Chapter 1

INTRODUCTION

1.1 Background

Capital expenditure is the list of planned investment expenditure on fixed assets outlays

for different projects. It is a process of selecting viable investment project. We can simply define

capital expenditure as investments to acquire fixed or long lived assets from which a stream of

benefits is expected. It represents an organization's commitment to produce and sell future

products and engage in other activities. Thus capital expenditure decision forms a foundation for

the future profitability of a company.

Capital expenditure activities are made up of two distinct processes: (a) making the decision and

(b) implementing it, which may include performing a post-appraisal. This Practice deals only

with the first process.

The capital expenditure decision is derived from and is closely associated with strategic planning

which is an effort by an organization to define its mission and goals and the policies and

strategies it will follow to attain them.

Capital Budgeting Tools

• Payback Period

• Accounting Rate of Return

• Net Present Value

• Internal Rate of Return

• Profitability Index

Modified Internal Rate of Return

Payback Period

Payback period is the time duration required to recoup the investment committed to a project.

Business enterprises following payback period use "stipulated payback period", which acts as a

standard for screening the project.

Computation of Payback Period

When the cash inflows are uniform the formula for payback period is cash outflow divided by

annual cash inflow

Indian Institute of Technology Madras

Accounting Rate of Return

Accounting rate of return is the rate arrived at by expressing the average annual net profit (after

tax) as given in the income statement as a percentage of the total investment or average

investment. The accounting rate of return is based on accounting profits. Accounting profits are

different from the cash flows from a project and hence, in many instances, accounting rate of

return might not be used as a project evaluation decision. Accounting rate of return does find a

place in business decision making when the returns expected are accounting profits and not

merely the cash flows.

Computation of Accounting Rate of Return

The accounting rate of return using total investment.

or

Sometimes average rate of return is calculated by using the following

formula:

Net Profit after Tax

Average Investment

Where average investment = total investment divided by 2

Net Present Value (NPV)

Net present value of an investment/project is the difference between present value of cash

inflows and cash outflows. The present values of cash flows are obtained at a discount rate

equivalent to the cost of capital.

Internal Rate of Return (IRR)

The internal rate of return method is also known as the yield method. The IRR of a

project/investment is defined as the rate of discount at which the present value of cash inflows

and present value of cash outflows are equal.

IRR can be restated as the rate of discount, at which the present value of cash flow (inflows and

outflows) associated with a project equal zero.

Profitability Index (PI)

Profitability ratio is otherwise referred to as Benefit/Cost ratio. This is an extention of the Net

Present Value Method. This is a relative valuation index and hence is comparable across

different types of projects requiring different quantum of initial investments.

Profitability index (PI) is the ratio of present values of cash inflows to the present value of cash

outflows. The present values of cash flows are obtained at a discount rate equivalent to the cost

of capital.

Modified Internal Rate of Return (MIRR):

Shortcoming of the IRR method is that it is commonly misunderstood to convey the actual

annual profitability of an investment. However, this is not the case because intermediate cash

flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is

almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of

Return (MIRR) is often used. 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.

1.2 Report Objective

The main objective of the study is

To understand about how the financial institutions make capital expenditure

decision.

To understand practically the capital budgeting techniques.

1.3 Limitations

Time constraints

Lack of accurate information from the respondents

Lack of knowledge about capital expenditure to respondents

Lack of reliability

Chapter 2

RESEARCH METHODOLOGY

2.1 Introduction

Information was collected from five financial institutions of Pokhara. The five financial

institutions that were surveyed are NIC Bank Limited, Muktinath Bikas Bank, Garima Bikas

Bank, Kist Bank and Lumbini Finance Company.

2.2 Research Design

A research design is the specification of methods and procedures for acquiring the

information needed to structure to solve problems. The present study is exploratory in nature.

The main aim of this study is to understand the capital expenditure practices in different

institutions of Pokhara. The survey research design has been adopted for this study. The

information were collected from the survey are analyzed according to the need of the study for

the attaining the stated objectives. Also, the analyzed data are presented in graphs using SPSS

package.

2.3 Sources of Data

The data were collected in the form of

i. Primary Data

ii. Secondary Data

i. Primary Data was collected in the form of Questionnaire and personal interview.

ii. Secondary Data was collected from

Internet

Books

Chapter 3

DATA ANALYSIS

3.1 DATA INTERPRETATION

Data Interpretation can be defined as "the application of statistical procedures to analyze specific

observed or assumed facts from a particular study". The collected data from each financial

institution was compared with each other and then observed.

Views on capital expenditure

1. Garima Bikas Bank- it covers decisions to acquire other firms, either through the purchase of their common stock or group of assets that can be used to conduct an ongoing business. It involves the entire process of planning expenditure with returns that are expected to extend beyond one year.

2. Muktinath Bikas Bank- Money spent to acquire and upgrade physical assets.

3. Kist Bank- Long term planning for making financial proposed capital outlay.

4. NIC Bank- Expenditure for acquiring physical assets at the time of establishment and

expansion of bank,

5. LFLC- long term decision for investment in assets.

For example: Tallo Modi Hydropower Project, Parbat

It is a hydropower project. If project wants to take lone from bank to operating its

activities, Project have to make capital structure and projected financial statement which shows

future cash inflow and outflow from this project. After that, calculate the NPV, IRR,

Discounted payback period of projected financial statement and have to submit bank’s credit

analysis committee. Bank’s credit analysis committee also makes project financials statement

and calculates the NPV, IRR, discounted payback period. Credit analysis committee have to tally

both calculated figure, if any deviation found once times they can evaluate project and make a

decision but company’s calculated figure should greater than or equal to bank’s calculated figure

and finally they make decision to invest on this project. Bank used the most appropriate tools to

take final decision which is NPV and IRR because discounted payback period ignores cash flow

after the expiration of the payback period. NPV and IRR may give contradictory result, but NPV

shown to lead to the correct project selection because banks are expected to add greatest

increment in value of the firm. Initial stage, bank doesn’t provide loan fully they provides

installment basis according to debt equity ratio to complete fixed period of task. If debt equity

ratio have 80%, bank provides 48% loan and project should invest 52% equity to complete the

fixed task during the fixed period. This cycle will be continuing up to end the project.

Taking about the capital expenditure fixed assets are included furniture fixture, office

equipment, computer software, leasing, machinery items and vehicles. They are using

deprecation method straight-line and diminishing balance method to depreciation and

amortization according to nature. The table below indicates the same.

Items Depreciation charge Method

Furniture 25% SLM

Leasehold property 5 years written off

Computer software 25% Zero at the end of five year

Fixture(leasehold development) 10% SLM

Computer accessories 25%

Office Equipment 25% SLM

Machinery 15% Diminishing rate

Vehicles 20% Diminishing rate

Computer parts 15% Diminishing rate

Comparative study of five financial institutions in making capital expenditure decision

3.1.1 Origin

Name Type of project

Originator of proposal

Official of

similar salary or

rank status

Proposal origination

Use of proposal

origination

Completion of proposal origination decided by

GBL Investment in loan

Board of directors

noneMgmt sponsored productivity scheme

Memorandum Financial Interaction committee

MBBL Investment in loan

Board of directors

noneFormal suggestion scheme

Memorandum Financial manager

Kist Investment in hydro project

Loan Approved Committee

someMgmt sponsored productivity scheme

Memorandum Operation managers

NIC Investment in loan

Board of directors

noneFormal suggestion scheme

Memorandum Loan head

LFLC Investment in loan

Executive members

noneFormal suggestion scheme

Specific formFinancial Manager

Table 1

From the table 1, it is clear that among the five financial institutions, Kist invests in Hydro

project whereas rest of the financial institutions invests in loan and other development programs

like construction of Blacktopped roads and infrastructure which were mentioned during the

interview.

It is also seen that Board of Directors are originators of proposals whereas in LFLC, executive

members does. Similarly, LFLC uses specific form for proposal origination whereas other

financial institutions use Memorandum for the same.

It is also found that there are various governing body as seen in the table which decides the

completion of proposal origination.

Graph of the above table is also shown.

Fig 1 shows the type of project that financial institutions invest in. Among the five institutions

surveyed, four has responded in favor of investments in loan and one institution in hydro project.

Fig 1

Fig 2 indicates the form used for proposal origination. Here, as stated in the table above four

financial institutions uses Memorandum whereas one of the surveyed institutions uses a specific

form for proposal origination.

Fig 2

3.1.2 Progression

NameAuthorization of

proposal

Duty undertaken Preliminary

investigation

Responsible

person for

proposal study

GBL CEOFinancial

Interaction

Committee

No production of

prototype

machine and

products

Loan manager

MBBLCEO Loan manager Not any Loan Manager

KistCEO Loan manager Not any Loan Manager

NICCEO Loan manager Not any Loan Manager

LFLC CEOFinancial

Manager

Not any Loan Manager

Table 2

From the above table, it is found that CEO authorizes the proposal and Loan Managers are

responsible for proposal study in the surveyed financial institutions.

Financial Interaction Committee undertakes the duty at GBL whereas Loan Managers undertakes

at MBBL, Kist & NIC and Financial Manager at LFLC. Fig 3 indicates the same.

Fig 3

3.1.3 Evaluation

NameFormal

Financial

Evaluation

Evaluation of

capital

expenditure

proposal

No. of years

project

assessed

Assessment of

cost to the

firm of

financing

Method of

evaluation

GBLsubjected

Prices

demanded by

customers

- Cash inflows-

cash outflows

NPV

MBBLsubjected

Working

capital

requirement

- Debt coverage

ratio

NPV, IRR,

Payback period

and ARR

Kist subjectedPrices quoted

by suppliers 2

Return on

Equity NPV and IRR

NICsubjected

Working

capital

requirement

- Debt/Equity

ratio

NPV and IRR

LFLCsubjected

Working

capital

requirement

- Cash inflows-

cash outflows

NPV and IRR

Table 3

From the table 3 it is found that all types of capital expenditure proposals are subjected to formal

financial evaluation at the surveyed financial institutions.

Increase working capital requirements is included for the evaluation of capital expenditure

proposal at MBBL, NIC and LFLC whereas at GBL and Kist, evaluation is included in the form

of prices demanded by customers and prices as quoted by suppliers respectively.

There was no response when asked number of years a project is assessed but in Kist, estimation

of 2 years would require.

Inorder for evaluation method, NPV, IRR and payback period are normally followed.

Fig 4 reflects the way in which the assessment of cost of the firm to the financing the capital

invested.

Fig 4

Fig 5 reflects the method of evaluation used by institutions

Fig 5

3.1.4 Decision Appraisal

NamePractice to appraise

profitability

Review the information

Benefits from decision

appraisal

Changes in approach to

capital expenditure management

GBL Project sizeFinancial committee Profitable return No changes

MBBL Cost of projectFinancial committee

Long term sustainability No use of ARR

Kist Cost of project Financial committee

Profitable returnChanges in the

use of NPV, IRR and Payback

period

NIC Cost of projectFinancial committee Profitable return No changes

LFLC Project sizeFinancial committee Profitable return No ARR

Table 4

Table 4 indicates the information about Decision Appraisal.

It is found that size of the project is the practice followed to appraise the profitability of

investments when they become operational at GBL and LFLC whereas cost of project

determines the practice to appraise profitability among the rest. It is also found common in all

the financial institutions surveyed that financial committee is the one who reviews the

information on decision appraisal. Long term sustainability is the benefit resulted from decision

appraisal at MBBL whereas Profitable return is the benefit resulted in rest of the financial

institutions surveyed.

Figures indicating the practice to appraise the profitability of investments and the benefits that

have resulted from the decision appraisal are shown on the following page.

Fig 6 indicates the practice to appraise the profitability of investments when they become operational.

Fig 6

Fig 7 indicates the benefits that have resulted from decision appraisal.

Fig 7

3.2 MAJOR FINDINGS OF THE STUDY

Capital expenditure covers decisions to acquire other firms, either through the purchase

of their common stock or group of assets that can be used to conduct an ongoing

business. It involves the entire process of planning expenditure with returns that are

expected to extend beyond one year.

If the present value of project's future cash flow is greater than cost of project, than such

project is accepted. The institutions are using NPV for maximizing the wealth which

measures the incremental wealth from undertaking the project. Such project is undertaken

whose NPV is greater than zero.

Under capital budgeting techniques we found that, the institutions are using NPV,

payback period, IRR and even ARR. For making decision, NPV is mostly used as it

shows present value of expected future cash flows.NPV is most preferred as it considers

risk factor.

In most of the institution we found that IRR is preferred after NPV criterion as it is

affected by size of cash flows and consider reinvestment rate.

It was found that profitability index was used by institutions to assess the amount of

profit from investment in assets. It is the ratio of present value of cash inflows and cash

outflows. It also assists in relative comparison of project as it is also a modified NPV.

Chapter 5

RECOMMENDATION

For the organizations:

The institution should use capital budgeting techniques for making major investment

decision and to implement it as it influence profitability.

As founded that capital budgeting techniques is the lifeblood for undertaking major

decision, financial institutions should pertain all the information require for capital

budgeting expenditure.

There should be discussions of quantitative estimates to represent decision model for

administration of the capital expenditure decision process in these institutions.

For the researcher:

Researcher need to prepare on the questionnaire part more so that the same could be

enquired with the interviewee with ease.

It would have been better if various organizations are surveyed instead of only financial

institutions.

REFERENCE

Brigham, E.F (June 2001, 10th edition). Financial Management Theory and Practice.

Florida: Thomson South Western Publication.

http://en.wikipedia.org/wiki/Capital_expenditure

http://EzineArticles.com/3452410

Appendix