and established presence in the
southern region with strong brand recognition. The ratings are, however, constrained by
low capacity utilization, high exposure to group/subsidiary companies, volatile input &
fuel prices and moderate industry out look with over capacity in the region and sub
dued cement prices.Ability of the company to derive benefit from the expanded
capacity, capture market share in western region and garner better realizations in
Southern market are the key rating sensitivities.

Background

Penna Cement Industries ltd.(PCIL.),incorporated in1991,belongs to Nana group of

Hyderabad, Andhra Pradesh (A.P). It is, currently, engaged in manufacturing of
Ordinary Portland Cement (OPC) 53 grade & 43 grade & Pozzolona Portland cement
(PPC) with the product mix of OPC: PPC in the ratio of about 30:70 an& Portland Slag
Cement (PSC).PCIL.has, currently, installed capacity of 7 Million Tones p.a. (expanded
from 5 MTPA inMarch, 2011) al its existing manufacturing facilities, spread across
four locations in A.P.Besides ,it also has a coal bsed powergeneration plant with
capacity of 77MW(commissioned on Mar.1i,2010)which contributed about 7% of total
sales in FY13.

PCIL.sells its cement under the brand name and has presence in all the states of
Southern region as well as Maharashtra.

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 Credit Risk Assessment

Long-track record of the company: PCIL., the flag ship company of the Penna Group,
was promoted in1991with initial capacity of 0.2Million Tones p.a.(MTPA) atits cement
plant at Tadipatri , Andhra Pradesh. Over the years, the company expanded its cement
capacity significantly and at present it operates four cement plants in A.P., having
anaggregate cement capacity of 7.0 MTPA. Further, a wholly owned subsidiary of
PCIL. operated acement plant (capacity 1.0 MTPA) in UAE in Joint Venture with RAK
Investment Authority(RAKIA) of the Government of the UAE In FY13, the stake inthe
JV was sold off toRAK1A at profit of Rs.216.9 crore

Experienced promoters and management team: Penna group, promoted by Shri P.

NathanReddy is an established industrial house of South India having experience of
more than adecade. The group has diversified activities with presence in Cement,
Power Generation and Construction & Infrastructure Development. Besides, one of die
group company; Anorak Alumina Ltd.(AAL)is in the process of setting up Alumina
Refinery plant in which PCIL.is one of the core promoter. PCIL.is governed by an
experienced management team with theboard of directors comprising two promoter
directors, one executive director and three non-executive directors. The directors have
engineering and business management background with long standing industry
experience.

Location advantage of planks:The cement plants of PCIL. Have location advantage

interns of proximity to raw material sources (limestone mines, gypsum, flyash, etc)
and modes of transport (roads&rail).Resides,there cently commissioned plant
Tandur,R.Rdistrict,
A.P. is situated close to the State of Maharashtra and would cater to the said market,
which has relatively better realizations.The location advantage has important bearing on
the profitability, considering cement is a freight intensive industry with cost of
transportation of PCIL.being 25%of the total cost of sales..

Strong brand recognition: PCIL sells its cement under the brand name of ‘Penns’ and
has presence in all the states of Southern region as well as Maharashtra. It is the third
largest player (in terms of cement dispatched) in AP' region with market share of
around 10.12% inthe last two years. During FY 13, about 97% sales were made to the
Southern market (AP-45%.TamilNadu 19%,Karnataka 18%, Kerala 7.5% and the
remaining to Maharashtra ,Goa ,Pondicherry ,Bihar and Orissa.

Raw material and fuel sourcing arrangement :Raw material and power and fuel costs
comprise about 55% of the total cost of sales. PCIL.has limestone mines having reserve
of about 410 million tunes which is adequate to mast the requirements of the existing
plant

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 capacity for the next several decades. The other raw materials are available from the
localplayers. Coal is the4 major source of fuel and the same is mainly sourced from
Singareni Collieries Company Limited (SCCL.) with whom PCIL. has a Fuel Supply
Agreement (FSA)for around 5.99300 MT per annum which is adequate tomeet
itsrequirement. However,given that SCCL.provides only 75% it of the contracted
capacity, PCIL. has to also rely one-action/importers.

The major requirement of power is met from the AP State Electricity Board (APSEB)
and with the commencement of PCIL's power plant; certain requirement of power is
also met through captive consumption.

High exposure to group /subsidiary companies :PCILs exposure to group /associate

companies as on March 31, 2013 was Rs.495.4 crore (against Its.434.5 crore) in the
form of investments of Rs.278.3core(FYI2Rs.216.7core),corporate guarantee
Rs.163.7crore (FY12-Rs.194.4 crore), receivables Rs.29.3 crone (FY10 11.2 crore) and
loans and advances Rs.5.2crore(FY 12-12.2crore) accounting for about 54% of its
tangible net worth as on the same date.

Further, PCIL.has given undertaking to the consortium lenders of AAL to cover the
cost bythe way of loans or equity, in case of cost over run in the project. It has also
entered into share buy-back agreement with IFCI for investment
madebythelateredemptionofCumulative Redeemable Preference Share Of Rs.125.0
Crore issued by AA1& Subscribed byLIFC..

Decline in capacity utilization: Capacity utilization (CU) of cement declined in FY 13

fromFY 11 (from 82% in FY11 to 57% in FY12) due to lower production. particularly,
duringH1FY12 in view of sluggish demand in the market and overcapacity in the
region. PCILexpanded its cement capacity on March.27. 2011 but owing to lower
demand in the
market,couldnotreapbenefitoutofthesame,whichalsoresultedinlowerCU.WhichtheCUwa
satabout57%inH1FY13,duringthemonthsof OctoberandtillmidNovember,thecompany
was operating at about 60-65% capacity utilization Backed by relatively
higherdemandinthemarketandupwardmovement ofcementprices.

Healthy financial position: Net sales increased by about 13% in FY 13 over FY 12

backed byincreasedsalespricerealizationsofcement(particularly
duringH2FY12andrelativelyhigher prices fetched in regions other than A.P), despite
decline in quantum sales (thusleading to only 5% growth in cement sales) and also
higher sale from power "Unit whichcommenced operation in March, 2012 and full
benefit of which was available in FY12.PBILDT, however, declined by about 3.2% in
FY12 due to non recovery of fixed overheadsand rise in input fuel prices which could
not be passed on to the customers due to sluggishdemand. Reduced PBILDT coupled
with significant rise in capital charge on
commissioningofthecementexpansionprojectinMarch,2012resultedinasharpdeclineinPA
T(after

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SANSKRITHI SCHOOL OF BUSINESS
 defd.tax)byabout30%inFYIIfromFY11. Marginsalsoshrunkaccordingly.

Capital structure was comfortable with overall gearing ratio below unity as on Mar. 31,
2012.The improvement wasbackedby repayment ofterm loans;particularly short term
loanavailedinFY12 and accretion ofprofits.

During half year ended Sept. 30,2012 (H1FY13), PCIL. achieved total income of
Rs.761.8Crore PBT of about Its.161.4 crore and PAT of about Rs. 108.1 core. The
operations of thecompany witnessed significant improvement during the half year.
While PCIL.has surpassedPAT earned for entire FY12, margins were also better in
view of relatively higher prices&utilizationlevel.

Moderateindustryoutlook:Thecementindustrywitnessedcapacityadditionofabout29.6mn
tones in the first 11 months of FY 12. The cement prices on an average have dropped
byabout 2% on a year over years basis to Rs.252 per bag. Moreover.due to the
increased
inpowerandfuelcost,freightcostandlackofpricingpower,thecementindustryhasregistered
a substantial drop in PBILDT margin in FY12.. The cement industry is expected
toregisteracapacityadditionofabout86mntonesintheperiodFY14-
16.Theoperatingrateoftheindustryisexpectedtomarginallyimproveto76%bythe
endoffy16.

Going forward, given the supply.glut situation in South India. particularly AP and
theindustry disturbances in the State in view of several political issues, growth of
cementcompanies like PCIL depends to a certain extent on the ability to diversify
market share toothernearbyregions&orrealizerelativelybetterpricesinAP.

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 FinancialResults:

Fortheyearended/AsonMar.31 2017 2018 2019

12m,A 12m,A 12m,A
WorkingResults
Netsales 1,140.6 1,226.3 1.376.7
Totaloperatingincome 1,140.6 1,226.3 1,376.7
PBILDT 286.3 290.7 281.3
Interest 39.5 26.9 67.9
Depredation 37.4 40.1 62.8
PBT 274.0 228.; 153.6
PAT(afterdefd.tax) 201.8 150.0 104.6
GrossCashAccruals(GCA) 262.6 222.5 181.9
FinancialPosition
Equitysharecapital 13 13.4 13.4
Tangiblenetworth 623.4 800.4 914.8
Totalcapitalemployed 1,257.8 1,632.6 1,801.1
KeyRatios (%)
Growth(%)
Growthintotalincome 38.91 2.16 12.07
Growthin PAT(afterdefd.tax) 39.25 (25.68) (30.26)
Profitability(%)
PBILDT/Totaloperatingincome 25.10 23.70 20.43
PAT(afterdefttax)/Totalincome 33.23 26.19 18.83
ROCE(operating) 33.23 26.19 18.83
Averagecostof borrowing(%) 7.16 3.67 7.90
Solvency:
longtermdebtequityratio(times)
0.95 0.85 0.89
Overallgearingratio (limes) 1.02 1.04 0.97
Interestcoverage(PBILDT/Interest) 7.25 10.80 4.14
Termdebt/ GCA(years) 2.26 3.07 4.46
TotalDebt/GCA(years) 2.42 3.74 4.88
Liquidity(times)
Currentratio 0.86 0.52 0.76
Quickratio 0.63 0.38 0.56

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SANSKRITHI SCHOOL OF BUSINESS
 Turnover(days)
Averagecollectionperiod 10 9 12
Averagecreditorsperiod 36 34 20
Averageinventoryperiod 34 43 39
Workingcapitalcycle 8 18 30

CARE:isheadquarteredinMumbai,withOfficesalloverIndia.Theofficeaddressesandcontactnumbersar
egivenbelow:

HEADOFFICE: MUMBAI

Mr.D.R.DograMana Mr. Rajesh

gingDirector MokashiDy.
Mobile:+91.9820416002 Managing
E- DirectorMobile+91-
mail:[email protected] 9820416001
m E-mail:[email protected]

Mr. Mr.SaikatRoy
SuryanarayanIyearRangaswamySen SeniorVicePresident–
iorVicePresidentMarketingMobile: MarketingMobile-
+919867365827 +919820998779
mail:[email protected] [email protected]
om

Mr.AnkurSachdeva
Vice President
Marketing
(SME)Mobile:+91-
9819698985
Email:[email protected]

4thFloor,GodrejColiseum,SomaiyaHospitalRoad,OffEasternExpressHighway,
Sion(East),Mumbai400022Tel.:(022)67544456Fax:(022)67543457
Website:www.careratings.com

20
SANSKRITHI SCHOOL OF BUSINESS
 OFFICES
Mr.MehulPandyaR Mr.DineshSharmaRe
egionalManager gionalManager
32TITANIUM,PrahaladnagarCorparateRoad, UnitNo.8,1floor,Commander’splaceNo.6,
Satellite,Ahmededad-380015. Raja Ram Mohan Roy Road,Richmond
Tel- CircleBangalore-560025Tel:080-
07940265656Mobile:91- 22117140Mobile:+919900041975
9824256265 E-
E-mail:[email protected] Mail:[email protected]

Mr.PradeepKumarR Mr.AshwiniJaniReginalManager401
egionalManager ,Ashoka Scintilla, 3-6-
Unit No.0.509/C, spencer 520,Himayatnagar Hyderabad-
plaza,5thFloor, No.769, Anna 500029Tel-04040102030
MobileNo:+919160074789
Email:[email protected]
Salai,Chennai600002Tel:04428497812/284
90811
Mobile:91-9840754521
E-mail:[email protected]
Mr.Sukanta Ms.SwathiAgrawal Regional
NagRegionalMana Manager3rdfloor,B-
ger 47,InnerCircle,nagarplazacinema,Connaug
3rdfloor,PrasadChambers(shagum hatplace,
NewDelhi-
MallBuildings) 110001.Tel:01123318701/237
10A,Shakespearesarani,Kolkata- 16199Mobile:-
70071,Tel:03340181600/1601/1602Mobile: 919811745677
+91-9831170075 E-
E-mail:[email protected] mail:[email protected]

21
SANSKRITHI SCHOOL OF BUSINESS
 INDUSTRYPROFILE

WhatisCement
Cement is a mixture of limestone, gypsum, iron-are, fly ash and bauxite/ Laurie.
It isfine power which when mixed with water set to a hard moss as a result of hydration
of theconstitutecompounds.It isthemost commonlyused material.
TypesofCementsandqualityrequirements
Thearedifferenttypesofcommentbasedondifferentcompositionsaccordingt
o specific end uses. The basic different compositions according to specific end uses.
Thebasic difference lies in the percentage of linker used. There are nearly three
varieties ofcementpresentlyexistingnamely.
 Ordinary partland
cement
(OPC)43grades15811
2(1989)
53grades1512269 (1987)
Thisispopularlyknownasgreycement.
 Partlandpozalonacement(PPC) 151489(1976)
 Partlandblastfurnacesslagcement (PBFSC)15455(1989)
Howiscementmade
Today part land cement is as essential commodity on which our modern
standard ofliving is greatly dependent building, water supply projects, sea parts,
airports, and irrigationschemeetc.,alldemandcement.
Cementismanufacturedbyeither“wet”processor“dry”process.Wetprocessremaine
dpopularformanyyearswiththemoderndevelopmentoftechniqueofdrymixingofpoweredm
aterialsusingcompressedair,thedryprocessgainedmomentum.
Now a day in most of the plants, cement is being manufactured by dry process.
Theraw material consisting of time stone, iron or and bauxite or laureate, in correct
proportions,are fed into a grinding met where they are reduced to very fine power it
isfurther blendedand corrected for the right compositions and mixed by means of
compressed air the powerfrom the strong silos is fed into rotary kiln the material in
subjected to a temperature of about1500c.chemicalreactiontakes.

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SANSKRITHI SCHOOL OF BUSINESS
 Placebetweenthevarious materialsresulting intheformattingofcementcompoundslike.
 C3–tricalciumsilicate(about45%)
 C3 -dicalciumsilicate(about20%)
 C3–tricalciumaluminates(about7to10%)
 C4ALFE–tetracalciumalumina(about10to12%)
It is these compound that the impart strength characteristics to cement at these
hightemperatures of 1500c, the linker isformed. The cooled linker is then ground in a
cementmillorballmillconsistingof severalcompartmentschargedwithprogressively.
Small hardened balls. At this stage gypsum in required quantities is added
(Generallyabout 2 to 3%) to facilitate easy working and prevent flash setting of cement.
The mixture isground to the required finesse and transferred either by bugged and
packed where from it iscementisanindicatorofeconomyprogress.
In Indian, first attempt to manufacture cement was made early in the country in
theEuropean company in the year 1904 opened a factory in Chennai “south India
industrieslimited”forthepurposeofmanufacturingcement.
The real beginning of cement industry was started by the formation of Indian
cementLtd.In1914underTATA’smanagement.
The Indian cement company started manufacture of cement at parbandur on a
largescale total world production of cement is to be around 1400 million tones. Asia is
largestconsumer(59%)followedbyEuropeandAmeriaca.Theconcentrationiflime–
stonedeposits in few states has led to the formatting of cement plant cluster seven
location in Indiasuch as silapur, santachandrapur, gulbarga, chanderia, Nolgonda and
Yerraguntla. 74% oftotallime-
stonereservesareinthestatesofA.P,karnakata,RajasthanandGujrat.
ThelargestproducerintermsofinstalledcapacityisBirlagroup(Above25%)followed
by associated coment (11%). India is the world’s fourth largest cement
producerafterchina.,JapanandU.S.

23
SANSKRITHI SCHOOL OF BUSINESS
 Productionprocess
Cementis producedin fourbasicstages.
 Quarryingandcrusting
 Grindingandblendingrawmaterial
 Clinkerproduction
 Finishgraining
Recentacquisition
Inlastfourfearsthefollowingcementunitshavebeensold.

Company Acquisitionedby

Namadacement - UltratechcementLtd
Modicement - Gujaratambujacement
CCIRasicementLtd - IndiancementLtd
SriVishnucementLtd -
JuaricementLtdSridigvijay
-
BirlatiscoRaymondLtd
(Cementdivision) - Lafarge

The Indian cement industry at present consists of 53 large cement companies and 113
cementplants varying between. 1MT to 8 MT in addition the country has nearly 150
mini cementplantswithacumulatecapacityofalmost10MT.

Majorplayersinthecementindustryare
 AndhracementLtd
 UltratechcementLtd
 MadrascementLtd
 BirlacorporationLtd
 GujaratambujacementLtd
 Kesoramcement Ltd

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SANSKRITHI SCHOOL OF BUSINESS
  ShreecementLtd
 TamilnaducementLtd
 PENNAcementLtd

Significanceofcement

Cement is major factor of every human being in their lives to building

constructions,roads, dams & bridges etc. The quality of cement plays an important role
for constructions ofslabs,walls,floars,pillars,tanksetc.
 Basicingredientto constructionofwork
 Generationofemployment
 Contributiontonationalexchequer
 ContributiontoIndianrailwayrevenue
 Helpfulindevelopmentofotherindustries
 Enhancementinnationalincome
 Hugeexpartpotentialitiesandquickmarketability’s

“Cement industries hasRs 15,000 credit the cement industry has an investment
value ofabout is in the form of debt form financial institutions (FIS) and banks. The
industry has beenposinganannualizedlossinexcessofRs1000cr.

Nearly 30 cement companies are in red out of which more than a dozen have
becomeBureau to industrial and financial reconstruction (BIFR) cases. May cement
units in thecountryareherebyseekingbuyers.

25
SANSKRITHI SCHOOL OF BUSINESS
 NEEDOFTHE STUDY

 Knowingtherelationshipbetweencapitalbudgetingandfirmvalue
 Toanalyzethereasonforlowstockpricesofthecompany
 Studyingrelationshipbetweencapitalbudgetingandcostofcapital
 ToassesstheImpactof alternativecapitalbudgetingonreturnoneequity.

Capital budgeting means planning for capital assets. Capital budgeting

decisions arevitaltoanyorganizationastheyincludethedecisionsasto.

a) Whetherornotfundsshouldbeinvestedinlongtermprojectssuchassettingofanindustr
ypurchaseofplantandmachineryetc.

b) Analysetheproposalforexpansionorcreatingadditionalcapacities.
c) Todecidethereplacementof permanentassets suchasbuildingandequipment’s.

d) Tomakefinancialanalysisofvariousproposalsregardingcapitalinvestmentssoastoc
hoosethebest outmanyalternativeproposals.

The importance of capital budgeting can be well understood from the fact the
anunsound investment decision may prove to be fatal to the very existence of the
concern.
Theneed,significanceorimportanceofcapitalbudgetingarisesmainlyduetothefollowing.

i) Largeinvestments
ii) Long-termcommitmentoffunds
iii) IrreversibleNature
iv) Long-termeffectonprofitability
v) Difficultiesof Investment decisions
vi) NationalImportance.

26
SANSKRITHI SCHOOL OF BUSINESS
 ScopeoftheStudy

 Thescopeandperiodof studyisrestrictedtothefollowing:
 Thescopeofislimited totheoperationof PENNAcementLtd.
 Theinformationhasbeenobtainedformtheprimaryandsecondarysourcesandislimitedto
PENNACement Ltd.

 Theworkingresultfromthelostfiveyears(2013-18)

Decrease of current assets or current liabilities in the budget the contents of the
totalevaluationofcurrentassetsandcurrentliabilitiesandtheirpercentagecontributionintheto
tal turn over. The yearly increase or decrease of current assets or current liabilities in
thebudget of PENNA cement Ltd is being reviewed form this one would be in a
position
toglancetheperformanceofcurrentassetsandcurrentliabilitiesofthecapitalbudgetingrequire
ments of PENNA cement and emphasizes on the company. This project greatly
dealswithkey rationstoobtainaclearerpictureofdifferentresourcesavailableandat
thedisposal of the organization which will enable one to give appropriation suggestion
to thecompanytoimproveitsperformanceifany.
DataCollection
Theprimarydataiscalledwithdiscussionsformtheofficials ofthecompany
SecondaryData
Thesecondarydataiscalculatedfromthefollowingsources
 Annualfinancialreportsof thecompany
 Brochuresandbooksofthecompany

27
SANSKRITHI SCHOOL OF BUSINESS
 ObjectiveofStudy
Tostudydifferentsourcesoffinanceavailablewiththefirmfaritsoperations.

 Toknowthetotal valueofthe firm.

 Toanalyzeearningspershareunderdifferentcapitalbudgetingform2013-2018.

 Toanalyzetheliquidityandabilityofthefirmtoservicechargesthroughratioanalysis.

 Togiveguidelinesforcapitalbudgetingplanning.

 Toanalyzethecapitalbudgeting inPENNAcementLtd.

 Todeterminethequantumof capitalbudgetingusedinPENNA cementLtd.

 TostudytheimpactofliquidityonprofitabilityofthePENNAcementLtd

Toolsusedforanalysis
The collected data is arranged according to the requirement to meet the
objective ofthe study by bringing together various components under each
cluster per example thevalue of the firm will not be directly given in the balance
sheet in the identify
inaccordancewiththeprinciplesandformulasinaccountinginfinancesimilarlyalloth
erelementstoo.Fortherthisdataanalyzedwiththehelpofratiosearningspershareand
comparisons.

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SANSKRITHI SCHOOL OF BUSINESS
 Limitationsofthestudy

 Thestudyisconductedisshortperiodduringthelimitedtime.Thestudymaynotbedetailedi
nall aspects.

 Thestudyisconductedwiththeavailabledatafromannualreports,internalreports,etc.,ofP
ENNAcement Ltdandanalysiswasmadeaccordingly.

 Figureswhateverappearingistoo roundedtothenearestrupeethousands.

 Thedataissecondaryinnaturebeingtherecordsandstatements,whichexperiencesitsownl
imitationsinpreparation.
Secondarydata:

Data collected is secondary in nature It was gathered mainly form the balance
sheetsand profits & loss accounts of the organization. Required data was gathered firm
variousreportsandotherdocumentsanddatawereanalyzed with helpof guide.
Capitalbudgetingtechniquessufferformthefollowinglimitations:
1. All the techniques of capital budgeting presume that various investment
proposalsunder consideration are mutually exclusive which may not practically
be true in someparticularcircumstances.
2. The techniques of capital budgeting require estimation of future cash in flows
and
outflows.Thefutureisalwaysuncertainandthedatacollectedforfuturemaynotbeexac
tobviouslytheresults based upon wrongdatamaynot begood.
3. There are certain factors like marale of the employees, good will of the firm,
etc.,which cannot be currently quantified but which other wise substantially
influence thecapitaldecision
4. Urgencyis anotherlimitationintheevaluationofcapitalinvestmentdecisions.
5. Uncertaintyandriskposethe biggestlimitationtothetechniques ofcapitalbudgeting
 Themajorproblemincompletingtheprojectisthetimeof8weekswhicheverlessinorderto
knowabouttheoverallobjectivesofthestudy

 Moredependencyonsecondarydata.

29
SANSKRITHI SCHOOL OF BUSINESS
 Capitalbudgetingistheprocessofmakinginvestmentdecisionsregardingcapitalexpenditure
s. A capital expenditure is an expenditure incurred for acquiring or improving thefixed
assets, the benefits of which are expected to be received beyond one year in future.
Inother words, any expenditure incurred which tends to improve existing fixed assets
so as
toincreasetheprofitabilityorreducingthecostofproductionmaybecalledcapitalexpenditure
.

Thefollowingaresomeoftheexamplesofcapitalexpenditure:

 Thepurchaseoffixedassetsforexpansion ofbusiness.
 Costof replacement offixedassetsalreadyinuse.
 Modernizationofexistingmachinery.
 Research and Development projects for reducing cost and improving
quality ofproductsandfindingnewusesoftheproduct.

NeedandImportanceofCapitalBudgeting

Capital budgeting decisions arevital roleanyorganization.

Specialcareshouldbetakeninmakingthesedecisionsonaccountofthefollowingreasons:

1. HeavyInvestment
All capital expenditure projects involve heavy investment of funds. These funds
areraised by the firm from various external and internal sources. Hence, it is important
for a firmtoplantitscapitalexpenditure.

2. PermanentCommitmentof Funds
The funds involved in capital expenditures are not only large but also more
or lesspermanently blocked. Therefore, these are long term investment decisions.
The longer thetime,thegreateristheriskinvolved.Hence,carefulplanningisessential.

30
SANSKRITHI SCHOOL OF BUSINESS
 3. LongTermEffect onProfitability
Capital budgeting decisions have a long term and significant effect on the
profitabilityof the concern. If properly planned, they can increase the size, scale and
volume of sales aswellasthegrowthpotentialoftheconcern.

4. IrreversibleinNature
In most cases, capital budgeting decisions are irreversible. Once the
decision foracquiring a permanent asset is taken, it is very difficult to reverse
that decision. This
isbecauseitisdifficulttodisposeoftheseassetswithoutincurringheavylosse

5. DifficulttomakeInvestmentDecision
The capitalinvestmentdecisions involveasassessment offutureevents whichin
factisdifficulttopredict.Itisreallydifficulttoestimatefuturecashflowsofaninvestment.
Thecashflowuncertaintyiscausedbyecon
omic,political,socialandtechnologicalfac
tors.

Process/Procedureof Capital Budgeting:

Thefollowingproceduremaybeadoptedinpreparingcapitalbudget:
1. IdentificationofInvestmentProposals
The first step in the capital budgeting process is the conception of a profit
making idea.The investment proposal of various types may originate at different levels
within a firm,depending on their nature. They may originate from the level of workers
to top managementlevel. The departmental head collects all the investment proposals
and analyses them in thelightoffinancialandriskpoliciesoftheorganization.

2. Screeningtheproposals.
In large organizations, the Capital Expenditure Planning Committee is established
to screen thevarious proposals received from different department heads. The
committee views these proposalsfrom various angles to ensure that these are in
accordance with the selection criterion of the firm andtheydo not lead to departmental
imbalances.

31
SANSKRITHI SCHOOL OF BUSINESS
 3. ProjectEvaluation.
The next step is to evaluate the profitability of various proposals in terms of the
cost of capital,the expected returns from alternative investment opportunities and the
life of the asset. The followingaresomeof thetechniques used to evaluatethe financial
aspects of aproject.
a. Payback method.
b. Discountedcashflowmethod and
c. Accountingrateofreturnmethod.

4. EstablishingPriorities.
After evaluation, the uneconomic or unprofitable proposalsshould be rejected.
Butitmay notbe possible for a firm to invest immediately in all the acceptable proposals
due to limitation of funds.Hence, it is necessary to rank the various proposals and to
establish priorities after consideringurgency,riskand profitabilityinvolvedtherein.

5. FinalApproval.
Proposals finally recommended by the committee are sent to the top management
along with thedetailed report, both of capital expenditure and of sources of funds to
meet them. The financialmanager will present several alternative capital expenditure
budgets to the top management. It willfinallyapprovethecapital budget for thefirm.

6. Implementation.
While implementing the project, it is better to assign responsibilities to project
managers forcompleting the project within the given time frame and cost limit. This is
necessary in order to avoidunnecessary delays and cost over runs. Further, it is the duty
of the top management to ensure thatfundsarespent in accordancewith the allocation
madein thecapital budget.

7. Performancereview.
The last stage in the process of capital budgeting is the evaluation of the
performance of theproject. Performance review or post completion auditisa feed back
device.It isa means forcomparing actual performance with budgeted data. The
unfavorable variances if any, should belookedinto andthe causes forthe same
beidentified so thatcorrectiveactionmaybetakenin future.

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SANSKRITHI SCHOOL OF BUSINESS
 FactorsInfluencingCapitalExpenditureDecisions:
There are many factors, both financial and nonfinancial which influence
the capitalexpenditure decisions. The crucial factor that influences the capital
expenditure decision is theprofitability on the proposed investment. However,
there are various other factors which alsoinfluencethecapital
expendituredecision. Theyare givenbelow:

1. AvailabilityofFunds
Generally, capital expenditure projects require large funds. A project, however
profitable
,maynotbetakenforwantoffunds.So,projectswithalesserprofitabilitymaybesometimespref
erreddueto lesserpayback period for want ofliquidity.

2. Urgency
Sometimes an investment is to be made on the grounds of urgency for the firm’s
survival or toavoid heavy losses. In such circumstances, proper evaluation of proposal
cannot be made throughprofitabilitytest.
3. LegalCompulsion
When statutory compulsion arises investment has to be made ina projectthough
it may notbe profitable one. For example, waste disposal plants have to be installed to
satisfy the environmentallaws,particularlyin industries likeleather and chemical.

4. Degreeof uncertaintyorRisk
Profitability is directly related to risk. Normally, higher the profits, greater is
the risk oruncertainty. Sometimes, a project with profitability may be selected due to
constant flow of incomeascompared to another project withan irregular and uncertain
flow of income.

5. Intangiblefactors
Sometimes, a capital expenditure has to be made due to certain emotional and
intangiblefactors such as safely and welfare of workers, prestigious project, social
welfare, goodwill of thefirmetc, though such investments arenot be profitable.

6. Obsolescence
Ifobsoleteplantandmachineryexistinafirm,theirreplacementbecomes
necessary.

7. ResearchandDevelopmentprojects
Itisnecessaryforthelong-
termsurvivalofthebusinesstoinvestinresearchanddevelopmentprojects though it maynot
look tobeaprofitable investment.

8. Competitors’activities
When competitors perform certain activities, they may compel a firm to
33
SANSKRITHI SCHOOL OF BUSINESS
 undertake similaractivitiesto withstand competition.

34
SANSKRITHI SCHOOL OF BUSINESS
 9. Futureearnings
Aprojectmaynotbeprofitabletodaywhencomparedtoanotherone,butitmaypromis
ebetterfuture earnings.Insuch cases, it maybepreferred to increaseearnings.

NATUREOFINVESTMENT DECISIONS

 Theinvestmentdecisionsofafirmaregenerallyknownasthecapitalbudgeting,orca
pitalexpendituredecisions.

 Thefirm’sinvestmentdecisionswouldgenerallyincludeexpansion,acquisitio
n,modernisation and replacement of the long-term assets. Sale of a
division or business(divestment)is also as aninvestmentdecision.

 Decisions like the change in the methods of sales distribution, or an

advertisement campaignoraresearchanddevelopmentprogrammehavelong-
termimplicationsforthefirm’sexpendituresandbenefits,andtherefore,theyshouldal
sobeevaluatedasinvestmentdecisions.

FEATURESOFINVESTMENTDECISIONS

 Theexchangeof currentfundsforfuturebenefits.
 Thefundsareinvestedinlong-termassets.
 Thefuturebenefits will occurto thefirm overaseries ofyears
IMPORTANCEOFINVESTMENTDECISIONS

 Growth
 Risk
 Funding
 Irreversibility
 Complexity

35
SANSKRITHI SCHOOL OF BUSINESS
 TYPESOFINVESTMENTDECISIONS

Therearemanywaystoclassifyinvestments. Oneclassification is asfollows:

 Expansionofexistingbusiness.
 Expansionofnewbusiness
 Replacementandmodernization.

Yetanother useful wayto classifyinvestments is as follows:

 Mutuallyexclusive investments
 Independentinvestments
 Contingentinvestments

INVESTMENTEVALUATIONCRITERIA

Threestepsareinvolvedin theevaluationofaninvestment:
 Estimationofcash flows
 Estimationof therequiredrate ofreturn(the opportunitycostofcapital)
 Applicationofadecisionrulefor makingthechoice

INVESTMENTDECISIONRULE

 Itshouldmaximizetheshareholders’wealth.

 Itshouldconsider allcash flowsto determinethe trueprofitabilityof theproject.

 Itshouldprovideforanobjectiveandunambiguouswayofseparatinggoodprojectsfr
ombadprojects.

 Itshouldhelprankingof projectsaccordingtotheirtrueprofitability.

36
SANSKRITHI SCHOOL OF BUSINESS
  Itshouldrecognisethefactthatbiggercashflowsarepreferabletosmalleronesandearl
ycashflows arepreferableto laterones.

 Itshouldhelptochooseamongmutuallyexclusiveprojectsthatprojectwhich
maximizesthe shareholders’wealth.

 Itshouldbeacriterionwhichisapplicabletoanyconceivableinvestmentprojecti
ndependentofothers.
REPLACEMENTANDMODERNISATION

The main objective of modernization and replacement is to improve operating

efficiency and reducecosts. Cost savings will reflect in the in efficiency and reduce
costs. Cost savings will reflect in
theincreasedprofits,butthefirm’srevenuetechnologicalchanges.Thefirmmustdecidetorepl
acethose assets with new assets that operate more economically. If a cement company
changes fromsemi-
automaticdryingequipmenttofullyautomaticdryingequipment.Itisanexampleofmoderniza
tionandreplacement.Replacementdecisionshelptointroducemoreefficientandeconomical
assets and therefore, are also called cost reduction investment. However,
replacementdecisions which involve substantial modernization and technological
improvements expand revenuesaswell as reducecosts.

INVESTMENTEVALUATIONCRITERIA

Thefollowingstepsareinvolvedin theevaluationofan investment:

 Estimationofcash flows.
 Estimationoftherequiredrate ofreturn
 Applicationofadecision formakingthe choice.

The investment decision rules may be referred to as capital budgeting techniques, or

investmentcriteria. A sound appraisal technique should be used to measure the
economic worth of an
investmentproject.Theessentialpropertyofasoundtechniquesothatitshouldmaximizethesh
areholder’swealth.Thefollowingcharacteristicsshouldalsobe

37
SANSKRITHI SCHOOL OF BUSINESS
 possessedbyasoundinvestment evaluationcriteria.

 Itshouldconsider allcash flowsto determinethe trueprofitabilityof theproject.

 Itshouldprovideforanobjectiveandunambiguouswayofseparatinggoodprojectfr
ombadproject.
 Itshouldrecognizethefactthatbiggercashflowsarepreferabletosmalleronesandearl
ycashflows arepreferableto laterones.
 Itshouldhelptochooseamongmutuallyexclusiveprojectsthatprojectmaximizest
heshareholder’swealth.
 Itshouldbeacriterionwhichisapplicabletoanyconceivableinvestmentprojecti
ndependentofothers.

DiscountedCashFlow(DCF)Criteria
 NetPresentValue(NPV)
 InternalRateofReturn(IRR)
 ProfitabilityIndex(PI)

Non-discountedCashFlowCriteria
 PaybackPeriod(PB)
 DiscountedPaybackPeriod(DPB)
 AccountingRateofReturn(ARR)

NETPRESENTVALUEMETHOD
 Cashflowsoftheinvestmentprojectshouldbeforecastedbasedonrealistica
ssumptions.
 Appropriatediscountrateshouldbeidentifiedtodiscounttheforecastedcashflows.T
heappropriatediscountrateis theproject’sopportunitycost ofcapital.
 Presentvalueofcashflowsshouldbecalculatedusingtheopportunitycostofcapitalast
hediscountrate.
 Theprojectshould be acceptedifNPV ispositive(i.e., NPV>0).
Netpresentvalueshouldbefoundoutbysubtractingpresentvalueofcashoutflowsfrompresent
valueofcash inflows. Theformulaforthenet presentvalue can bewrittenas follows:

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SANSKRITHI SCHOOL OF BUSINESS
 ACCEPTANCERULE

 AccepttheprojectwhenNPVispositive NPV >0

 RejecttheprojectwhenNPVisnegative NPV<0
 Mayaccept theproject when NPVis zero NPV =0
 TheNPVmethodcanbeusedtoselectbetweenmutuallyexclusiveprojects;theonewit
hthehigher NPV should beselected.
EVALUATIONOFTHENPVMETHOD

 NPVismostacceptable investmentruleforthefollowingreasons:
 Timevalue
 Measureof trueprofitability
 Value-additivity
 Shareholdervalue
 Limitations:
 Involvedcash flowestimation
 Discountratedifficulttodetermine
 Mutuallyexclusive projects
 Rankingofprojects

INTERNALRATEOFRETURNMETHOD

The internal rate of return (IRR) is the rate that equates the investment outlay with the
present valueof cash inflow received after one period. This also implies that the rate of
return is the discount ratewhichmakes NPV =0.

39
SANSKRITHI SCHOOL OF BUSINESS
 CALCULATIONOFIRR
Uneven cash flows: calculating IRR by trial and error :The approach is to select any
discount rateto compute the present value of cash inflows. If the calculated present
value of the expected cashinflow is lower than the present value of cash outflows, a
lower rate should be tried. On the otherhand, a higher value should be tried if the
present value of inflows is higher than the present value ofoutflows.This process will be
repeated unless thenetpresent valuebecomeszero.

ACCEPTANCERULE

 Accepttheprojectwhenr>k.
 Rejecttheproject whenr<k.
 Mayaccept theproject whenr =k.
 Incaseofindependentprojects,IRRandNPVruleswillgivethesameresultsifthefirmh
asno shortageoffunds.

EVALUATIONOFIRRMETHOD

 IRRmethodhasfollowingmerits:
 Timevalue
 Profitabilitymeasure
 Acceptance rule
 Shareholdervalue

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SANSKRITHI SCHOOL OF BUSINESS
  IRRMETHODMAYSUFFERFROM:
 Multiplerates
 Mutuallyexclusive projects
 Valueadditivity

PROFITABILITYINDEX

Profitabilityindexistheratioofthepresentvalueofcashinflows,attherequiredrateofreturn,tot
heinitial cash outflowof theinvestment.

ACCEPTANCE RULE

 Thefollowingarethepiacceptancerules:
 Accepttheproject whenPIisgreaterthanone. PI>1
 RejecttheprojectwhenPIislessthanone. PI<1
 Mayaccept theproject when PIis equalto one. PI=1
TheprojectwithpositiveNPVwillhavePIgreaterthanone.PIlessthanmeansthattheproject’s
NPVis negative.

EVALUATIONOFPI METHOD

 Itrecognisesthetimevalueof money.

 Itisconsistentwiththeshareholdervaluemaximizationprinciple.AprojectwithPIgre
aterthanonewillhavepositiveNPVand ifaccepted,itwill
increaseshareholders’wealth.

 InthePImethod,sincethepresentvalueofcashinflowsisdividedbytheinitialcashoutfl
ow,it is a relative measureofaproject’sprofitability.

 LikeNPVmethod,PIcriterionalsorequirescalculationofcashflowsandestimateofth
ediscountrate.Inpractice,estimationof cashflowsanddiscount rateposeproblem

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SANSKRITHI SCHOOL OF BUSINESS
 PAYBACKPERIOD

The pay back is one of the most popular and widely recognized traditional methods of
evaluatinginvestment proposals. Payback is the number of years required to recover the
original cash outlayinvested in a project. If the project generates constant annual cash
inflows, the payback period can becomputed bydividingcash outlaybythe annual cash
inflow. That is:

Initial Investment
Payback= AnnualCashInflow = C0 C

Unequal cash flows:Incaseof unequal cash inflows, the payback period can befound
out byaddingup thecash inflows untilthetotal is equal tothe initial cashoutlay.

ACCEPTANCERULE
Many firms use the payback period as an accept or reject criterion as well as a method
of rankingprojects. If the payback period is calculated for a project is less than the
maximum or standardpayback period set by management. It would be accepted. If not,
it would be rejected. As a rankingmethod, it gives highest ranking to the project which
has the shortest payback period and lowestrankingto theproject which has highest
paybackperiod.

 Theprojectwouldbeacceptedifitspaybackperiodislessthanthemaximumorstan
dardpayback period set bymanagement.
 Asarankingmethod,itgiveshighestrankingtotheproject,whichhastheshortestpa
ybackperiod and lowestrankingto theprojectwith highest paybackperiod.

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 EVALUATIONOFPAYBACK
 Certainvirtues:
 Simplicity
 Costeffective
 Short-termeffects
 Riskshield
 Liquidity
 Seriouslimitations:
 Cashflowsafterpayback
 Cashflowsignored
 Cashflowpatterns
 Administrativedifficulties
 Inconsistentwithshareholdervalue

PAYBACKRECIPROCALANDTHERATEOFRETURN

 Thereciprocalofpaybackwillbeacloseapproximationoftheinternalrateofreturn
ifthefollowingtwo conditions aresatisfied.
 Thelifeof theproject islargeoratleasttwicethepayback period.
 Theprojectgeneratesequalannualcashinflows.

DISCOUNTEDPAYBACKPERIOD

 Thediscountedpaybackperiodisthenumberofperiodstakeninrecoveringtheinv
estmentoutlayon thepresent valuebasis.

 Thediscountedpaybackperiodstillfailstoconsiderthecashflowsoccurringaftert
hepaybackperiod.

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SANSKRITHI SCHOOL OF BUSINESS
 AVERAGERATEOFRETURN

TheAverageRateofReturn(ARR)isalsoknownasAccountingRateofReturn(ARR)useacco
untinginformation,asrevealedbyfinancialstatements,tomeasuretheprofitabilityofaninvest
ment. The accounting rate of return is found out by dividing the average after tax profit
by theaverage investment. The average investment would be equal to half of the
original investment if it isdepreciated constantly. The accounting rate of return is the
ratioof the average after-tax profitdivided by the average investment. The average
investment would be equal to half of the originalinvestmentif it
weredepreciatedconstantly.

Averageincome Averageinvestment
ARR=
ACCEPTANCE RULE

 This method will accept all those projects whose ARR is higher than the
minimum rateestablished by the management and reject those projects
which have ARR less than theminimum rate.

 This method would rank a project as number one if it has highest ARR and
lowest rankwouldbeassigned to theproject with lowestARR.

EVALUATIONOFARRMETHOD

TheARRmethodmay claimsome merits

 Simplicity
 Accountingdata
 Accountingprofitability

Seriousshortcoming
 Cashflowsignored
 Timevalueignored
 Arbitrarycut-off

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SANSKRITHI SCHOOL OF BUSINESS
 CONVENTIONALANDNON-CONVENTIONALCASHFLOWS

 A conventional investment has cash flows the pattern of an initial cash

outlay followed bycash inflows. Conventional projects have only one
change in the sign of cash flows; forexample,the initial outflow followed
byinflows,i.e.,– +++.

 A non-conventional investment, on the other hand, has cash outflows

mingled with cashinflows throughout the life of the project. Non-
conventional investments have more thanonechangein thesigns of cash
flows; for example, i.e.,–+++
–++–

NPVVERSUSIRR

Conventional Independent Projects: In case of conventional investments, which are

economicallyindependent of each other, NPV and IRR methods result in same accept-
or- reject decision if the firmisnot constrained for funds inacceptingall profitable
projects.

Lending and borrowing-type projects: Project with initial outflow followed by

inflows is a lendingtype project, and project with initial inflow followed by outflows is
a lending type project, Both areconventionalprojects.

PROBLEMOFMULTIPLEIRRS

A projectmay have both lending and borrowing features together.IRR method, when
used toevaluate such non-conventional investment canyield multiple internal rates of
return because ofmorethan onechangeofsigns in cash flows.

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SANSKRITHI SCHOOL OF BUSINESS
 CASEOFRANKINGMUTUALLYEXCLUSIVEPROJECTS

 Investmentprojectsaresaidtobemutuallyexclusivewhenonlyoneinvestmentcouldb
eacceptedand others would haveto beexcluded.
 Twoindependent projects mayalso bemutuallyexclusiveif afinancialconstraint is imposed.
 TheNPVandIRRrulesgiveconflictingrankingtotheprojectsunderthefollowingcond
itions:
 Thecashflowpatternoftheprojectsmaydiffer.Thatis,thecashflowsofoneproject
mayincreaseover time,while thoseof others may decreaseor vice-versa.
 Thecash outlays of theprojects maydiffer.
 Theprojects mayhavedifferent expectedlives.

REINVESTMENTASSUMPTION
TheIRRmethodisassumedtoimplythatthecashflowsgeneratedbytheprojectcanbereinveste
dat its internal rate of return, whereas the NPV method is thought to assume that the
cash flows arereinvestedat theopportunitycost of capital.
MODIFIEDINTERNALRATEOFRETURN(MIRR)
The modified internal rate of return (MIRR) is the compound average annual rate that is
calculatedwith a reinvestment rate different than the project’s IRR. The modified
internal rate of return (MIRR)is the compound average annual rate that is calculated
with a reinvestment rate different than theproject’sIRR

VARYINGOPPORTUNITYCOSTOFCAPITAL

Thereisno problemin usingNPV methodwhen theopportunitycostofcapitalvarying.

Iftheopportunitycostofcapitalvariesovertime,theuseoftheIRRrulecreatesproblems,asther
eisnot aunique benchmark opportunitycost ofcapital to comparewithIRR.
The capital budgeting appraisal methods or techniques of evaluation of investment
proposalswill help the company to decide upon the desirability of an investment
proposals dependingupon their relative income generating capacity and rank them in
proposal depending
upontheirdesirability.Thesemethodsprovidethecompanyasetofnormsonthebasisofwhich,
eitherithastoacceptorrejecttheinvestmentproposal.Therefore,asoundappraisalmethod

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SANSKRITHI SCHOOL OF BUSINESS
 shouldenablethecompanyto measuretherealworthoftheinvestmentproposal.

AllCapitalBudgeting TechniquesDividedin totwotypes

1. Traditional(OR)NonDiscountedCashFlowTechnique.
A. PayBackPeriod(P.B.P)Method.
B. AccountingRateofReturn(OR)Average RateOfReturn(A.R.R)Method.

2. Modern(OR)TimeAdjusted(OR)DiscountedCashFlowTechniques.
C. NetPresentValue(N.P.V)Method.
D. InternalRate Of Return(I.R.R)Method.
E. ProfitabilityIndex(P.I.M)Method.
1. NonDiscountedCashFlow(OR)TraditionalMethods

These methods are based on principles to determine the desirability of an

investmentproject on the basis of its useful life and expected returns. These methods
depend upon theaccounting information available from the books of accounts of the
company. These will nottake into account the concept of ‘time value of money’, which
is a significant factor todeterminethedesirabilityofaprojectintermsofpresentvalue.
A) PayBackPeriod (P.B.P)Method:
Paybackperiod methodisoneoftheusedpopularmethods
in Traditional cash flow techniques. Here the term pay back refers “The number of
yearsrequiredrecoveringtheoriginalcashoutlayinvestedin aproject”.

According To Weston and Brigham “The pay back period is thenumber

ofyearsittakesforthefirmtorecoveritsoriginalinvestmentbynetreturnsbeforedepreciation,b
utaftertaxes”

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SANSKRITHI SCHOOL OF BUSINESS
 CashOutLay
PayBackPeriod= ───────────────
AnnualCashInflows

AcceptanceRules
1 Youshouldaccepttheprojectitpaybeckperiodisless
2 Youshouldrejecttheprojectitpaybeckperiodishigh.

Meritsofthe Method:-
1. Easyto understand.
2. Easycalculation.
3. Lesscost.
4. Easyavailabilityofinformation.
5. Moreusefultosmallsector.
6. Possibilityforquickdecision making.
7. Demeritsofthe Method:-

1. Heretimevalueofmoneyisnotconsidered.
2. Maximizationofmarketvaluenotpossible.
3. Failureintakingcashflowsafterpayback period.
4. Failureinconsideringtimevalueofmoney.
5. Non-considerationofinterestfactor.
6. Failureintakingmagnitudeand timing of possible.

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SANSKRITHI SCHOOL OF BUSINESS
 B) Accounting(OR) AverageRateOf Return(A.R.R)Method:-

It is an accounting method which uses the accounting information revealed by

thefinancialstatementstomeasuretheprofitabilityofaninvestmentproposal.Itcanbedetermi
ned by dividing the average income after taxes by average investment that is theaverage
book value after depreciation. According to Solomon, according rate of return on
aninvestment canbecalculatedastheratioofaccountingnetincometo theinitialinvestment.

Accounting(OR)Averagerateofreturnmethodcanbecalculatedwiththehelpofthefollowingf
ormula

AverageIncome
AverageRateOf Return(A.R.R)=  100
AverageInvestment

Here

TotalProfitEarned BytheProjectInAllThe Years=

Averageincome
No.ofyears

Initial
InvestmentAverageInvestment=

2

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SANSKRITHI SCHOOL OF BUSINESS
 ACCEPTANCERULES:

Accept the project if calculated average rate of return is greater than cost of

capital.Rejecttheprojectifcalculatedaveragerateofreturnislessthancost

ofcapital.

MeritsoftheMethod :
1. Easyto understand

2. Easyto calculate

3. Itcanbereadilycomputedwiththehelpoftheavailableaccountingdata

4. Itusesthe entirestreamofearningstocalculate theARR

5. Itisbettermethodwhenwecomparewithpaybackperiodmethodbecauseheretheen
tirecashin flowvaluesgenerated bythe project wereconsidered.

Demeritsof Method:-

 Timevaluemoneyisnot considered
 Itis notbasedoncash flowsgenerated byaproject.
 Itdoesnot take intoaccount thefact thatthe profitscan bereinvested.
 Itignoresthetime valueof money.
 Thismethoddoesnotconsideredtheobjectiveof wealthmaximization
2. Modern(OR)DiscountedCashFlowMethods:

The discounted cash flow methods provide a more objective basis for evaluating
andselecting an investment project .These methods considered the magnitude and
timing of cashflow in each period of a project‘s life. Discounted cash flow methods
enable us to is late thedifferences in the timing of cash flow of project by discounting
them to know the presentvalue .The present value can be analysed to determine the
desirability of the project .Thesetechniquesadjustthecashflowoverthelifeof
aprojectforthetimevalueof money.

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SANSKRITHI SCHOOL OF BUSINESS
 Thediscountedcashflowtechniquesare:
a. Netpresentvalue method.
b. Internalrate of return method,and

c. Profitabilityindexmethod.
A) Netpresentvalue(N.P.V)method:
Netpresentvaluemethodisthewildlyusedandmoresophisticatedproject.Evaluation
techniques under discounted cash flow method .It are a superior method. Becausethe
value of cash in flow are taken at discounted value of one rupee .Net present value
iscalculated by sub stating present value of cash in flow from present value of Cash out
flows.Itrecognizesthe impotence oftimevalueofmoney.
AccordingtoEzraSolomon,“Itis apresentvalueoffuturereturns,discounted
at the required rate of return, minus the present value of the cost of the

investment”.Netpresent value methodcanbecalculated withthehelp of

thefollowingformula

NetPresentvalue(N.P.V)=PresentValue OfCash InFlows –present

Valueofcashoutflows.

AcceptanceRules:-
Thepresentvalueofinvestmentoutlaysandcashinflowsaretobecalculatedusingp
resentvaluetable.Thedecisioncriteriaforacceptingorrejecting
aprojectagivenunder:

NPV>Zero Accepttheproposal
NPV<Zero Rejecttheproposal

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SANSKRITHI SCHOOL OF BUSINESS
 Inotherwords,iftheNPVispositive,(thatisthepresentvalueofcashinflowsismore
than the present value of cash outflows or investment outlays, the project should
beaccepted,other wiserejected

NPV>c Accepttheproposal
NPV<c Rejecttheproposal

H
E NPV=present value ofcashin
R
flowsC=presentvalueofcashoutfl
E
ows
ZeroNPV implies asituationwherethefirmNcanonlyrecovertheoriginalinvestment.

MeritsoftheMethod:-

It consider time value of money, it consider all cash in flow values generated by
theproject, it considers the cost of capital for discounting rates of one Rupee which is
moreappropriatemethoditisconsideredastruemethodofprofitability.

1. Recognition to the time value of money: This method explicitly recognizes

thetimevalueofmoney,whichisinevitableformakingmeaningfulfinancialdecisio
ns.
2. Considerationtototalcashinflows:TheNPVmethodconsidersthetotalcashinflo
wsof investment opportunities over the entire life-time of the project
unlikethe paybackperiodmethod.

Demeritsof theMethod:-

1. Difficulttounderstand
2. Difficulttocalculate
3. Theconceptofdiscountingfactormaynotsutteesforallprojectsinasimilarwa
y
4. TheNPVcalculatedbyusingthecostofcapitalasadiscountrate.Buttheconce
ptof cost of capitalitselfisdifficult tounderstandanddetermine.

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SANSKRITHI SCHOOL OF BUSINESS
 B) InternalRateofReturn(I.R.R)Method:

Theinternalrateofreturnisto bedeterminedbytrialanderrormethod.Thefollowing
stepscanbe usedfor itscomputation.
1. Computethepresentvalueofthecashflowsfromaninvestment,byusinganarbitrarilys
elected interest rate.
2. Thencomparethepresentvaluesoobtainedwithinvestmentcost.
3. Ifthepresentvalueishigherthanthecost,thenthepresentvalueofinflowsistobedeterm
ined byusinghigherrate.
4. Thisprocedureistobe continueduntilthe presentvalueofthe
flows from theInvestmentsareapproximatelyequaltoitscost.

5. Theinterestratethatbringsabout thisequalityisthe’internalrate ofreturn’.

If the internal rate of return exceeds the required rate of return, then the
project isaccepted. If the project’s IRR is lower than the required rate of return, it will
be rejected.
Inthecaseofrankingtheproposal,thetechniqueofIRRissignificantlyused.Theprojectswithhi
ghestrateofreturnwillberankedasfirst,
Comparedtothelowestof returnprojects.

InternalRate of Return methodcanbecalculatedwiththe helpof thefollowingformula

Positive Value –
InvestmentI.R.R=LowerDiscountRate+

PositiveValue–

NegativeValueDifferenceBetween PositiveAnd

NegativeConstants.

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SANSKRITHI SCHOOL OF BUSINESS
 MeritsoftheMethods:-

1. Considerationoftimevalueofmoney
2. Considerationoftotalcashflows
3. Easierappeal tothe users
4. Maximizationmarketshare possible
5. Provisionforriskanduncertainty
6. Eliminationofpre-determineddiscount rate

DemeritsoftheMethod:

1. Itis verydifficult tounderstandanduse

2. Itinvolvesaverycomplicatedcomputationalwork
3. It maynot giveuniqueanswerinallsituations
4. Theassumptionre-investmentofcashflows maynotbepossible inpractice.

C) ProfitabilityIndexMethod(P.I):

This method is also known as ‘Benefit Cost Ratio’, According to Van Horne,
theProfitability index of a project is the ratio of the present value of future net cash
flows to thePresentvalueofinitialcashoutflows.
ProfitabilityIndexmethodcanbecalculatedwiththehelpof thefollowingformula

Present Value of Cash in

FlowsProfitabilityIndex(P.I)=

PresentValueOfCash OutFlows

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SANSKRITHI SCHOOL OF BUSINESS
 AcceptanceRules:-
1 Wewillaccepttheprojectifprofitabilityindexis>1
2 Wewillrejectthe projectifprofitabilityindex<1

MeritsoftheMethod :-
1. Ittakesintoaccount thetimevalue ofmoney
2. ItrequireslesscomputationworkthanIRRmethod
3. Ithelpstoaccept/rejectinvestmentproposalsonthebasisofvalueof theindex.
4. Itisusefultorank the proposalsonthebasis ofthehighest/lowestvalueoftheIndex.

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SANSKRITHI SCHOOL OF BUSINESS
 DATAANALYSISANDINTERPRETATION

The followingare detailsofa project ofARBL based

onthatFindoutthecapitalbudgetingTechniques.

DETAILSOF THEPROJECT:

Investment 1135millions
Estimatedlifeoftheproject 7years
Estimatednetcashflows Inmlns
C1 612.00
C2 34.81
C3 405.56
C4 393.91
C5 325.02
C6 321.29
C7 824.08

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SANSKRITHI SCHOOL OF BUSINESS
 Simplepay back is3years11
monthsDiscount factor

1.Traditional(OR)NonDiscounted CashFlowTechniques:

A) PayBackPeriod (P.B.P)Method:
Pay back period method is one of the used popular methods in
Traditional Cashflow techniques. Here the term pay back refers “The number of years
required recovering theoriginalcashoutlayinvestedinaproject”.

Paybackperiod methodcanbecalculatedwiththehelpofthefollowingformula

CashOutLay
PayBackPeriod=───────────────
Annual CashInflows

COMPUTATIONOFPAYBACKPERIOD

Cumulative
CashInFlowVal Cashin Flow
Years ues Values inMillions
InMillions

C1 612.00 612.00
C2 34.81 646.81
C3 405.56 1,052.37
C4 393.91 1,466.28
C5 325.02 1,771.30
C6 321.29 2,092.59
C7 824.08 2,916.67

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SANSKRITHI SCHOOL OF BUSINESS
 Therecoveryof theinvestmentfallswithinbetweenthethirdandfifthyears.
Therefore,thePBis3yearsplusa fractionofthefourth year.

PaybackPeriod=3years+1135─1052.37÷393.91

=3years+82.63÷393.91
=3years+0.20years
=3.20years.

Interpretation:

The Targeted Payback Period of the Project is 3 years 11 months. Here the
totalinvestment completely recovered with in a period of 3 years 2 months, which is
less than theTargetedPeriod.SotheProjectisacceptable.

B) Accounting(OR)AverageRateOfReturn(A.R.R)Method:

It is an accounting method which uses the accounting information revealed by

thefinancialstatementstomeasuretheprofitabilityofaninvestmentproposal.Itcanbedetermi
ned by dividing the average income after taxes by average investment that is theaverage
book value after depreciation. According to Solomon, according rate of return on
aninvestment canbecalculatedastheratioofaccountingnetincometo theinitialinvestment.

Accounting(OR)Averagerateofreturnmethodcanbecalculatedwiththehelpofthefollowingf
ormula
AverageIncome
AverageRateOf Return(A.R.R) =  100
AverageInvestment

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SANSKRITHI SCHOOL OF BUSINESS
 Here

TotalProfitEarnedBytheProjectin Allthe Years

AverageIncome
= 
NumberOfYears

InitialInvestment
AverageInvestment= 
2

ComputationofAverageIncome

Years Cash In
FlowValuesInMil
lions
C1 612.00
C2 34.81
C3 405.56
C4 393.91
C5 325.02
C6 321.29
C7 824.08
TotalIn 2,916.67
come
Average 416.67
Income

InitialInvestment
AverageInvestm 
ent= 
2

=1135millions/2=56.75millions

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SANSKRITHI SCHOOL OF BUSINESS
 AverageIncome
AverageRateof Return(A.R.R)=  100
AverageInvestment

416.67
millionsAverageRateof Return(A.R.R)=
100
567.65millions

=0.734 100

=73.40%

INTERPRETATION:
TheAverageRateofReturnoftheProjectis73.40%,whichishigherthantheratespecifie
dby thePENNAcementLtd. SotheProjectisacceptable.

2. Modern(OR)DiscountedCashFlowMethods

A) Netpresentvalue(N.P.V) Method:
B)
Netpresent valuemethod isthe wildlyused andmore sophisticatedproject is
theEvaluationtechniquesunderdiscountedcashflowmethod.Itisasuperiormethod.
Becausethevalueofcashinflowaretakenat discountedvalueofonerupee
.
NetpresentvalueiscalculatedbysubstatingpresentvalueofcashinflowfrompresentvalueofC
ashoutflows.Itrecognizestheimpotenceoftimevalueofmoney.

According to Ezra Solomon, “It is a present value of future returns,

discountedAttherequiredrate of return, minusthepresentvalueof
thecostoftheinvestment”.

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SANSKRITHI SCHOOL OF BUSINESS
 Netpresent value methodcanbecalculated withthehelp of thefollowingformula;

N.P.V=NetPresentValueofCashInflows–NetPresentValue
ofCashOutflows.

ComputationofNetPresentValueofCashInflows

CashInFlowVal Present Value

Years ues DiscountedValueof1/- OfCash In Flows
InMillions InMillions
At10%CostOfCapital
C1 612.00 0.909 556.31
C2 34.81 0.826 28.75
C3 405.56 0.751 304.58
C4 393.91 0.683 269.04
C5 325.02 0.621 201.84
C6 321.29 0.564 181.20
C7 824.08 0.513 422.75
NetPresentValue ofCash 1,964.47
inFlows

N.P.V=NetPresentValueofCashInflows–NetPresentValue ofCashOutflows

=1,964.47millions─1,135millions

=829.47millions.

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SANSKRITHI SCHOOL OF BUSINESS
 Interpretation:
Based on Acceptance rule of Net Present Value method we will accept the
Project.The Present value of investment out lays and cash inflows are to be calculated
using Netpresent value table. The decision criteria for accepting this project because the
Net presentvalueProjectisPositivevalue(AND)>0.SothisProjectisacceptable.

B) InternalRateofReturn(I.R.R)Method:

Theinternalrateofreturnistobedeterminedbytrialanderrormethod.Thefollowingstepsc
anbeusedforitscomputation.
4. Computethepresentvalueofthecashflowsfromaninvestment,byusinganarbitrarilys
elected interestrate.
5. Thencomparethepresentvaluesoobtainedwithinvestmentcost.
6. Ifthepresentvalueishigherthanthecost,thenthepresentvalueofinflowsistobedeterm
ined byusinghigherrate.
4. This procedure is to be continued until the present value of the flows
from theInvestmentsareapproximatelyequaltoitscost.
5. Theinterestratethatbringsaboutthisequalityisthe‘internalrateofreturn’Interna

lRate of Returnmethodcanbecalculatedwiththe helpofthe followingformula

ExcessiveValue
I.R.R=Lower Discount Rate + Difference
inDiscount rates
PositiveValue–Negativevalue

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SANSKRITHI SCHOOL OF BUSINESS
 ComputationofInternal RateofReturn

Years Cash DiscountedValueO PresentValu DiscountedV PresentV

f1/- e of alue alueOfCa
inflowVal At27% Cost Cash shInFlow
uesInMill OfCapital Of1/- sIn
ions InFlowsInM Millions
illions At 30%
CostOfCapi
tal
C1 612.00 0.781 477.97 0.769 470.63
C2 34.81 0.620 21.58 0.592 20.61
C3 405.56 0.488 197.91 0.455 184.52
C4 393.91 0.384 151.26 0.350 137.87
C5 325.02 0.302 98.16 0.269 87.43
C6 321.29 0.249 80.00 0.207 66.50
C7 824.08 0.198 163.67 0.159 131.02
NetPresentValueofCashInflow 1,190.58
s 1,098.58

I.R.R= 27%+ (30 -27)

1,190.58–1,098.58

1,190.58-1135
=27%+ (30-27)
1,190.58–1,098.58

=27%+ 0.60(3)

=27+1.8%

=28.8%

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SANSKRITHI SCHOOL OF BUSINESS
 Interpretation:
BasedonAcceptanceruleInternalRateofReturnmethodwewillaccepttheProject.
The projectisacceptedtheIRRismorethanthe10%forthisproject.

C) ProfitabilityIndex(P.I)Method:
This methodisalsoknownas‘BenefitCostRatio’,AccordingtoVan Horne, theProfi
a project is the ratio of the present value of future net cash flows to
thePresentvalueofinitialcashoutflows.
ProfitabilityIndexmethodcanbecalculatedwiththehelpofthefollowingformula

Present Value of Cash

InflowsProfitabilityIndex(P.I)=

PresentValueOfCashOutflows

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SANSKRITHI SCHOOL OF BUSINESS
 ComputationofNetPresent ValueofCashInflows

CashInFlowVal Present Value

Years ues DiscountedValueof1/- OfCash In Flows
InMillions InMillions
At10%CostOfCapital
C1 612.00 0.909 556.31
C2 34.81 0.826 28.75
C3 405.56 0.751 304.58
C4 393.91 0.683 269.04
C5 325.02 0.621 201.84
C6 321.29 0.564 181.20
C7 824.08 0.513 422.75
NetPresentValue ofCash 1,964.47
inFlows

Profitabilityindex(P.I)=

1,964.47millions
= 
1135millions

= 1.73
Interpretation:

Basedon AcceptanceruleProfitabitabilityIndexmethodwewillaccepttheProject.
BecausethePIoftheProjectisgreaterthan1that1.73,sotheprojectisaccept.

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 FINDINGS

Thefollowingarethefindingsduring thestudyoftheproject.
Pay Back Period: The project is accepted when pay back is less than 3 years
11monthswhich is standard pay back set by the management. The project gives less
payback period sotheprojectisaccepted.
Average Rate of Return: As per the management the minimum rate of return expected
is30%.theprojectARRgreaterthan30%isaccepted.
Net Present Value:The net income of theproject is discounted at the minimum
requiredrateofreturn –10%andNPVispositive sotheprojectisaccepted.
Internal Rate of Return: The capital invested is getting more return which is greater
than10%.
Profitability Index: The project showing Profitability Index is more than one. So the
projectisaccepted.

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 SUGGESTIONS

 Usuallyacashsaleisbetterthancreditsalesbutifthecompanyallowscreditsalestheycanim
provethe salesmuchbetter.
 Insteadofpurchaseofinvestmentsitisbetter
toinvestincapitalbudgetingwhichimprovetheturnover.
 Inordertomaintaingoodrelationshipwiththeircreditorstheyshouldpaytheircreditorswit
hinsixmonths.
 Anotherwayofimprovingthecapital…
budgetingisbypassingthecreditorswithinsixmonthstheyalsoincreasethegoodwillof
thecompany.
 Thecompanydivide intotheitaliccementgroups.Sothecompany.Soitshould…
concentrateinthepromotionalactivitiestoimprovethesales.

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 CONCLUSION

It is concluded that the project is viable and profitable as the ARR is

getting morethan30%.The pay back indicates that the investment is fully

recovered in shortperiod.NPV of the project is considered as better

because of its higher net presentvalue. The IRR of the project is giving

higher rate of return. The ProfitabilityIndexismore

than1andwhereprojectshows NPVaspositive.

Bibliography

TitleOfthebo I.M.Pandey
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FinancialManage
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Sharma&Gupta KalyaniPublishing,New
ManagementAccou D
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l
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i
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PrasannaChandra Tata Ac. Graw Hill

FinancialManage Publishing Ltd., NewDelhi.
mentTheoryPrac
tice

nalysis
A
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 A
n
n
ua
lR
ep
or
ts

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