APROJECT REPORT ON

CAPITAL BUDGETINGAT

(Krishna Dish Ends Pvt Ltd)

BY

This project submitted inPartial fulfillment of the requirement

For the degree of

MASTER OF BUSINESS ADMINISTRATION

(Affiliated to Osmania University, Hyderabad)APPROVED BY A.I.C.T.E

CERTIFICATE

(M.B.A) Finance, has prepared “A Project Report on Capital

Budgeting”., in “Krishna Dish Ends Pvt. Ltd”., as par the curriculum of

Masters Degree in Business Administration (OSMANIA UNIVERSITY)

for the academic year

(Internal guide)

Dated: _____________

Place: ______________

CERTIFICATE

student of final year Masters of Business Administration

(M.B.A) Finance, has prepared “A Project Report on Capital

Budgeting”., in “Krishna Dish Ends Pvt. Ltd”., as par the curriculum of

Masters Degree in Business Administration (OSMANIA UNIVERSITY)

for the academic year

(Principal)

Place Date R.R DIST

CERTIFICATE OF THE GUIDE

This is to certify that the project work titled “A PROJECT REPORT ON CAPITAL BUDGETING” with regard to “KRISHNA DISH ENDS PVT”. LTD ”, is a bonafide work of in partial fulfillment for the award of degree of MBA Finance (Osmania University) under my guidance. This project work is original and not submitted earlier for the award of any degree / diploma or associate ship of any University / Institution.

(Guide)

Place: ________________

Date: _________________

Student Declaration

project work titled “A PROJECT REPORT ON CAPITAL BUDGETING” with regard to “KRISHNA DISH ENDS PVT. LTD”, is the original work done by me and submitted to the (Osmaina University) in partial fulfillment of requirements for the award of Master of Business Administration in Finance (Area of Specialization) under the supervision

Place: R.R.DIST

Date: __________

ACKNOWLEDGEMENT

I express my sincere thanks to to prepare this project.

(Faculty)., for their valuable guidance in this endeavor. They have been a constant source of inspiration and I sincerely thank them for their suggestions and help to prepare this report. I express my deep sense of gratitude to my external guide, of “

Finally, it is my foremost duty to thank all my respondents, who helped me to complete my fieldwork without which this project would not have been possible.

Date: __________

CONTENTS

INDEX PAGE NO

CHAPTER – I

1. INTRODUCTION 1 - 3

2. OBJECTIVES OF THE STUDY 4 - 5

CHAPTER – II

3. COMPANY PROFILE 6 - 13

CHAPTER - III

4. METHODOLOGY 14 - 15

CHAPTER - IV

5. THEORY OF CAPITAL BUDGETING 16 - 17

6. CAPITAL BUDGETING PROCESS 18 - 25

7. INVESTMENT CRITERIA 26 - 35

8. PHASES OF CAPITAL BUDGETING 36 - 43

9. KINDS OF CAPITAL BUDGETING DECISIONS 44 - 46

10. DIFFICULTIES IN CAPITAL BUDGETING 47 - 48

11. DATA REQUIRED 49 - 52

CHAPTER – V

12. ANALYSIS 53 - 63

CHAPTER - VI

13. CONCLUSION & SUGGESTIONS 64 - 65

DECISION 66 - 67BIBLIOGRAPHY 68 - 69

CHAPTER – I

INTRODUCTION

1INTRODUCTION

Capital Budgeting is perhaps the most important Issue in Corporate Finance. How a firm finance its investments that they has to make or to define the business or businesses that it wants to be. That’s why the process of Capital budgeting is also referred to as strategic asset allocation.

Once the managers of a firm choose the business or businesses they want to be in, they have to develop a plan to invest in buildings, machineries, equipments, research and development, go downs, showrooms, distribution network, information infrastructure, brands, and other long lived assets. This is the capital budgeting process.

Considerable managerial time, attention, and energy are devoted to identify, evaluate, and implement investment projects. When you look at an investment project from the financial point of

view, you should focus on the magnitude, timing, and risk ness of cash flows associated within. In addition, consider the options embedded in the investment project.

CHAPTER – I

OBJECTIVES OF THE STUDY

4

Objectives of this study

-: Main Objective: -

The main Objective of the project is to suggest the company weather to establish a new manufacturer Processed Equipments of Pharmaceuticals at Vishakapatnam or not.

-: Sub – Objectives: -

a) To study the financial feasibility of the proposal

b) To find out the benefits that the company is going to get from the new projects.

c) To critically evaluate the project to arrive at the right conclusion

d) Estimate of post scenario of the company

e) Estimating of assets & tools required for this new project

5

CHAPTER – II

COMPANY PROFILE

6 Company profile

“Krishna Dish Ends” established in the year 1984, as a manufacturer of Processed Equipments in the field of Pharmaceuticals, Bulk Drugs, Oil Industries.

Krishna Dish Ends undertakes a single point responsibility on turnkey basis for all the related services including Technical Feasibility studies, Basic Engineering, Detailed Engineering, Project Engineering and Management, Quality Assurance, Project Commissioning, Validation and Post Project Documentation and maintenance after commissioning.

Strongly backed up by our own manufacturing capabilities, a full-fledged design and CAD Center, a strong team of technical experts and project team, Krishna provides timely delivery of quality products systems to the projects.

Infrastructure

Krishna Dish Ends has a covered area of 8400 sq.m at APIE Balanagar, Sanathnagar, and CITD Road, Hyderabad. The totally integrated fabrication, machining and glass lining facilities ensure timely delivery of quality products. In addition to a captive 2 MW wind farm, it has an adequately sized DG set to ensure uninterrupted power supply.

Design and Engineering

The state-of-the-art CAD facilities and experienced engineers not only automate the day-to-day engineering drawing requirements, but also innovate and improve the versatility of the product. In addition to standard equipment, Krishna designs and manufactures equipment for specific customer applications or process performance improvement.

7

QUALITY POLICY

13

CHAPTER – III

METHODOLOGY

14

Methodology of the study

The information required for successful completion of the project has been collected through primary and secondary sources.

Primary Sources of information is through interviewing, meetings and etc. with the various officials and employees of company (name).

Secondary Sources of information are the balance sheets and other financial statements of the company.

15

CHAPTER – IV

THEORY OF CAPITAL

BUDGETING

16 CAPITAL BUDGETING

I) Meaning:

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

II) Importance:

Capital budgeting decisions are crucial to a firm's success for several reasons. First, capital expenditures typically require large outlays of funds.

17

CHAPTER – IV

CAPITAL BUDGETING

PROCESS

18 Capital budgeting process

The capital budget process is usually a multi-step process, including:

Identification of potential investment opportunities

Assembling of proposed investments Inventory of Capital Assets; Developing a Capital Investment Plan (CIP); Developing a Multi-Year CIP; Developing the Financing Plan; and, Implementing the Capital Budget.

A central element of the capital budget and the multi-year capital investment plan is the

25

CHAPTER – IV

INVESTMENT CRITERIA

26

INVESTMENT CRITERIA

A wide range of criteria has been suggested to judge the worthwhile ness of investment projects. The important investment criteria, classified into two broad categories—non-discounting criteria and discounting criteria—are shown in exhibit subsequent sections describe and evaluate these criteria in some detail:

INVESTMENT CRITERIA

DISCOUNTING NON-DISCOUNTING CRITERIA CRITERIA

NET PRESENT INTERNAL RATE MODIFIED INTERNAL PROFITABILITY PAYBACK DISCOUNTED PAYBACK VALUE OF RETURN RATE OF RETURN INDEX PERIOD PERIOD

27Table 1: Comparing Methods of Valuation under Various Scenarios

Method IndependentProjects

Mutually ExclusiveProjects

*CapitalRationing

*Scale Differences

IRR Acceptable Not Acceptable

Not Acceptable

Not Acceptable

MIRR Acceptable Not Acceptable

Not Acceptable

Not Acceptable

NPV Acceptable Acceptable Acceptable Acceptable

Payback Not Acceptable

Not Acceptable

Not Acceptable

Not Acceptable

Discounted Not Acceptable

Not Acceptable

Not Acceptable

Not Acceptable

Basic Data

Expected Net Cash FlowYear Project L Project S012

(100)1060

(100)7050

3 80 20

28The Six CriteriaThere are six criteria that we will use:

Non-discounting criteria The payback period The discounted payback period

Discounting criteria Internal rate of return (IRR) Modified internal rate of return (MIRR) Net present value (NPV) Profitability index (PI)

Non-discounting criteria

a) The Payback Period:

The payback period measures the time that it takes to recoup the cost of the investment.

If the cash flows are an annuity, then we can simply divide the cost by the annual cash flow to determine the payback period. Otherwise, as in the example, we subtract the cash flows from the cost until the remainder is zeroThe shorter the payback period, the better. Generally, firms will have some maximum allowable payback period against which all investments are compared. For our example project, we will subtract the cash flows from the initial outlay until the entire cost is recovered:

Problems with the Payback PeriodThe payback period suffers from two primary problems that limit its usefulness in evaluating investments:

It ignores the time value of moneyIt ignores all cash flows beyond the payback periodStill, it has a couple of redeeming qualitiesIt is quick and easy to calculateIt gives a measure of the liquidity of the projectPayback period = Expected number of years required to recover a project’s cost.

29Project LExpected Net Cash Flow

Year Project L Project S0123

(100)106080

(100)(90)(30)50

PaybackL = 2 + 30/80 years = 2.4 years.

PaybackS = 1.6 years.

Weaknesses of Payback:

1. Ignores the time value of money. This weakness is eliminated with the discounted payback method.

Ignores cash flows occurring after the payback period.

b) The Discounted Payback Period

The discounted payback period is exactly the same as the regular payback period, except that we use the present values of the cash flows in the calculation.

Since our required return (WACC) is 12%, the timeline with the PVs looks like this:

Problems with Discounted Payback

The discounted payback period solves the time value problem, but it still ignores the cash flows beyond the payback period.

Therefore, you may reject projects that have large cash flows in the outlying years that make it very profitable.

In other words, any measure of payback can lead to a focus on short-run profits at the expense of larger long-term profits.

30Discounted Payback - is almost the same as payback, but before you figure it, you first discount your cash flows. You reduce the future payments by your cost of capital. Why? Because it is money you will get in the future, and will be less valuable than money today. (See Time Value of Money if you don't understand). For this example, let's say the cost of capital is 10%.

Year Cash flow Discounted Cash flow Running Total0 -8000 -8000 -80001 3733 3397 -46072 3200 2645 -19623 1600 1202 -7604 1066 728 -325 533 331 299

So we break even sometime in the 5th year. When?

Negative Balance / Cash flow from the Break Even Year = When in the final year we

break even-32 / 331 = .096

So using the Discounted Payback Method we break even after 4.096 years.

31DISCOUNTING CRITERIA

a) The Internal Rate of Return The internal rate of return (IRR) is the discount rate that equates the present value of the cash flows and the cost of the investmentUsually, we cannot calculate the IRR directly; instead we must use a trial and error process. For our example, the IRR is found by solving the following:

Problems with the IRRThe IRR is a popular technique primarily because it is a percentage, which is easily compared to the WACC.

However, it suffers from a couple of flaws:

The calculation of the IRR implicitly assumes that the cash flows are reinvested at the IRR. This may not always be realistic.Percentages can be misleading (would you rather earn 100% on a $100 investment, or 10% on a $10,000 investment?)

.

Project L:

8.47

43.02

0 1 2 3

100.00 10 60 80

18.1%

18.1%

48.57 $ 0.06 $0

IRRL = 18.1%IRRS = 23.6%

32If the projects are independent, accept both because IRR > k.

If the projects are mutually exclusive, accept Project S since IRRS > IRRL.

Note: IRR is independent of the cost of capital.

b) The Net Present Value

The Net Present Value (NPV) Calculator:The calculation of net present value is useful when preparing a capital budgeting project. With this calculator, you can determine whether the total present value of a project's expected future cash flows is enough to satisfy the initial cost.

In the calculator fields below enter your required discount rate, also known as the cost of capital or required rate of return. This is the return you require for the project to be an attractive investment. Secondly, enter the length of the project (in years) and the amount required to initiate the project. Finally, enter any projected net cash flows to be received throughout the life of the project. (If you project any cash outflows to be greater than inflows, enter a negative number for that net cash flow.)

The net present value (NPV) is the difference between the present value of the cash flows (the benefit) and the cost of the investment (IO):The NPV: An Example

NPV is calculated by subtracting the initial outlay (cost) from the present value of the cash flows

Note that the discount rate is the WACC (12% in this example)

18.1%

33

Project L:

9.0949.59 60.11NPVL = $ 18.79

NPVS = $19.98If the projects are independent, accept both.

If the projects are mutually exclusive, accept Project S since NPVS > NPVL.

Note: NPV declines as k increases, and NPV rises as k decreases.

d) The Profitability Index

The profitability index is the same as the NPV, except that we divide the PVCF by the initial outlay: E. PROFITABILITY INDEX (PI) The profitability index, or PI, method compares the present value of future cash inflows with the initial investment on a relative basis. Therefore, the PI is the ratio of the present value of cash flows (PVCF) to the initial investment of the project.

In this method, a project with a PI greater than 1 is accepted, but a project is rejected when its PI is less than

0 1 2 3

100.00 10 60 80

1. Note that the PI method is closely related to the NPV approach. In fact, if the net present value of a project is positive, the PI will be greater than 1. On the other hand, if the net present value is negative, the project will have a PI of less than 1. The same conclusion is reached, therefore, whether the net present value or the PI is used.

34In other words, if the present value of cash flows exceeds the initial investment, there is a positive net present value and a PI greater than 1, indicating that the project is acceptable.

PI is also known as a benefit/cash ratio.

Project L

Accept project if PI > 1.Reject if PI < 1.0

0 1 2 3

-100.00 10 60 80

PV1 9.09PV2 49.59PV3 60 .11

118.79

10%

35

CHAPTER - IV

PHASES OF CAPITAL

BUDGETING

36Phases of capital budgeting

1. Planning:

The long term or short term capital budgeting plan represents a blue print of what a firm proposes to do in the future typically it covers a period of three to ten years moat commonly it spans a period of five years naturally, planning over such an extended time horizon tends to be in fairly aggregative terms. While there is considerable variation in the scope, degree of formality, and level of sophistication in financial planning acres firms, most corporate financial plans have certain common elements. These are

Economic assumptions: The financial plan is based on certain assumptions about the economic environment (interest rate, inflation rate, growth rate, exchange rate, and so on).

Sales forecast: The sales forecast is typically the starting point of the capital forecasting exercise. Most capital variables are related to the sales figure.

2. Analysis:

The Three Stages of Capital Budgeting AnalysisCapital Budgeting Analysis is a process of evaluating how we invest in capital assets; i.e. assets that provide cash flow benefits for more than one year. We are trying to answer the following question:

Will the future benefits of this project be large enough to justify the investment given the risk involved?

It has been said that how we spend our money today determines what our value will be tomorrow. Therefore, we will focus much of our attention on present values so that we can understand how expenditures today influence values in the future. A very popular approach to looking at present values of projects is discounted cash flows or DCF. However, we will learn that this approach is too narrow for properly evaluating a project.

37We will include three stages within Capital Budgeting Analysis:Decision Analysis for Knowledge Building Option Pricing to Establish Position Discounted Cash Flow (DCF) for making the Investment Decision

Different basic capital budgeting analysis

Horizontal analysis: - Analysis involves the computation of amount changes and percentage change

Vertical analysis: - uses percentage to show the relationship of the different items to the total in a single statement sets a total figure equal to 100%and compute the percentage of each components of that figure

Trend analysis: - percentage changes are calculated for several successive years instead of between two years

Ratio analysis: - represent meaningful relationship between two numbers financial ratios have been classified into five categories as follows

Liquidity ratio: - Current ratio=current assets /current liability Quick ratio=quick assets*/current liability *Excluding inventories

Leverage ratio: -

Debt equity ratio=debt/equity

Interest coverage ratio=PBIT+DEP/interest on debtDSCR=[(PAT+DEP+INT ON DEBT)/(INT ON DEBT+installment of debt

Turnover ratio:- Inventory turnover ratio=cost of good sold/average inventoryFixed asset turnover ratio= net assets/average net fixed assetsTotal assets turnover ratio=net sales/average total assets

38 Profitability ratio: -

Grass profit margin=grass profit / met sales Net profit margin= net profit /sales Return on total assets=profit after tax/average total assets

Valuation ratio: -

EPS=equity earning/ number of share holders PER=MPPS/EPS Yield ratio=dividend+price change/initial price I3. Financial analysis

Financial analysis seeks to ascertain whether the proposed project will be financially viable in the sense of being able to meet the burden of servicing debt and whether the proposed project will satisfy the return expectations of those the shareholders (owners of the firms). The aspects, which have to be looked into while conducting financial appraisal in ICT projects, are:Investment outlay analysisMeans of financing –Cost of Capital –Projected profitability- Break-even point – Cash flows of the project Level of risk

a) Means of financing Means by which a budget deficit is financed or a surplus

is used. Means of financing are not included in the budget totals. The primary means of financing is

borrowing from the public. In general, the cumulative amount borrowed from the public (debt held by the public) will increase if there is a deficit and decrease if there is a surplus, although other factors can affect the amount that the government must borrow.

39Those factors, known as other means of financing, include reductions (or increases) in the government's cash balances, seignior age, changes in outstanding checks, changes in accrued interest costs included in the budget but not yet paid, and cash flows reflected in credit financing accounts.

b) The Cost of Capital

Cost of Capital, Discounts Rates, andThe required Rate of Return

We know how to do capital budgeting problems, but what about the discount rate?

We also know that the discount rate will depend on the risk of the project:

Investors will require a higher required rate of return for riskier projectsInvestors will look at projects as portfolios and therefore the systematic risk is the correct measure of risk. Any unsystematic risk can be diversified away, and no compensation for this is necessary.

Required rate of return, appropriate discount rate, and cost of capital are different names for the same concept.

The cost of capital depends on the risk, and hence primarily on the use of the funds, not the source.

Firm's overall cost of capital reflects the required rate of return on the firm's assets as a whole. This overall cost of capital is called the weighted average cost of capital, and reflects the costs of debt, equity, and preferred stock.

c) Investment outlay Analyses

Having the exclusive rights to a product or project is valuable, even if the product or project is not viable today.

40The value of these rights increases with the volatility of the underlying business.

The cost of acquiring these rights (by buying them or spending money on development - R&D, for instance) has to be weighed off against these benefits.

d) Projected profitability

Refers to the amount of profit received relative to the amount invested, often measured by a rate of profit or rate of return on investment.

Economists and accountants measure profit in slightly different ways. What is commonly known as profit is the difference between sales and costs by a business enterprise? However, the term is also used more generally to refer to value added, which only be the same when all the factors of production have been credited their full opportunity cost.

e) Break-even point

Definition The price at which an option's cost is equal to the proceeds acquired by exercising the option. For a call option, it is the

strike price plus the premium paid. For a put option, it is the strike price minus the premium paid

Breakeven analysis a management control that approximates how much you must sell in order to cover your costs with NO profit and NO loss. Profit comes after breakeven.  The following formula will help in the calculation of your breakeven sales volume level:

41

Breakeven = Fixed Costs * / Contribution Margin % **

= 250 000/15%= 1 666 667

* Fixed Costs are those costs that are not variable as a result of the sales activity. For example, rent of the building or insurance costs may be fairly constant no matter how sales vary, while, expenses such as advertising and usage of shop or store supplies will vary with sales.

** Contribution Margin = Revenue - Variable Costs. In a retail business, the gross margin % is generally recognized as the Contribution Margin %. Gross Margin equals the difference between the Sales and the Cost of the Sales.

In this example, $1 667 are the sales that are required to cover fixed costs of $250 000 and a margin of 15 percent, with nothing left over for profit.

If you now wanted to calculate the sales that are required to now build in a profit factor, add the profit factor you want to allow for to the fixed costs. If in this example, the fixed costs are $250 000 and you want a $150 000 profit, add the two together and then apply the breakeven formula to this.

Breakeven = (Fixed Costs + Profit Margin) / Contribution Margin %

= (250 000 + $150 000) / 15%= 400 000 / 15%= 2 666 667

If this was a small manufacturing company and you wanted to calculate how many unit sales you need to breakeven, you could divide the breakeven sales volume by the unit-selling price. For example, if the unit sells for 10, the breakeven unit sales before a profit is allowed for is 166 667 units and after a profit is allowed for, 266 667 units

42f) Project’s Cash Flow

You have to keep the schedule of your expenditure in-line with your income throughout the various stages of your project.

Preparing a cash flow schedule is especially important if you will be receiving income across several stages through out your project's duration (development grant, ticket door or art work sales, program advertising, pre-sold tickets or workshop attendance fees, etc).

By preparing a cash flow chart you will be able to schedule your expenditure in line with your project's income as it fluctuates from week to week

g) Level of Risk

A big question that companies have to deal with is, "What is enough security?" This can be restated as, "What is our acceptable risk level?" These two questions have an inverse relationship. You can't know what constitutes enough security unless you know your necessary baseline risk level. To set an enterprise wide acceptable risk level for a company, a few things need to be investigated and understood. A company must understand its federal and state legal requirements, its

regulatory requirements, its business drivers and objectives, and it must carry out a risk and threat analysis. (I will dig deeper into formalized risk and threat analysis processes in a later article, but for now we will take a broad approach.) The result of these findings is then used to define the company's acceptable risk level, which is then outlined in security policies, standards, guidelines and procedures. Although there are different methodologies for risk management, the core components of any risk analysis is made up of the following:

Identify company assets Assign a value to each asset Identify each asset's vulnerabilities and associated threats Calculate the risk for the identified assets

43

CHAPTER – IV

KINDS OF CAPITAL

BUDGETING DECISIONS

44

KINDS OF CAPITAL BUDGETING DECISIONS

There are basically three different kinds of decisions in capital budgeting they are as follows

a) The Option to Expand/Take Other Projects

Taking a project today may allow a firm to consider and take other valuable projects in the future.

Thus, even though a project may have a negative NPV, it may be a project worth taking if the option it provides the firm (to take other projects in the future) provides a more-than-compensating value.These are the options that firms often call “strategic options” and use as a rationale for taking on “negative NPV” or even “negative return” projects.

b) Mutually Exclusive Projects

In many cases, a firm will be faced with a choice of between mutually exclusive investment projects. These are cases in which the firm can undertake only one of the potential projects. For example, a firm may be considering whether to construct an office building or a shopping mall on a parcel of land, or deciding whether to refurbish an old apartment building or turn it into a parking garage. In this case, the NPV rule is to undertake the project with the largest NPV, so long as it is positive.

Example 3.8 A manufacturer is considering purchasing one of two machines, A and B. The cash flows of each of the projects are represented below on a time line. The project’s required rate of return is 10 percent. Since these projects are mutually exclusive, which proposal (if any) should the manufacturer choose?

45Project A

Year 0 1 2 3 4 5Cash Flow

-3,000

1,000

1,000

1,000

1,000

1,000

Project B

Year 0 1 2 3 4 5

Cash Flow

-2,000 700 700 700 700 700

The NPV computations are:

Since these are mutually exclusive projects and both have NPV > 0, we take the project with the highest NPV. Project A is thus the preferred alternative.

46

CHAPTER – IV

DIFFICULTIES IN CAPITAL BUDGETING

47Difficulties in Capital Budgeting

a) General difficulties where we get across

Ensuring that forecasts are consistent (across departments) Eliminating (reducing) conflicts of interest Reducing forecast bias: the proportion of proposed projects that have a positive NPV is independent of the estimated opportunity cost of capital.

Bottom-up and top-down planning is necessary.Control projects in progress, Post-audit afterwardsTry hard to measure incremental cash flows--when you canEvaluate performance: actual versus projected; actual versus absolute standard of the true cost of capital

b) Measurement problem:

While calculating the NPV, IRR, PAY BACK PPERIOD, AND PROFITABILITY INDEX, we have to be vary much careful with the calculations values throw it is a very difficult job to remember many values at a time but we have to be care full because it will effect on the total output of project in decision making Risk and uncertainty: Different capital investment proposals have different degrees of risk and uncertainly there is a slight difference between risk and uncertainty risk involves situations in which the probabilities of a particular event occurring are known where as in uncertainty these probabilities are unknown. In many cases these two terms are used inter changeably. Risk in capital investments may be due to the general economic conditions competition, technological developments, consumer preferences etc. One to these reasons the revenues costs and economic life of a particular investment are not certain. While evaluating capital investment proposals a proper adjustment should therefore be made for risk and uncertainty

48

CHAPTER – IV

DATA REQUIREMENT

49Data Requirement

a) Cash flow estimates

While estimation of cash flow we have to use the four principles of cash flow they are:-

(1) separation principle :- There are two sides of a project the investment side and the financing side and the cash flows associated with these sides should be separated the important point to be emphasized is that while defining the cash flows on the investment side, financing costs should not be considered because they will be reflected

in the cost of capital figure against which the rate of return figure will be evaluated.

Operationally this means that interest on debt is ignored while computing profits and taxes thereon. Alternatively, if interest is deducted in the process of arriving at profit after tax an amount equal to interest (1- tax rate) should be added to profit after tax note that Profit before interest and tax (1 – tax rate)

= (Profit before tax + interest)(1 – tax rate) = (Profit before tax (1 – tax rate) + interest (1 – tax rate) =Profit after tax + interest (1 – tax rate)

b) Incremental principle

The cash flow of a project must be measured in incremental terms. To ascertain a projects incremental cash flows you have to look at what happens to the cash flows of the firm with the project and without the project the different between the two reflects the incremental cash flows attributable to the project. That is,

Project cash flow for year t = cash flow for the firm – cash flow for the firm

50 In estimat5ing the incremental cash flows of the project, the following guidelines must be borne in mind they are consider all incidental effects ,ignore sunk costs, include opportunity costs, question the allocation of overhead costs ,estimate working capital properly

c) Post-tax principle:

Cash flows should be measured on an after-tax basis. Some firms may ignore tax payments and try to compensate this mistake by discounting the pre-tax cash flows at a rate that is higher than the cost of capital of the firm. Since there is no reliable way of

adjusting the discount rate, you should always use after-tax cash flows along with after-tax discount rate cash flows should be measured after taxes the important issues in assessing the impact of taxes are what tax rate should losses be treated? What is the effect of non-cash charges?

d) Consistency principle

Cash flows and the discount rates applied to these cash flows must be consistent with respect to the investor group and inflation

Investor group:

Cash flows to all investors = PBIT (1- TAX RATE) + Depreciation and non cash charges– Capital expenditure – Change in working capital

Inflation:

Nominal cash flow t= real cash flow (1+ expected inflation rate) t

e) Effect of indirect expenses

Cost Allocation is vital to understanding the costs and cost drivers of individual products, orders, customers and suppliers. Activity Based Costing is the best method of accurately assigning indirect costs to departments, customers, suppliers, products and orders.

51

However, only Resource Based costing, also known as Time Driven Costing, accounts for variability of different transactions and orders. Other solutions assign average costs, penalizing the most profitable, lowest-cost, products, customers and suppliers, while rewarding the high cost ones.

f) Effect of deprecation

If you buy agricultural property such as machinery, computers, breeding livestock, equipment, etc. that has a useful life of more than one year, you spread the cost of it over several years for record keeping and tax purposes. This is called depreciation. Property is depreciable if it meets these tests: 1. It must be used in business or held for the production of income. 2. It must have a determinable useful life longer than one year, and 3. It must be something that wears out, decays, gets used up, becomes

obsolete or loses value from natural causes.

g) Working capital effect

A company's current assets minus its current liabilities - considered a good measure of both a company's efficiency and its financial health. A positive working capital means that the company is able to pay off their short-term liabilities. A negative working capital means that a company currently is unable to meet their short-term liabilities with their current assets (cash, accounts receivable, inventory).

If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors that want their money quickly. The working capital ratio, which measures this ability to pay back creditors, is calculated as current assets divided by current liabilities.

Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company can’t be used to pay off any of its obligations. So if a company is not operating in the most efficient manner (slow collection) it will show up in the working capital. Comparing the working capital from one period of time to another can see this; slow collection may illustrate an underlying problem in the company’s operations.

52

CHAPTER – V

ANALYSIS

53

ANALYSIS

Calculation of total sales of the project

Years Capacity Production Local Sales

Selling Price

Total Sales

(in units)

1 80% 2570 1850 4132 76442002 90% 2892 2085 4649 96921233 90% 2892 2085 4649 96921234 90% 2892 2085 4649 96921235 90% 2892 2085 4649 96921236 90% 2892 2085 4649 96921237 90% 2892 2085 4649 96921238 90% 2892 2085 4649 96921239 90% 2892 2085 4649 969212310 90% 2892 2085 4649 9692123

54Calculation of variable Cost (000)

S.No. Particulars 1 2 3 4 5 6 7 8 910

Salaries & Wages 5500 6500 7500 8000 8200 4500 6200 8250 9775 12680

Electricity 1284 1456 1560 2140 3250 1590 3570 4150 4225 1478

Repairs & Maintenance

500 564 528 598 574 563 521 591 540 578

Administration exp

350 320 280 300 380 210 158 176 170 220

Total7634 8840 9868 11038 12404 6863 10449 13167 14710 14956

55Calculation of Net Profit of the Project

A B C D E F

Total Sales

Variable Cost

Fixed Cost

GP=A2-B2-C2

TAX 40%

NET PROFIT

15000 7634 3500 3866 1546 2319.6

17000 8840 3500 4660 1864 2796

17300 9868 3500 3932 1573 2359.2

17500 11038 3500 2962 1185 1777.2

18000 12404 3500 2096 838.4 1257.6

18500 6863 3500 8137 3255 4882.2

18800 10449 3500 4851 1940 2910.6

19250 13167 3500 2583 1033 1549.8

22890 14710 3500 4680 1872 2808

56PROJECT COST

Project Cost (omit 000)

phase-I phase-II Total

Land 1495

Civil Works 1621 538Buildings 1160 1788

Contingency 140 116

PreliminaryExpenses 341

Pre-operativeExpenses 756

Margin money forWorking capital 45

Total 5558 2442 8000

So the total cost of project is of 8000000

57Profitability Index or Benefit Cost

PI = [(Present value of cash in flows)/(Present value of cash out flows)]

Cash Flow- We is going to assume that the project we are considering approving has the following cash flow. Right now, in year zero we will spend 8,000,000 rupees on the project. Then for 5 years we will get money back as shown below.

Year Cash flow (000)

0 -80001 37332 32003 16004 10665 533

Payback – When exactly do we get our money back, when does our project break even? Figuring this is easy. Take your calculator.

Year Cash flow (000)

Running Total (000)  

0 -8000 -8000  

1 3733 -4267 (So after the 1st year, the project has not yet broken even)

2 3200 -1067 (So after the 2nd year, the project has not yet broken even)

3 1600 533 (So the project breaks even sometime in the 3rd year)

58 But when, exactly? Well, at the beginning of the year we had still had a -1067 balance, right? So do this.

Negative Balance / Cash flow from the Break Even Year = When in the final year we

break even1607 / 1600 = .666

So we broke even 2/3 of the way through the 3rd year. So the total time required to payback the money we borrowed was 2.66 years.

Discounted Payback –

Is almost the same as payback, but before you figure it, you first discount your cash flows. You reduce the future payments by your cost of capital. Why? Because it is money you will get in the future, and will be less valuable than money today. (See Time Value of Money if you don't understand). For this project, the cost of capital is 10%.

Year Cash flow(000)

Discounted Cash flow (000)

Running Total (000)

0 -8000 -8000 -80001 3733 3397 -46072 3200 2645 -19623 1600 1202 -7604 1066 728 -325 533 331 299

So we break even sometime in the 5th year. When?

Negative Balance / Cash flow from the Break Even Year = When in the final year we

break even-32 / 331 = .096

So using the Discounted Payback Method we break even after 4.096 years.

59Net Present Value (NPV) –

Once you understand discounted payback, NPV is so easy! NPV is the final running total number. That's it. In the example above the NPV is 299. That's all. You're done, baby. Basically NPV and Discounted Payback are the same idea, with slightly different answers. Discounted Payback is a period of time, and NPV is the final rupees amount you get by adding all the discounted cash flows together. If the NPV is positive, then approve the project. It shows that you are making more money on the

investment than you are spending on your cost of capital. If NPV is negative, then do not approve the project because you are paying more in interest on the borrowed money than you are making from the project. PROJECTED COST=8000000SALVAGE VALUE =5500000COST OF CAPITAL =10% ANDTAX RATE =50%

CFBT Debt CBT Tax50% EAT CFAT 10%cap CP6966 500 6466 3233 3233 3733 .909 33935900 500 5400 2700 2700 3200 .826 26432700 500 2200 1100 1100 1600 .751 12021632 500 1132 566 566 1066 .683 728566 500 66 33 33 533 .620 331

NPV = +297

DEP= ((0PROJECTED COST- SALVAGE VALUE)/NUMBER OF YEARS) = ((8000-5500)/5) = 500

NPV= (SUM OF PROFIT VOLUME – INITIAL INVESTMENT) = (8297-8000) = (+297)

60Profitability Index

Profitability Index Equals NPV Divided

byTotal Investment Plus 1

PI = 297 / 8,000 + 1

So in our project, the PI = 1.0375. For every borrowed and invested we get back 1.0375, or one rupees and 3 and one-third cents. This profit is above and beyond our cost of capital.

Internal Rate of Return –

IRR is the amount of profit you get by investing in a certain project. It is a percentage. An IRR of 10% means you make 10% profits per year on the money invested in the project. To determine the IRR, you need your good buddy, the financial calculator.

Year

Cash flow (000) 10%CAP PV 5%CAP PV

0 -8000 1 -8000 1 -80001 3733 .909 3393 .95 35462 3200 .826 2643 .90 28803 1600 .751 1202 .86 13764 1066 .683 728 .81 8635 533 .620 331 .77 410

NPV = +297 -1075

IRR=LR+ (NPV@LR/PV)*R =10+ (297/1372)*5 =11.08

61

Modified Internal Rate of Return - MIRR –

Is basically the same as the IRR, except it assumes that the revenue (cash flows) from the project are reinvested back into the company, and are compounded by the company's cost of

capital, but are not directly invested back into the project from which they came. OK, MIRR assumes that the revenue is not invested back into the same project, but is put back into the general "money fund" for the company, where it earns interest. We don't know exactly how much interest it will earn, so we use the company's cost of capital as a good guess.

Why use the Cost of Capital?

Because we know the company wouldn't do a project, which earned profits below the cost of capital. That would be stupid. The company would lose money. Hopefully the company would do projects, which earn much more than the cost of capital, but, to play it safe, we just use the cost of capital instead. (We also use this number because sometimes the cash flows in some years might be negative, and we would need to 'borrow'. That would be done at our cost of capital.)

How to get MIRR - OK, we've got these cash flows coming in, right? The money is going to be invested back into the company, and we assume it will then get at least the company's-cost-of-capital's interest on it. So we have to figure out the future value (not the present value) of the sum of all the cash flows. This, by the way is called the Terminal Value. Assume, again, that the company's cost of capital is 10%. Here goes...

62

Cash Flow(000)

Times   = Future Value of that year’s

Note

cash flow.

3733 X (1+. 1) ^ 4 = 5465 Compounded for 4

years

3200 X (1+. 1) ^ 3 = 4260 Compounded for 3

years

1600 X (1+. 1) ^ 2 = 1936 Compounded for 2

years

1066 X (1+. 1) ^ 1 = 1173 Compounded for 1

years

533 X (1+. 1) ^ 0 = 533

Not compounded at all becausethis is the final cash flow

TOTAL     = 13367 This is the Terminal Value

Why all those zeros? Because the calculator needs to know how many years go by. But you don't enter the money from the sum of the cash flows until the end, until the last year. Is MIRR kind of weird? Yep. You have to understand that the cash flows are received from the project, and then get used by the company, and increase because the company makes profit on them, and then, in the end, all that money gets 'credited' back to the project. Anyhow, the final MIRR is 10.81%.

63

CHAPTER – VI

CONCLUSION &

SUGGESTIONS

64

CONCLUSION & SUGGESTIONS

Decision and review of project

Company is getting its payback with in 2 to 3 years (approximately 2.66 years) Project can be approved such

that company can get back its profit with in a limited period.

Company is getting its “ Discounted Pay Back” with in 4.06 years even after discounting cost of capital.

NPV (Net Present Value) of the company is positive “297” so project the project can be approved.

PI (Profitability Index) is good because company is making money. Hence, the project can be approved.

IRR (Internal Rate of Return) is more than the cost of capital “11.08% so approve the project.

MIRR (Modified Internal Rate of Return) is also more than the cost of capital 10.81%

65

DECISION

66Decision Time- Do we approve the project? Well, let's review.

Decision Method Result Approve? Why?

Payback 2.66 years Yes Well, cause we get our money

back

Discounted Payback

4.096 years Yes

Because we get our money back, even after discounting our cost of capital.

NPV 297 Yes Because NPV is positive (reject the project if NPV is negative)

Profitability Index 1.0375 Yes Cause we make money

IRR 11.08 Yes Because the IRR is more than the cost of capital

MIRR 10.81% Yes Because the MIRR is more than the cost of capital

67

BIBLIOGRAPHY

68Bibliography

Financial Management - I .M PANDEY

Financial Management - Prasanna Chandra

Financial Accounting Analysis - Jainand Narang

Financial management - M.Y.Khan and Jain

International finance – Tata Mc Graw hill

Internet – www.google.co.in, www.indiainfo.com

Last year’s annual report - 2006 Project Planning, Analysis, and selection implementation: Satyanaryana.

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