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CHAPTER 1

INTRODUCTION


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INTRODUCTION TO CAPITAL BUDGETING

CAPITAL BUDGETING

Capital budgeting is an essential managerial tool used in decision making. One

duty of a financial manager is to choose investments with satisfactory cash flows and rate

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 is needed to evaluate, compare, and select projects and sub

options. This procedure is called capital budgeting.

Capital budgeting is investment decision-making as to whether a project is worth

undertaking. Capital budgeting is basically concerned with the justification of capital

expenditures.

Current expenditures are short-term and are completely written off in the same

year that expenses occur. Capital expenditures are long-term and are amortized over a

period of years.

Capital budgeting is the process by which the financial manager decides whether

to invest in specific capital projects or assets. In some situations, the process may entail in

acquiring assets that are completely new to the firm. In other situations, it may mean

replacing an existing obsolete asset to maintain efficiency.

Capital budget may be defined as the firms decision to invest its current funds

most efficiently in the long-term assets in anticipation if an expected flow of benefits over a

series of years". Therefore it involves a current outlay or series of outlay of cash resources

in return for an anticipated flow of future benefits. Capital budgeting is the process of

identifying , analyzing and selecting investment projects whose returns (cash flow) are

expected to extend beyond one year.


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Long-term investments represent sizable outlays of funds that commit a firm to

some course of action. Consequently, the firm needs procedures to analyze and properly

select its long-term investments. It must be able to measure cash flows and apply

appropriate decision techniques. As time passes, fixed assets may become obsolete or may

require an overhaul, at these points too financial decisions are to be made.

Capital budgeting is the process of evaluating and selecting long-term investments

that are consistent with the firms goal of maximizing owner wealth. Firms typically make a

variety of long-term investments, but the most common for the manufacturing firm is in

fixed assets, which include property (land), plant, and equipment.

Components of Capital Budgeting

Initial Investment Outlay

It includes the cash required to acquire the new equipment or build the new plant, less any

net cash proceeds from the disposal of the replaced equipment. The initial outlay also

includes any additional working capital related to the new equipment. Only changes that

occur at the beginning of the project are included as part of the initial investment outlay.

Any additional working capital needed or no longer needed in a future period is accounted

for as a cash outflow or cash inflow during that period.

Net Cash benefits or savings from the operations:

This component is calculated as follow:

The incremental change in operating revenues-The incremental change in the operating

cost = Incremental net revenue-Taxes Changes in the working capital and other

adjustments

Terminal Cash flow

It includes the net cash generated from the sale of the assets, tax effects from the

termination of the asset and the release of net working capital.


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The Net Present Value technique

Although there are several methods used in Capital Budgeting, the Net Present Value

technique is more commonly used. Under this method a project with a positive NPV implies

that it is worth investing in.

Example: A company is studying the feasibility of acquiring a new machine. This machine

will cost $350,000 and have a useful life of three years after which it will have no salvage

value. It is estimated that the machine will generate operating revenues of $300,000 and

incur $75,000 in annual operating expenses over the useful life of three years. The project

requires an initial investment of $15,000 in working capital which will be recovered at the

end of the three years. The firms cost of capital is 16%. The firms tax rate is 25%.

Steps in Capital Budgeting

Capital budgeting is the process of determining whether a big expenditure is

in a company's best interest. Here are the basics of capital budgeting and how it works.

Company undertakes capital budgeting in order to make the best decisions

about utilizing its limited capital. For example, if we are considering opening a distribution

center or investing in the development of a new product, capital budgeting will be

essential. It will help to decide if the proposed project or investment is actually worth it in

the long run.

Identification or Innovation of Investment Projects

The first step in the capital budgeting process is to identify the opportunities that we have.

Many times, there is more than one available path that a company could take. We have to

identify which projects we want to invest and further and which ones do not make any

sense for company. If we overlook a viable option, it could end up costing us quite a bit of

money in the long term.


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Estimating Cash Flow

We need to determine how much cash flow it would take to implement a

given project. We also need to estimate how much cash would be brought in by such a

project. This process is truly one of estimating--it takes a bit of guesswork. We need to try

to be as realistic as we can in this process. Do not use the best-case scenario for numbers.

Most of the time, we need to use a fraction of that number to be realistic. If the project takes

off and the best-case scenario is reached, that is great. However, the odds of that happening

are not the best on new projects.

Evaluate the Investment Projects

Once have identified the reasonable opportunities, we need to determine

which ones are the best. Look at them in relation to overall business strategy and mission.

See which opportunities are actually realistic at the present time and which ones should be

put off for later.

Selection the Best Investment Project

After we look at all of the possible projects, it is time to choose the right

project mix for company. Evaluate all of the different projects separately on their own

merits. We need to come up with the right combination of projects that will work for

company immediately. Choose only the projects that match with company goals.

Implementation of the Project

Once the decisions have been made, it is time to implement the projects. Implementation is

not really a budgeting issue, but we will have to oversee everything to be sure it is done

correctly. After the project gets started, we will need to review everything to make sure the

finances still make sense.


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Continuous Evaluation of the Selected Project

Here, project manager has to see the performance of the selected project. He has to check

for any error and calculate the profit as per cash flow.

Application/Grounds of Capital Budgeting

As already discussed, capital budgeting is used to take decision for future financial

investment of large amount.

Purchases of FixedAssets

Capital budgeting is used to take decision for new investment to purchases land, equipment

or building for any organisation.

Modernization of Production Process

Here one needs to distinguish a new production method and an old one. The need is to

compare administrative disbursement, life time of projects, salvage value, market price etc

by financial investment method and determine which is best one and which method need

to follow: continuation of old method or set new production method?

Expansion of business

When a company wants to expanse business, there is a need to take decision for such

expansion. Such business expansion may necessitate buying a machine for production. In

this case, company production manager need to calculate the total net cash outlet for

machine setup and the total profit from this machine for selected year.


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Importance of Capital Budgeting

Capital budgeting decisions are of paramount importance in financial decision. So it needs

special care on account of the following reasons:

Long-term Implications

A capital budgeting decision has its effect over a long time span and inevitably affects the

companys future cost structure and growth. A wrong decision can prove disastrous for the

long-term survival of firm. On the other hand, lack of investment in asset would influence

the competitive position of the firm. So the capital budgeting decisions determine the

future destiny of the company.

Involvement of large amount of funds

Capital budgeting decisions need substantial amount of capital outlay. This underlines the

need for thoughtful, wise and correct decisions as an incorrect decision would not only

result in losses but also prevent the firm from earning profit from other investments which

could have been undertaken.

Irreversible decisions

Capital budgeting decisions in most of the cases are irreversible because it is difficult to

find a market for such assets. The only way out will be to scrap the capital assets so

acquired and incur heavy losses.

Risk and uncertainty

Capital budgeting decision is surrounded by great number of uncertainties. Investment is

present and return is future. The future is uncertain and full of risks. Longer the period of

project, greater may be the risk and uncertainty. The estimates about cost, revenues and

profits may not come true.


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Accept-reject decisions

Business firm is confronted with alternative investment proposals. If the proposal is

accepted, the firm incur the investment and not otherwise. Broadly, all those investment

proposals which yield a rate of return greater than cost of capital are accepted and the

others are rejected. Under this criterion, all the independent proposals are accepted.

Limitation of Capital Budgeting

Capital budgeting is very important to take future financial decision. Because future profit

and loss depends of capital budgeting. But capital budgeting has some limitations.

Lack of Adequate Data, Lack of Reliability of the Data, Problem of Measuring Future, Timing

of the Projects, Problems of Quantification, Personal Judgment of the Decision.

RESEARCH METHODOLOGY

Methodology: Methodology may be a description of process, or may be expanded to

include a philosophically coherent collection of theories, concepts or ideas as they relate to

a particular discipline or field of inquiry.

Methodology may refer to nothing more than a simple set of methods or procedures or it

may refer to the rationale and the philosophical assumptions that underlie a particular

study relative to the scientific method. For example, scholarly literature often includes a

section on the methodology of the researchers.

RESEARCH: Research is defined as human activity based on the intellectual application in

the investigation of matter. The primary purpose for applied research is discovering,

interpreting, and the development of the methods and systems for the advancement of

human knowledge on a wide variety of scientific matters of our world and the universe.

Research can use the scientific method, but need not do so.


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SCOPE OF RESEARCH: Research needs valuable resources such as money, time, materials,

manpower and machines to get the work done effectively to minimize input value for a unit

value of output and the return-on-investment.

AIM OF RESEARCH:

The assigned task was to conduct a survey for a well reputed company. Research is

concerned with the systematic and objective collection, analysis and evaluation of

information about specific aspects in order to help management make effective decisions.

Once the aspect is identified and defined, it is the responsibility of the researcher to chalk

out a comprehensive plan explaining each step required to conduct the research in a

successful manner.

OBJECTIVES OF RESEARCH: The principal objective of research is to find solutions to

problems in a systematic way. In general, the objectives of research can be specified as:

y To acquire familiarity with a phenomenon.y To study the frequency of connection or independence of any activity or occurrence.y To determine the characteristics of an individual or a group of activities and the frequency

of the occurrence of these activities.

y To test a hypothesis about a causal relationship that exists between variables.The first step in research is setting the objectives for which their study is to be undertaken. It is

essential that objectives are set before hand. The objectives must be hierarchical, quantifiable,

realistic and verifiable.


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CAPITAL BUDGETING IN BHEL

The capital budgeting in BHEL is based elaborate, which covers the following aspects.

1) CAPITAL FUNDS BUDGET:-y Five year plansy Annual plan exercise.

2) FEASIBILITY REPORT/DETAILED PROJECT REPORT:-y Submission and approval procedure/financial limits.y Guidelines for preparation of feasibility reports.y Externally funded schemes.

3) PROGRESS REPORTINGAND MONITORING

4) REPLACEMENT GUIDELINES

5) GOVERNMENT GUIDELINES


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DEFINITIONS:-

CAPITALEXPENDITURE:-

All expenditure exceeding Rs. 10,000 which results in the acquisition of permanent

assets is called capital expenditure. These assets are intended to be continuously used in

the business for the purpose or earning revenue directly or indirectly.

FIVE-YEAR PLAN:-

Fiveyear plan of the company constitute the preliminary programmes of budgeted

investment during the plan period of 5 years. These investments are planned against

various categories viz schemes under implementation, new schemes to be taken up in

science and technology, modernization & rationalization and welfare facilities.

ANNUAL PLAN:-

The annual plan comprises yearly capital investment funds budget of the company to

be submitted to the government for approval. The allocated funds by the government are

utilized in a planned manner against at the investment schemes of modernization and

rationalization, township, science and technology.

CAPITAL FUNDS BUDGET:-

Capital funds budget is what enable a programme of action on all capital expenditure

item to be grouped in one consolidated document. This outlines the proposal for creation of

new assets additions for increase in production; diversification or reduction of cost ensures

how these ventures will be financed over a given period. Included five year plan, annual

plan exercise and no-plan budget exercise, which are described blow.


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FIVE-YEAR PLAN EXERCISE:-

The government has been formulating five-year plans for the economic growth of the

country. In line with this policy, BHEL also formulates the five-year plans of the company

and submits to the government for inclusion in every five-year plan of the country.

Five-year plans exercise normally starts from the third year of the previous five-

year plan. These schemes included in the five-year plan approved by planning commission

are prioritized for implementation depending on the need/resources etc, these schemes

should be in line with Perspective Plan of the company.

FINDING MODE:-

Plan funds are provide by the planning commission for each scheme based the

progress, funds availability etc, the five-year plan funds are then distributed and released

as per the annual plans of the undertakings.

ANNUAL PLAN EXERCISE:-

The capital funds budget/annual plan is meant for making provision for cash

expenditure of capital nature including the foreign exchange component wherever

necessary.

The capital funds budget will mainly contain the following information along with

other information.

1) Revised estimates for the current year.2) Budget estimated for the ensuring year i.e. budget year

FUNDING MODE:-

As per present practice, the annual plan/capital funds budget of the company is

financed under two major headsBudgetary supports from the government.

Internal resources of the company.


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1) The budgetary support from the government is received in the form ofloan and equity the ratio of 1:1 approximately as per the government

guidelines.

2) Internal resources are the companys own funds/reserves. The presenttrend indicates gradual decline budgetary support from the government

and it is insisting on utilizing of more internal resources for capital

funding. This necessitates a rigorous and critical budget formulation

exercise.

BUDGET SUBMISSION

The complete consolidated capital funds budget as per the prescribed formats/information

required giving revised budget for current year, funds budget for ensuing year (i.e. budget

year) preliminary budget for the year following the budget year should reach corporate

office be 10th August every year. The division will be communicated about the board

approval/provisional government indications by December/January every year.

NON-PLAN BUDGET EXERCISE:-

All expenditure on capital equipment like cranes, materials handling equipment,

special tools and plants equipment, which are required at project sits for erection and

commissioning purpose etc, should be considered as non-plan expenditure.

FEASIBILITY REPORT:-

Guidelines for preparation of feasibility report.

For investments a detailed feasibility report is required to be formulated for approval

of the competent authority. The feasibility report must spell out in detail the following,

yObjectives of the scheme/project.

yConsistency with the company plans/policies.yInputs required and their phasing.yFinancial economic analysis.


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yImplementation plan.yExpansions programmed in future if any.

In BHEL the capital investment proposal can be classified broadly as

ySchemes for expansion of plan capacity diversification etc.yModernization and rationalization, including replacement schemesyTownshipyScience and technology

SCHEMES/PROJECTS:-

Feasibility report for such schemes should include an analysis for the project/plant,

its present status, its products and this role in the industry. Government view on the

present/ future growth plans for thee industry to which the products belong and current

five year plan provisions for the scheme should also be brought out.

NEED FOR THE PROJECT:-

A brief paragraph on alternatives examined/results obtained should be included in

the report.

This should done taking into consideration factors like optimum size of the plant,

location, product mix, technology, demand, transportation etc.

TECHNOLOGY CONSIDERATION/CHOICE:-

For the products to which the scheme relates all considerations /parameters analyzed

in making the choice should be outlined. These may enumerated as follows.ySuitability of technology for the product/raw material availableyStatus of technology within BHELyWhether exiting/new technology, if new, reasons for preference and benefits.


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yTrends in world/ local markets.yCompetitiveness of the technology chosen.yCollaboration proposedyR&D activities required.yChances of technology chosen getting obsolete.

PROJECT DESCRIPTION:-

In order to help the appraisal in analyzing evaluating the proposal, the

description should touch upon site, equipment requirements, input requirements, laborsphasing of construction, production built up, and any collaboration required, housing needs

etc.

MARKETING:-

The detailed market analysis in the feasibility report should answer questions like,

Total market potential for the product.

Expected market share.

Competitors details.

Based on the market survey, the demand supply position in details should be given.

Marketing plan for the product based on market survey and studies conducted for the

product should be mentioned in the report.

CAPITAL INVESTMENT REQUIREMENTS:-

It is necessary that the estimates of capital costs presented in the feasibility report

should be reasonable, complete and properly estimated. For the purpose of the project

appraisal, capital costs are essentially those costs, which are incurred before the

commencement of commercial production. For fixed assets costs like customs duty, excise

insurance, transportation at the latest applicable rate should be calculated.


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OPERATING REQUIREMENTS:-

For the purpose of project appraisal, operation costs are essentially those costs, which

are incurred after the commencement of commercial production. This will help in financial

analysis.

FINANCIALANALYSIS:-

The purpose of financial analysis of a project is to presents some measures to assess

the financial viability of the project. The data presented in this format should be consistent

with the production plans, operation costs, and capital costs.

SENSITIVITYANALYSIS

The feasibility report should also briefly indicate present the results of sensitivity

analysis. This is relevant whenever the key assumptions made in the feasibility report are

likely to be changed/affected.

PROJECT IMPLEMENTATION PLAN:-

The feasibility report should briefly indicate the project implementation, organization

that will be responsible for executing the scheme. This is most essential for

expansion/diversification schemes at existing plant locations.

ECONOMICANALYSIS:-

Economic analysis of the viability of the project is evaluated taking in, to the account

the opportunity cost of the tradable inputs/outputs, which go in to the project, shadow

prices for foreign exchange, domestic resources costs to the non-tradable inputs. Such

analysis may be relevant for planning commission in evaluating the projects form the

national perspective/plans.

PREPERATION OF DETAILED PROJECT:-

For all capital investment schemes, which have been approved by the government, it

is essential to prepare a detailed project report, which will form the basis of project

execution. The purpose of detailed project report is not only to enable projecting a realistic


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requirement of budgetary funds, but it would also improve the planning the

implementation aspects of capital projects. The detailed projects reports should be

submitted within six months from the date of financial sanction for the scheme.

BASIC STRUCTURE/LAYOUT OF TYPICAL FEASIBILITY REPORT:

1. NEED FOR THE PROJECTy Company plans/objectivesy Government policy/five year plansy Industry detailsy Examination of various alternatives and results

2. TECHNOLOGY CONSIDERATIONAND CHOICE

3. PROJECT DESCRIPTIONy Site selection/availability of existing infrastructurey Environmental considerationy Housingy Plant & machinery equipment descriptiony Constructions description and materialsy Manpowery Transportationy Planning of constructiony Production technologyy Input requirements


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4. MARKETING DEMAND SUPPLYANALYSISy Industry datay Demand/supply positiony Choice and product mixy Selling price and Export potential marketing organization5. CAPITAL INVESTMENT REQUIREMENTy Capital cost for plant and machinery, civil works buildingy Basis for estimationy Other items of capital cost/interest during construction6. OPERATING REQUIREMENTSy Operating cost and its basisy Inventoryy Production built up7. FINANCIALAGENCIESy Assumptions made regarding depreciation, income tax, investment allowances,y Profit and loss statementy Return on investment at various plant capacities,y Discounted cash flow analysisy Financial statementy Break even analysis


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8. PROJECT IMPLEMENTATIONy Schedule of the activities of the projecty Project organizationy Availability of scarce construction inputsy Infra structure9. SENSITIVITYANALYSISy With respects to demand forecasty With respect to capital costsy With respect to input pricey With respects to any other critical element.

10. ECONOMICANALYSES

y Foreign exchange savingsy Development of labour skills/employment generatedy Ancillary developmenty Exporty Time cycle reduction


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PROGRESS REPORTING/MONITORING NEED: -

Once the capital budget has been approved, it has to be ensured that targets

laid down regarding physical progress adhered to. Any shortfall in this regard is likely to

delay the completion of project and ultimately affects production program me. Therefore,

each project is continuously monitored at division level both physical and financial.

For major projects costing more than 5 crores, project review committees are required to

be constituted having representatives from project unit and corporate office. These

committees should meet periodically to review the progress and recommend taking

corrective actions.

REPORTING PROCEDURE:

At the beginning of each financial year mid April, each division should make a detailed

month wise cash outflow plan for each scheme linked with the major physical activities of

that scheme. Complete progress of the scheme for the budget year should be reported on

this plant.

1. MONTHLY REPORTING:The capital expenditure progress should be reported to corporate office in this first

week of the every month with effect from April.

2. QUARTER REPORTING:Apart from above, quarterly report should be submitted to corporate for the purpose of

information to be sent to government/directors and CMD on the progress status everyquarter.


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3. COMPLETION REPORT:In case of completed projects, a completion report should be submitted one year

after the start of commercial production

REPLACEMENT GUIDELINES:

Substantial investments have been made in the plant and machinery in all the BHEL

manufacturing division. Through modernization and expansion programmers, new

machine tool has been added from time to time. New projects are underway increasing

investment in plant and machinery still to higher level.

Capital expenditure will be considered to have been accrued for replacement if an item

of equipment is declared to be unfit to perform the desired functions and similartechnologically better piece of equipments is purchased in its place to continue the specific

work.

Replacement of plant and machinery may be warranted for the following reasons:

1. Due to natural wear and tear2. Technological obsolescence3. Change in service requirements4. Accident

PROCEDURE FOR REPLACEMENT

Each unit will have replacement committee, the replacement committee should

comprise representatives from manufacturing technology, maintenance and services,

factors engineering, finance industrial engineering management services and central

planning divisions. They are representatives from the maintenance and services

department will be the convener does not change often. The committee may formulate a

written guideline indicating factors, which are to being taken on to account while carrying

out technical appraisal. Once the need for replacement is established and various

alternatives suggested, the proposal would be submitted to replacement committee for

taking the decisions.


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DISPOSAL OF EXISTING MACHINE

Replacement committee will also decide the manner in which the existing machine tool,

is to be disposed off, before giving to outside party, it will examine the possibility of

assigning the existing machine to alternative uses within the division or sister divisions.

Having taken the decision on the disposal, responsibility may be fixed on suitable agencies

within the division.

GOVERNMENT GUIDELINES/POLICIES

Reference has been made in the manual to various governments publications containing

guidelines/policies which are relevant/useful for the capital budgeting exercise within the

BHEL and with the other government departments.

PROCEDURE OF CAPITAL BUDGETING IN BHEL

The following budgeting procedure in BHEL is done in four phases which can be

explained as follows:

FIRST PHASE

This phase involves the different aspects involved in approval put forth by the department

concerned. The different steps involved are:-

1. A letter of requisition with the proposal is sent to the department concerned tothe R&D department. This letter contains the specifications of the item and in

the case of replacement the need for the replacement is to be clearly specifiedalong with the estimate

2. This proposal is sent from R&D department to finance, industrial engineeringand maintenance and services departments for their consent.

3. Finance department looks into the financial aspects of the proposal.


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4. Industrial engineering department checks whether the specifications are apt forthe proposal.

5. Maintenance and service department.

SECOND PHASE

This phase involves the following steps:

1. The departments which has sent the proposal, gives 100% specifications to thepurchase department.

2.

The purchase department list outs the suppliers and quotations are invited.

3. After the quotations are received, the proposal with least cost is opted for, alsokeeping in view the quality of the item.

4. The item is then ordered.5. The stores department receives the item ordered for.6. The stores department unpacks the item and physical effects if any are checked.7. If the item is satisfactory, it is installed in the right place.

THIRD PHASE

This phase involves the following steps:

1. A representative of the supplier gives demonstration with respect to thetechnical aspect and usage of the item.

2. The item is then put to use.3. From time to time, steps are taken for proper maintenance.


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FOURTH PHASE

If the machines become worn out or obsolete, it is disposed off for replacement.

The price is described above its continuous cycle. It can be represented diagrammatically

as follows:

APPROVAL

DISPOSAL PROCUREMENT

PUT IN USE


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CHAPTER 2

COMPANY PROFILE


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BOARD OF DIRECTORS

Shri B.P. Rao (Chairman & Managing Director)

PART TIME OFFICIAL DIRECTORSy Shri Saurabh Chandra (Additional Secretary & Financial Adviser)y Shri Rajiv Bansal (Joint Secretary)

PART TIME NON-OFFICIAL DIRECTORSy Shri S. Raviy ShriAshok Kumar Basuy Shri M.A. Pathany Smt. Reva Nayyary Shri V. K. Jairath

FUNCTIONAL DIRECTORSy Shri C. S. Verma (Director Finance)y ShriAnil Sachdev(Director HR)y ShriAtul Saraya (Director Power)y Shri O.P. Bhutani(Director (E, R & D))


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COMPANY PROFILE

BHEL AN OVERVIEW

BHEL is the largest engineering and manufacturing enterprise in India in the energy,related/infrastructure sector, today.

BHEL was established more than 40 years ago, ushering in the indigenous Heavy

Electrical Equipment industry in India - a dream that has been more than realized with a

well-recognized track record of performance. The company has been earning profits

continuously since 1971-72 and paying dividends since 1976-77.

BHEL manufactures over 180 products under 30 major product groups and caters to

core sectors of the Indian Economy viz., Power Generation & Transmission, Industry,

Transportation, Renewable Energy, etc. The wide network of BHEL's 14 manufacturing

divisions, four Power Sector regional centres, over 100 project sites, eight service centers,

18 regional offices and one subsidiary enables the Company to promptly serve its

customers and provide them with suitable products, systems and services -- efficiently and

at competitive prices. The high level of quality & reliability of its products is due to the

emphasis on design, engineering and manufacturing to international standards by

acquiring and adapting some of the best technologies from leading companies in the world,

together with technologies developed in its own R&D centers.

BHEL caters to core sectors of the Indian Economy:

1. Power Generation and Transmission,2. Industry,3. Transportation,

4. Renewable Energy,


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Power Generation and Transmission:

Power Generation Sector comprises thermal, gas, hydro and nuclear power plan

business.

The company manufactures 220/235/500/540 MW nuclear turbine-generator sets.

Custom-made hydro sets the power plant equipment manufactured by BHEL is based on

contemporary technology comparable with the best in the world, and is also internationally

competitive.

The company has proven expertise in plant performance improvement through

renovation, modernization and up rating of a variety of power plant equipment, besides

specialized know how of residual life assessment, health diagnostics and life extension of

plants.

Industries:

BHEL manufactures and supplies major capital equipment and systems like captive

power plants, centrifugal compressors, drive turbines, industrial boilers and auxiliaries,

waste heat recovery boilers, gas turbines, pumps, heat exchangers, electric machines,

valves, heavy casting and forgings etc. to a number of industries other than power utilities

like metallurgical, mining, cement, paper, fertilizers, refineries and petro-chemicals, etc.

BHEL has also emerged as a major supplier of controls and instrumentation systems,

especially distributed digital control systems for various power plants and industries.

Transportation:

Most of the trains on Indian Railways, whether electric or diesel powered are equipped

with BHELs traction propulsion system and controls. The systems supplied are both with

conventional DC drives and state of the art AC drives. Indias first underground metro at

Kolkata runs on drives and controls supplied by BHEL.

Renewable energy:

BHEL has been manufacturing and supplying a range of renewable energy system and

products. It includes solar energy system namely PV modules, PV power plants, solar

lanterns, street lighting, solar pumps and solar water heating system. A large no of small


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hydro power stations have also been completed. New areas like wind power generation etc.

are also being explore for entry.

ABOUT BHEL RAMACHANDRAPURAM UNIT:

The Ramachandrapuram unit of Bharat Heavy Electricals Limited (BHEL) has achieved

its highest-ever turnover of Rs. 5,004 crore and a record profit of Rs. 930 crore during the

year 2009-10.

The company registered a 21 per cent increase in turnover as compared to Rs. 4,149

crore and 24 per cent increase in profit from Rs. 753 crore in the previous fiscal despite

global instability, stiff competition and critical input constraints. BHEL Ramachandrapuram

has set a target of achieving a turnover of Rs. 6,651 crore in the current fiscal, envisaging

33 per cent growth.

Announcing the company's results here on Monday, BHEL Ramachandrapuram general

manager (in-charge) R. Krishnan said the unit had a healthy order book of Rs. 15,264 crore

and it was facing a major challenge in meeting the contractual requirements. It was,

therefore, decided to accelerate manufacturing and project delivery for which initiatives

such as outsourcing of finished assemblies, pre-order advance manufacturing and process

improvements were being taken.

He said the unit was contemplating to significantly enhance capital investment for

capacity expansion during the current fiscal and Rs. 205 crore, 60 per cent higher than the

previous year's Rs. 128 crore, had been earmarked towards this end.

Mr. Krishnan said the company was gearing up to meet super critical applications as

adoption of super critical technology was essential for the low carbon growth strategy ofthe country. BHEL had also initiated steps to enter into technology tie-ups for higher

capacity compressors to cater to the ever-increasing demand from fertilizer plants and

refineries.


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In line with its commitment to expand manufacturing capacity to 20,000 MW by

2012, BHEL had invested more than Rs. 200 crore during the previous year while the

company was fully on track to surpass the strategic plan target of Rs. 7,000 crore by the

end of 2011-12

Evolution and growth of BHELHyderabad unit:

The Hyderabad Unit of BHEL is located at Ramachandrapuram which is around 30KM

from the historic city of Charminar . Foundation Stone of the Plant was laid in 1959 and

the production commenced in the year 1965. The Unit was set up mainly to manufacture

60MW and 110MW Steam Turbo Generator sets for State Electricity Boards and also 12

MW TG Sets. From this small beginning, the Ramachandrapuram Unit has been growing

steadily in different phases of development and today it caters to a wide spectrum of

business in Power, Industry, Transmission, Oil and Gas. It now boasts the largest number

of products under a single roof as compared to any of the other BHEL Units.


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Phase. I - Project Implementation & Technology absorption (1959-70)

Phase. II - Diversification (1971-78)

Phase.III - Technology upgradation (197985)

Phase.IV - Market orientation (1985-91)

Phase.V - Adaptation to liberalization (1992-2002)

Phase.VI - Modernization and Capacity enhancement (2003-2012)

B.H.E.L RAMACHANDRAPURAM UNIT:

y As a member of the prestigious BHEL family, BHEL Hyderabad has earned areputation as one of its most important manufacturing units, contributing its lions

share in BHEL Corporations overall business operation

y The Hyderabad unit was setup in 1963 and started its operations with manufactureof turbo-generator sets and auxiliaries for 60 and 110 MW thermal utility sets.

y Over the years it has increased its capacity range and diversified its operations tomany other areas. Today, a wide range of products are manufactured in this unit,

catering to the needs of variety of industries like fertilizers & chemicals,

petrochemicals & refineries, paper, sugar, steel, etc.,

y BHEL Hyderabad unit has collaborations with world renowned MNCs like M/SGeneral Electric, USA, and M/S Nuovo pig none, etc.

HISTORY OF BHEL:

y BHARAT HEAVY ELETRICALS LIMITED (BHEL) is one of the pioneers in engineeringindustries in the world. The vital role played by the BHEL today in the country is themark of its continuous effects to improve the service in the nation by consultancy,

manufacturing and offering services in Power section.


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y The success story of BHEL how ever goes back to 1956 when its first plant was setup in BHOPAL. Three major plants in Haridwar, Hyderabad and Tiruchirapalli

followed this. These plants have been the core of BHELs effects to grow and

diversify and become one of the most Integrated Power and Industrial Equipment

manufacturers in the world. The company now has 14 manufacturing units, 8

service centers and 4 Power stations spread all over India and abroad.

y BHEL manufactures over 180 products under 30 major product groups and meetthe needs of core sector like Power, Industry, Transmission, Defense,

Telecommunications, Oil business etc. Its products have established on enviable

reputation for high quality and reliability. This is due to the emphasis placed all

along on Design, Engineering and manufacturing to International Standards by

acquiring and adapting some of the best technologies developed in its own centers.

BHEL has acquired ISO 9000 certification for quality management and ISO14001

certification for Environment Management. BHEL caters to the needs of different

sectors by Designing and Manufacturing according to the needs of its Clients in

Power sector.

BHEL Ramachandrapuram unit to upgrade gas turbine facility:

THE BHEL Ramachandrapuram unit has decided to upgrade its gas turbine facility with

an initial investment of Rs 34 cores during the current financial year. The investment is

essentially directed towards procuring machinery to strengthen the existing

infrastructure, according to Mr. A.N. Jagadeeswaran, Executive Director.

Buoyed by the good performance in the gas turbine sector, BHEL is also diversifying into

advanced class turbines, low-cost steam turbine generators and export markets, Mr.

Jagadeeswaran told Business Line.

With orders from Kazakhstan, Iran, Oman in hand, the company was exploring markets in

Algeria, Nigeria, Iran, Bosnia and other Latin American countries. Plans had also been


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firmed up for the manufacture of gas turbine-driven compressors for gas

transportation/LNG projects, he said.

The Ramachandrapuram unit is also focused on upgradation of gas turbines and

retrofitting for low emissions. The BHEL unit, achieved a turnover of Rs 1,533 cores

during fiscal 2001-02. It is pinning its hopes of quick turnover growths in the power

sector. The Union Power Ministry has set an ambitious target of adding about one lakh

MW of power during the Tenth and Eleventh Five-Year plans.

BHEL had also equipped itself to provide expertise in life extension studies for the existing

power plants in the country, he said.

In the power sector, BHEL units wants to diversify into setting up small, biomass-based

power plants of the size of 10-15 MW. "There is a definite demand for such compact

alternate energy units and we propose to capture this market with our advantages", he

added.

The Ramachandrapuram unit has emerged as an important contender for the 660 MW

supercritical power plant of NTPC proposed in Madhya Pradesh. The company has

identified a foreign consortium partner and the bid for the project is to be executed on a

turnkey basis, as for the NTPC's 500 MW Simhadri power plant in Andhra Pradesh, he said.

In the area of pumps and heaters, BHEL units had signed up MoUs with Sulzer Pumps of

Switzerland for the design, upgradation and retrofit of different pumps.

INTERNATIONAL OPERATIONS

BHEL has exported its equipment and services to over 50 countries. In Malaysia,

BHEL has supplied 80% of the Boilers besides several Hydro sets andG

as Turbines. BHELequipment are in operation in Matta, Cy, Saudi Arabia, Oman, Egypt, Libya, Greece,

Bangladesh, Srilanka, Iraq, Australia etc. BHEL exports turnkey power projects of Thermal,

Hydro, Gas based types, Substation projects Rehabilitation project besides a wide variety of

product like Insulators, Transformers, Valves, Motors, Traction Generators and services for

Renovation and Modernization and Operation Power station.


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RESEARCHAND DEVELOPMENT (R & D)

BHEL is one of the few companies world wide involved in Development of Integrated

Gasification Combined Cycle (IGCC) Technology, which word uses in clean Coal Technology.

BHEL R & D efforts have produced several new products. Some of the recent successful R &

D products are Automated Storage Retrieval Systems, Automated Guided Vehicles for

Material Transportation, Automatic Robotic Welding Systems.

HUMAN RESOURCEAND DEVELOPMENT (HRD)

The greatest strength of BHEL is its highly skilled and committed people. Every

employee is given equal opportunity to develop himself and improve his position.

Continuous training and retraining a positive work culture and participation style of

management have led to the Development of a motivated work force and enhanced

Productivity and Quality.

COMPANY VISION, MISSIONAND VALUES:

VISION

A world Class, Innovation, Competitive and Profitable Engineering Enterprise

Providing total Business Solutions.

MISSION

To be the leading Engineering Enterprise providing Quality products System and

services in the field of Energy, Transportation, Industry, Infrastructure and other

potential areas.

VALUES

Meeting commitments made to External and Internal customers.

Faster learning, Creativity and Speed of response. Respect for Dignity and potential of Individuals. Loyalty and Pride in the Company. Team playing. Zeal to Excel.


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COMPANY OBJECTIVES

GROWTH

To ensure a steady growth by enhancing the competitive edge of BHEL in existing

Business, new areas and International operation so as to fulfill National expectations

from BHEL.

PROFITABILITY

To provide a reasonable and adequate return on Capital employed, Primarily

through improvements in Operational efficiency, Capacity Utilization and

Productivity and generate adequate Internal resources to Finance the companys

growth. Confidence in providing increased value for this money through

International Standards of Product, Quality, Performance and superior customer

services.

TECHNOLOGY

To achieve Technology excellence in operations by development of Indigenous

Technologies to and efficient absorption and adaptation of Imported Technologies

to suit Business needs and priorities and provide a competitive advantage of the

company.

IMAGE

To fulfill the expectation which stock holders like Government as own, employees,

customers and the country at large have from BHEL.


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PRODUCT PROFILE

BHEL manufactures a wide range of Power plant equipments and also caters to theindustry sector.

The products profile includes

y Gas Turbinesy Steam Turbinesy Compressorsy Turbo generatorsy Pumpsy Pulverizersy Switchgearsy Solar Water Heating Systemsy Oil Rigsy Electrics for Urban Transportation System


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GAS TURBINES

BHEL - the largestG

as Turbine manufacturer in India, with the state-of-art facilities in allareas of Gas Turbine manufacture provide complete engineering in-house for meeting

specific customer requirement.

With over 100 machines and cumulative fired hours of over four million hours,

BHEL has supplied gas turbines for variety of applications in India and abroad. BHEL also

has the worlds largest experience of firing highly volatile naphtha fuel on heavy duty gas

turbines.

STEAM TURBINES

BHEL has the capability to design, manufacture and commission steam turbines of up to

1000 MW rating for steam parameters ranging from 30 bars to 300 bars pressure and


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initial & reheat temperatures upto 6000C. Steam Turbines are manufactured under

technical collaboration with Siemens, Germany covering the whole rang of requirements

for Drive, Cogeneration, Captive Power, Utility and Combined Cycle applications. BHEL

today, is fully equipped to provide comprehensive service to clients covering system

engineering, equipment design, and turnkey erection and commissionin

COMPRESSORS

BHEL made its foray into Centrifugal Compressors in the year 1970 with technical

collaboration from Nuovo Pignone, Italy and since then has been catering to the Fertilizer,

Refinery, Petrochemical and other process industries. BHEL today, has built up a

cumulative experience of more than 30 million hours of operation for various applications.

BHEL offers CENTRIFUGAL compressors for pressures as high as 350Kg/Cm2 and flows

upto 350,000 Nm3/Hr. BHEL has the unique capability of offering the Compressor with

any kind of drive being a manufacturer ofGas Turbine, Steam Turbine as-well-as Motors

and can offer the Compressor station fully tested as per the requirements.

BHEL offers total package of Compressor with its drive and all the associated auxiliaries

which includes inter-stage coolers, separators, lube oil and sealing systems, anti-surge

control systems, instrumentation and controls and process gas and cooling water piping for

supporting the compressor for continuous and trouble free operation.


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Compressors are made as per API Standards/Specification as

y API 610 Centrifugal Pumpsy API 611 Auxiliary Steam Turbinesy API 612 Drive Steam Turbinesy API 613 Gearboxy API 614 Oil Systemsy API 616 Drive Gas turbinesy API 617 Centrifugal Compressorsy API 670 Instrumentationy API 671 Couplingsy API 672 Packaged, Integrally Gearedy Compressorsy API 676 Positive Displacement Pumpsy IS 325 Auxiliary Electric Motorsy

ASME PTC 10 Performance Test

y ASME Sec. VIII & IX Heat ExchangersTURBO GENERATORS


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BHEL presently has manufactured Turbo-Generators of ratings upto 560 MW and is in the

process of going up to 660 MW. It has also the capability to take up the manufacture of

ratings up to 1000 MW suitable for thermal power generation, gas based and combined

cycle power generation as-well-as for diverse industrial applications like Paper, Sugar,

Cement, Petrochemical, Fertilizers, Rayon Industries, etc. Based on proven designs and

know-how backed by over three decades of experience and accreditation of ISO 9001, the

Turbo-generator is a product of high-class workmanship and quality. Adherence to

stringent quality-checks at each stage has helped BHEL to secure prestigious global orders

in the recent past from Malaysia, Malta, Cyprus, Oman, Iraq, Bangladesh, Sri Lanka and

Saudi Arabia. The successful completion of the various export projects in a record time is a

testimony of BHEL's performance.

PUMPS

BHEL started manufacture of Pumps during the mid-sixties under technical collaboration

with M/s Sigma Latin, Czechoslovakia, to meet the requirements of 60 MW, 110 MW and210 MW thermal power stations, the scope of which was widened to meet the

requirements of power plants up to 500 MW, with the help of another collaboration with

M/s Weir Pumps, U.K. BHEL has also made some in-house product development to gain


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spin off benefits from the above collaboration as well as to develop new pumps to meet the

requirements of Combined Cycle Power plants.

BHEL has undertaken a design up-gradation and retrofit of the existing 200 KHI Boiler

Feed pumps Inside Stators with energy efficient hydraulics and cartridge design internals

under technical tie-up with M/s Sulzer Pumps, Germany; and recommended the upgraded

200 KHI-S Boiler Feed pump to all customers of 110 MW & 210 MW Power Stations

operating with the earlier Czech design for increase of pump availability and reliability and

also considerable reduction in operational costs.

PULVERIZERS

BHELmanufactures mills for pulverized coal fired Thermal and Industrial boilers. BHEL till

date has manufactured over 1200 bowl mills and over 100 tube mills, operating in different

coal fired Thermal power stations in India.

BHEL has absorbed technology from world leader M/s. Combustion Engineering USA for

bowl mills. The specific range - 583 XRP/XRS to 1043 XRP covers the-state-of-the-art mills

required for the Indian market and are supplied as Industrial boilers as-well-as Utility

boilers of 60 MW, 110 MW, 120 MW, 210 MW, 250 MW & 500 MW capacities.


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To meet the requirement of very high ash content coal with high moisture, BHEL in

collaboration with M/s Stein Industry, France of the ALSTHOM group, manufactures Ball

Tube Mills for Tower-type Boiler as-well-as conventional Boiler. These are horizontal mills

that grind coal by impact and attrition. They do not lose any of their grinding

characteristics with time, and provide constant fineness throughout the service life of their

wear parts. They are the only mills truly adapted to both, very abrasive high -ash coals and

very low volatile coals which require very fine grinding.

SWITCHGEARS

BHEL is involved in the design, commissioning and service of a wide range of

Switchgears catering to various applications like power station auxiliaries, power

distribution, process industries, rural electrification, open cast mines, electric traction and

other special applications. BHEL started manufacturing circuit breakers in 1965 in

collaboration with ASEA, Sweden and to keep pace with the technological advancement and

to meet customer requirements, SF6 technology was introduced in 1981 in collaboration

with Siemens, Germany for manufacture of 145 kV to 420 kV class circuit breakers. BHEL

also introduced Vacuum Circuit Breakers in the range of 3.3 kV to 33 kV and the present

range also includes the indigenously developed and successfully tested 'Gas Insulated

Switchgear' for 36 kV range.

Over 750000 Circuit Breakers of different media (Air, Oil, Vacuum and SF6) with variety of

operating drives (spring & hydraulic), supplied by BHEL are rendering trouble free service

all over the country and abroad. The switchgear designs are fully type tested as per the

I.E.C and I.S standards.


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SOLAR WATER HEATING SYSTEMS

BHEL a pioneer in the field of design manufacturing and installation of solar water heating

systems (SWHS) in the country till date have installed systems covering more than 74,000

m2 of absorber area of capacity over 37 Lakh liters per day. The largest over SWHS of

40000 LPD for space heating is in use at Dr. Willmar Schwa be India Pvt. Ltd. Noida.

Solar water heating systems are environmental friendly, pollution free equipments,

harnessing the abundantly available Sun's energy. They find application at homes, hostels,

hotels, and hospitals (swimming pool, bathing, washing, cleaning and cooking); inindustrial process heating (Textile, Food processing, Pharmaceutical, Dyeing, Breweries,

Metal Plating industries); Milk dairies and chilling plants; space heating in central air

conditioning systems; pre-heating of boiler feed water.

In the BHEL make Solar Collector, stabilized efficiency values up to 65% is assured under

normal circumstances over a long period without degradation.


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OIL RIGS

BHEL started manufacturing oil field equipment in collaboration with M/s US Steel

Engineers and Consultants USA (National Oil well), M/s Sky top Brewster USA, M/s

Branham Industries USA, M/s IRI International, USA. After successful absorption of

technology, BHEL now has the capability to manufacture conventional deep drilling rigs up

to a depth of 9000 meters, mobile rigs to a depth of 3000 meters and well servicing rigs to a

well depth of 6100 meters. BHEL is authorized by the American Petroleum Institute (API)

for manufacturing products under specification API 4F, API 7K and API 8A.

BHEL also undertakes refurbishment, up gradation and renovation of the existing rigs withthe customers to provide better flexibility of operation for faster drilling, and higher

availability of rigs.

BHEL, since the first order for oil rigs in 1977, has manufactured and supplied 84 nos.

drilling and well servicing rigs to both M/s ONGC Ltd. and M/s Oil India Ltd., that are

deployed for drilling and well servicing operations. In addition BHEL has upgraded 3 nos.

rigs by installing Independent Rotary Drive system.

BHEL offers services for refurbishment and modernization of the rigs and rig equipment of

both BHEL make and also others. This includes

yTotal inspection of rig equipmenty Major overhauling of rig equipment


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y Supply of spares (for BHEL make rigs)y Refurbishment of rig equipmenty Repairs on mast and substructures and reassessment of

the structure

y Up gradation of rigsy Supply and installation of Independent Rotary Drive system on the conventional

drilling rigs.

ELECTRICS FOR URBAN TRANSPORTATION SYSTEM

y 25 KV AC, 50 HZ, single phase, broad gauge/metre gauge, Electrical Multiple Unitswith DC Drives.

y 1500V DC, broad gauge/meter gauge, Electric Multiple Units with DC Drives.y 25 KV AC/1500 VDC broad gauge Electrical Multiple Units with 3 phases drive.y Diesel Electric at Multiple Unitsy Metro Railway.y Tram Cars


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y BHEL at a Glance:Rupees (In Million)

2006-07 2007-08 CHANGE (%)

Turnover 18739 21401 14.2

ValueAdded 7182 8323 15.9

Employee (Nos.) 42124 43636 3.6

Profit Before Tax 3736 4430 18.6

ProfitAfter Tax 2415 2859 18.4

Dividend 600 746 24.4

Dividend Tax 93 127 36.8

Retained Earnings 1722 1986 15.3

TotalAssets 22280 29352 31.7

NetWorth 8788 10774 22.6

Total Borrowings 89 95 6.3

Debt : Equity 0.01 0.01 0

Per Share (in Rupees) :

- Net worth 179.5# 220.1 22.6

- Earnings 49.3# 58.4 18.4

- Dividend

(US $ in million)

Turnover 4344 5419 24.8

Profit Before Tax 866 1122 29.5

ProfitAfter Tax 560 724 29.3


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SHAREHOLDING PATTERN

Business Mix Industry Segment Break-up

BHELs Expected Performance for the year 2010-11

Gross Sales (Turnover) (Rs. Millions) 380,000

Gross Margin (Rs. Millions) 81,200

PBDIT to Total Employment (Rs. Millions) 1.740

Gross Margin to Gross Block (%) 92.02

Gross Profit to Capital Employed (at year end) (%) 45.71

Net Profit to Net Worth (at year end) (%) 25.67

Added Value to Gross Sales (%) 17.03


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Further, a stretch Turnover target of Rs. 395,000 Millions has been fixed under 'Excellent'

rating.

In addition, a number of Dynamic parameters covering areas such as, Quality & Customer

Satisfaction, Human Resource, Engineering and R&D including Technology Development

Projects,

Patents & Commercialization (In house developed products), Project Implementation

(Modernization/Expansion), Capital expenditure for Capacity augmentation, Delivery index

in

Customer projects, Extent ofGlobalization, Sustainable development and Corporate social

Responsibilities have been identified with specific targets for each of them to be achieved

during the year.

SWOTANALYSIS OF BHEL

The strength, Weaknesses, Opportunities and Threats which are being experienced

by BHEL as a growing concern have been summarized up in the following lines.

STRENGTHS

y Vast pool of Trained Man Power.y Excellent state of art facilities.y Good working atmosphere.y Rapport between Management and Union.y Product manufactured to International Quality.y Low labour Cost and Low manufacturing cost.

WEAKNESSES

y Excess Man Power.y Slippage in delivery commitments.y System implementation inadequate.y No Financial package.y Inadequate compensation package to employees.


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OPPORTUNITIES

y Growing Power Sector Machinery.y Liberalization has opened up the market.y Navratna company status.y Dominant player in Domestic Market.y Expert potential growing.

THREATS

y Liberalization Entry of MNCs or Private sector more competitiony MNCs taking away good employees with attractive packages.y Government taxation policy against manufacturing sector.


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CHAPTER 3

THEORETICAL ASPECTS OF CAPITAL

BUDGETING


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THEORETICALASPECTS OF CAPITAL BUDGECTING

AN OVERVIEW OF FINANCIAL MANAGEMENT

EVOLUTION OF FINANCIAL MANAGEMENT:-

Financial management emerged as distinct field of study at the turn of the 20 century. Its

evolution may be divided into three broad phases.

TRADITIONAL PHASE:-

It begins the early 1940s and continued through the early 1950s. Though the nature of financial

management during this phase was similar to that of the traditional phase, greater emphasis

was placed on the day-to-day problems faces by financial managers in the areas of funds

analysis, planning and control. The focus shifted to working capital management.

MODERN PHASE:-

It begins in the mid 1950s and has witnesses an accelerated pace of development with the

infusion of ideas from economic theory and application of quantitative methods of analysis.

Their central concern of financial management is considered to be a rational matching of funds

to their uses so to maximize the wealth of current shareholders.

Financial management is service activity, which is associated with providing quantitative

information, of financial nature and that which may be needed for making economic decision

regarding the choice among alternative course of actions.

Thus financial management process of identification, accumulation, analysis, preparation,

interpretation and communication of financial and control a business firm.


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DEFINITIONS:-

Financial management is an area of financial decision making harmonizing individual

motives and enterprise goals

Weston and Brigham

Financial management is the application of the planning and control functions to the

finance functions

Howard and Upon.

FINANCIAL DECISION INA FIRM

CAPITAL BUDGETING DECISIONS

The first and perhaps the most important decisions that any firm has to make is

to define the business or businesses that is wants to be this decision has a significant bearing

on how capital is allocated in the firm.

CAPITALSTRUCTURE DECISIONS

Once a firm has decided on the investment projects it wants to undertake, it has to

figure out ways and means of financing them. The key issues in capital structure decisions are:

what is the optimal debt-equity ration of the firm? Which specific instruments of equity and

debt finance should the firm employ? Which capital markets should the firm access?

DIVIDEND DECISIONS

Determining the dividend policy is an important task. The dividend decision involves what

percentage of profit to be paid of the shareholder. A number of factors affect the dividend

decision such as market price of the share earnings, tax positions etc.

WORKING CAPITAL MANAGEMENT

Working capital management, also referred to as short-term financial management, refers

to the day-to-day financial activities that deal with current assets (inventories, debtors, short-

term holdings of securities, and cash) and current liabilities (short-term debt, trade creditors,

accruals and provisions).


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The key issues in working capital management are:

What is the optimal level of inventory for the operations of the firm?

How much cash should the firm carry on hand? Etc

A business proposal regardless of whether it is a new investment or acquisition of another

company or restructuring initiative-raises the value of the firm only if the present value of the

future stream of net cash benefit expected from the proposal is greater than the initial cash

outlay required to implement the proposal.

RISK-RETURN TRADEOFF

The alternative course of action typically has different risk-return implications. A large

plant may have a higher expected return and a higher risk exposure, where a small plant has

may have a lower expected return and a lower risk exposure. A higher debt-equity ratio,

compared to a lower debt-equity ratio, May reduced the cost of capital but expose the firm to

greater risk.

LONG TERM SOURCES OF FINANCE

It is natural phenomenon that the firm is always in deficit of funds. There are two

methods of rising of funds.

1) LONG TERM SOURCES

2) SHORT TERM SOURCES

Capital budgeting decisions involve long-term funds. The different long-term sources of

finance generally followed by companies are.

EQUITY CAPITAL:-

Equity capital represents ownership capital, as equity shareholders collectively own thecompany. They enjoy the rewards and bear the risk of ownership. However, their liability of the

owner in a proprietary firm and the partners in a partnership concern is limited to their capital

contributions.


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CAPITAL BUDGETING HAVE THREE DISTINCTIVE FEATURES:-

1. They have long-term consequences2. They often involve substantial outlay.3. They may be difficult or expensive.

FEATURES:-

y It involves exchange of current funds for the benefits to be achieved in future.y Future benefits are expected to be realized over a series of years.y There is relatively high degree of risk.y They are invariable decisions.y They have long-term and significant effect on profitability of the concern.y They generally involve huge funds.

IMPORTANCE

Capital budgeting is of a paramount importance in financial decision-making.

Capital budgeting decision affects the profitability of the firm. They also have a bearing on

the competitive position of the enterprise. Capital budgeting decisions determine the future

destiny of the company.y An opportunity investment decision can yield spectacular returns where as an ill-

advised and incorrect investment decision can endanger the very survival even

of the large sized firms.

y A capital expenditure decisions has its effect over a long-term time span andinevitably affects the companys future cost structure.

y Capital investment decisions are not easily reversible, without much financial lossto the firm.

y Capital investment involves cost and the majority of the firms have scares capitalresources

y Capital investment decisions are of national importance because of it determinesemployment, economic activities and economic growth.


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INVESTMENT DECISIONS REDUCCUIND COST:-

These decisions add the total revenue of the firm. These investment decisions are

subject to less uncertainty. This is because the firm has a better feel for potential cost

saving as it can examine past production and cost data.

THEREARE THREE TYPES OF CAPITAL BUDGETING DECISIONS:

1) Accept-reject decisions:This is a fundamental decision capital budgeting. If the project is accepted, -

the firm invests in it. If the proposal is rejected, the firm does not invest in it so, by

applying this criterion, all independent projects are accepted. Independentprojects are projects that do not compete with one another in such a way the

acceptance a project preclude the possibility of acceptance of another.

2) Mutually exclusive projects decision:These are projects, which, compete with other projects in such a way that

the acceptance of one will exclude the acceptance of other projects. The

alternatives are mutually exclusive and only one may be chosen. Mutually

exclusive investment decisions acquired significance when more than one

proposal is acceptable under accept-reject criterion.

3) Capital rationing decisions:Capital rationing refers to situation in which the firm has more acceptable

investments requiring greater amount of finance then is available with the firm. It

is concerned with selection of group of investment proposals actable under

accept-reject criterion under financial constraints.


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EVALUATION OF INVESTMENT PROPOSALS:

At each point of time a business firm has a number of proposals regarding various

number of projects in which it can invest funds. But funds available with the firms are

always limited and its not possible to invest in all the proposal at a time

In selecting the criterion, the following two fundamental principles must be

kept into view.

y The bigger, the better principles: the principle means that other things being equalbigger benefits are preferable to small ones.

y The bird in hand principles: this principle means that other things being equal,early benefits as other things are seldom equal.

Bother the above principles have to be applied to take the right decision

TECHNIQUES OF CAPITAL BUDGETING

The methods of appraising capital expenditure proposals can be classified in to two

broad categories:

1. Traditional or un discounted cash flow techniques

2. Discounted or time adjusted cash flow techniques

DISCOUNTED CASH FLOW METHODS

The distinguishing characteristics of discounted cash flow capital budgeting

techniques are that they taking in to consideration the time value of money while

evaluating the cost and benefits of the project. They also take into consideration the

benefits and cost occurring during an entire life of the project.

NET PRESENT VALUE METHOD (NPV)

NPV may be defined as the summation of the present values of the cash proceeds in

each year minus the summation of the present values of the net cash outflows in each year.


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The net present value (NPV) of a project is the sum of the present values of all the cash-

flows positive as well as negative that are expected to occur over the life of the projects.

The generally formula of NPV is:-

n

NPV of project = -------- Initial investment

Ct

T=1(1+rt)t

Where Ct = Cash flow at the end of year t

RT = Discounted rate for year t

The steps to be followed for adopting the NPV methods:

1) Determine an appropriate rate of the interest that should be selected as aminimum required rate of return. This rate should be the minimum rate of return

below which the investor considers that does pay him the invested amount.

2) Compute the present value of total investment outlay; if the total investment is tobe made in the initial year, the present value shall be the same the cost of

investment.

3) Compute the present value of total investment proceeds i.e. cash inflows at theabove determined discounted rate

4) Calculate the NPV of each project by subtracting the present value of cash out flowfor each project.

The present value of rupee 1 due in any number of years can be found by using the

following formula.

1

PV = -------

(1+r)t


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Where PV = Present value

r = rate of interest

t = number of years

ACCEPT OR REJECT CRITERION:

If NPV >ZERO, ACCEPT

If NPV< ZERO, REJECT

In case of mutually, exclusive projects, the various proposals would be ranked in order to

descending order. The proposal with higher NPV is to be accepted.

MERITS:-

1) It recognizes the time value of money.2) It is sound method of appraisal as it considers the total benefits arising out of the

proposal over its lifetime.

3) Changing discount rate can be built in to the NPV calculation by altering thedenominators. This rate normally changes because longer the time span, lower the

value of money and higher, the discount rate

4) This method is very useful for selection of normally exclusive projects.DEMERITS:

A. It is difficult to calculate to understandB. The present value method involves the calculation of required rate of return to

discount the cash flows, which present serious problems.

C. It is an absolute measure.


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D. This method may not give satisfactory results in case of projects having differenteffective lives.

INTERNAL RATE OF RETURN (IRR):

The internal rate of return (IRR) of a project is the discount rate, which makes its NPV

equal to 0.Put differently, it is the discount rate, which equates the present value of future

cash flows with the initial investment. It is the value or r in the following equation:

n

Investment = -------

?

Ct

T = ---------

1(i+r)

Where,

Ct = Cash flow at the end of the year

r = internal rate of return (IRR)

t = life of the project

Applying following stapes can calculate IRR

Step 1

Calculate cash flow after tax

Step 2

Calculation fake payback period

Initial investment

Fake PBP = ------------------------

Average cash flow


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Step 3

Look for the factor in the present value annuity table in the year column until you arrive at

figure until you closest to the fake PBP

Step 4

Note the corresponding percentage.

Step 5

Calculate NPV at that percentage

Step 6

If NPV is positive take a rage higher and if NPV is negative take regret lower and once again

calculate NPV

Step 7

Continue Step5 until we arrive at low rates one giving positive NPV and another giving

negative NPV.

STEPS

Actual IRR can be calculated by using the following formula:

LR + P.V of cash inflows at LR-P.V cash outflows

IRR = --------------------------------------------------------------------------------- (HR-LR)

P.V of cash inflows atLR-P.V of cash inflows at HR.

Where,R = interest rate,

LR = lower rate

HR = Higher rate


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ACCEPT OR REJECTION CRITERION:-

ACCEPT: If the IRR is greater than the cost of capital.

REJECT: If the IRR is less than the cost of capital.

MERITS:

1) It recognizes the time value of money.2) It considers all cash flows occurring over the entire life of the projects to

calculate its return.

3) It is consistent with the shareholders wealth maximization objective.

DE

ME

RITS

:

1) It gives misleading and inconsistent results when the NPV of a project doesnot decline with discount rates.

2) It also fails to indicate a correct choice between mutually exclusive projectsunder certain situations.

PROFITABILITY INDEX METHOD (PI)

It is ratio of the present value of the cash inflows at the required rate of return to the

initial cash outflow of the investment. Using the profitability index PI or benefits cost ratio

(BCR) a project will qualify often acceptance if its PI exceeds one. The NPV will be positive

greater than one and will negative when the PI is less than one. Thus, NPV& PI approaches

give the same results regarding the investment proposal. The selection of project with the

PI method can also be done on the basis of ranging. PI depends upon cash inflows before

depreciation and after tax. It makes into consideration the scrap value. The formula to

calculate PI or BCR is as follows:

Total present value of cash inflows

PI = ------------------------------------------------

Total present value of cash outflows


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MERITS:

1) It gives due consideration to the time value of money.2) Since the present value of cash inflows is divided by initial cash outflows it is a

relative measure of the projects profitability.

DEMERITS:

1) It is difficult to understand2) It involves more computation than traditional methods.

TRADITIONAL OR NON-DISCOUNTED TECHNIQUES:

1. PAY BACK PERIOD METHOD (PBP):Pay back measures the number of years required by the cash flows after tax to pay back the

original outlay required in an investment proposal. It depends upon cash inflows before

depreciation and after tax. Payback period does not consider the scrap value. There are two

ways of calculating the PBP.

The first method can be applied when the cash inflows are uniform.

Original investment

PBP = ------------------------------------------

ConstantAnnual Cash Inflows

The annual cash flow represents the earnings i.e. estimated cash savings resulting from

the proposed investment.

If the calculated PBP is less than the standard, project is accepted and vice versa

The second method is used when projects cash flows are not equal and vary from year to

year. Payback period is calculated.


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2. DISCOUNTED PAY BACK METHOD:This is developed due to the limitation of the PBP method that it ignores time value of

money. Hence, an improvement is made where the present values of all inflows are

cumulated in order of time. The time at which the cumulated present value of cash inflows

equals the present value of cash outflows is known as discounted PBP. The project, which

gives a shorter discounted payback period, is accepted.

REASONS FOR POPUIARITY OF PBP:

Despite its serious short comings the PBP is widely used in appraising investments.

p The PBP May be regarded roughly as the reciprocal for the IRR when the annualcash inflow is constant and the life of the project fairly long.

p The PBP is somewhat akin to the breakeven point. A rule of thumb, it serves as auseful shortcut in the process of informational of generation and evaluation

p The PBP conveys information about the rate at which the uncertainty associatedwith a project is resolved. The shorter the PBP the faster the uncertainty

associated with the project is resolved and vice versa.

ACCEPT OR REJECT CRITERION:

The payback period method can be used as a decision criterion to accept or reject

investment proposals. If a single investment is being considered, if the annual pay back

period is less than the predetermined payback period the project will be accepted, if not it

would be rejected.

When the mutually exclusive projects consideration they may be ranked according to

the length of the payback period. The project with shortest pay back may be assigned


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MERITS:

1) It is the best method incase o evaluation of single project.2) It is to calculate and simple to understand.3) It is bases on the cash flow analysis.

DEMERITS:

1) It completely ignores all cash flows after the payback period.2) It completely ignores time value of money.

In case the cash flow are unequal the payback period can be found by adding up the cash

flows until the total is equal to the initial cash outlay of the project.

3. ACCOUNTING RATE OF RETURN (ARR):Average rate or return is also known as accounting rate or return method. It is based on

accounting information rather than cash flows. ARR is a technique that helps us in knowing

the particular project, from which decision can be made to accept or reject the investment

proposal.

According to ARR as an accept / reject criterion, the actual ARR would compared with the

predetermined or a minimum required rate of return or cut off rate. A project can be

accepted if the actual ARR is higher than the minimum desired ARR, otherwise it is liable to

reject

ARR depends upon profit after depreciation and tax (PAT), ARR neglects the scrap value.

The time value of money is not taken into consideration.

Average annual profit after tax

ARR = ------------------------------------------------- *100

Average investment

Average Investment = NetAdditional working capital + Salvage value +

1/2(Original Investment-Salvage value).


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y Expected economic life of the project.y Salvage value of the asset at the end of the economic life.y Capacity of the product.y Selling price of the product.y Production cost.y Depreciation.y Rate of Taxationy Future demand of the product, etc.

But due to uncertainties about the future the estimates of demand, production, sales

costs, selling price, etc cannot be exact, for example a product may become obsolete much

earlier than anticipated due to un expected technological developments all these elements

of uncertainties have to be take into account in the form of forcible risk while making an

investment decision. But some allowances for the element of risk have to be proved.

FACTORS INFLUENCING CAPITALEXPENDITURE DECISIONS:

There are many factors financial as well as non financial which influence the

capital expenditure decisions and the profitability of the proposal yet, there are many other

factors which have to be taken into consideration while taking a capital expenditure

decisions. They are

1) URGENCY:Sometime an investment is to be made due to urgency for the I survival of the firm

or to avoid heavy losses. In such circumstances, proper evaluation cannot made though

profitability tests. Examples of each urgency are breakdown of some plant and machinery

fire accidents etc.


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2) DEGREE OF UNCERTAINTY:Profitability is directly related to risk, higher the profits, greater is the risk or

uncertainty.

3) INTANGIBLE FACTORS:Sometimes, a capital expenditure has to be made due to certain emotional and

intangible factors such as safety and welfare of the workers, prestigious projects, social

welfare, goodwill of the firm etc.

4)AVAILABILITY OF FUNDS:As the capital expenditure generally requires the previsions of laws solely influence

by this factor and although the project may not be profitable. Yet the investment has to be

made.

5) FUTUREEARNINGS:A project may not be profitable as competed to another today, but it may be profited

to increase future earnings.

Sometimes project with some lower profitability may be selected due to constant

flow of income as compared to another project with an irregular and uncertain inflow of

income.

CAPITALEXPENDITURE CONTROL:

Capital expenditure involves no-flexible long-term commitments of funds. The

success of an enterprise in the long run depends up on the effectiveness with which the

management makes capital expenditure decision. Capital expenditure decisions are veryimportant as their impact is more or less permanent on the well being and economic health

of the enterprise. Because of this large scale mechanization and automation and

importance of capital expenditure for increase in the profitability of a concern. It has

become essential to maintain an effective system of capital expenditure control.


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OBJECTIVES CONTROL OF CAPITALEXPENDITURE:

y To make an estimate of capital expenditure and to see that the total cash outlay iswithin the financial resources of the enterprise

y To ensure timely cash inflows for the projects so that no availability of cash may notbe problem in the implementation of the problem.

y To ensure that all capital expenditure is properly sanctioned.y To properly coordinates the projects of various departmentsy To fix priorities among various projects and ensure their follow-up.y To compare periodically actual expenditure with the budgeted ones so as to avoid

any excess expenditure.

y To measure the performance of the project.y To ensure that sufficient amount of capital expenditure is incurred to keep pace

with rapid technological development.

y To prevent over expansion.

STEPS INVOLVED IN CONTROL OF CAPITALEXPENDITURE:

y Preparation of capital expenditure budget.y Proper authorization of capital expenditure.y Recording and control of expenditure.y Evaluation of performance.


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LEASE FINANCING:-

Lease finance is an agreement for the use of an asset for a specified rental. The owner of the

asset is called the lesser and the user the lesser

1) Operating leases2) Financial leases

Operating leases are short-term no-cancel able leases where the risk of obsolescence in

borne by the lesser

Financial leases are long-term non-cancelable leases where any risk in the use of asset is

borne by the lessee and he enjoys the return too.

y Preliminary budget estimates for the year following the budget year.GENERAL GUIDELINES:-

The capital funds b

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