INTRODUCTION

INTRODUCTION:

HDFC involved in industrial financing. They extend term loans for acquiring fixed
assets and also working capital term loans. When they are to extend term loans for acquiring
fixed assets like land building, machinery etc they appraise the project to establish the financial,
economic and technically viability of the project while extending long term loans HDFC use
capital budgeting techniques. The basic idea of using capital budgeting is to compare ,whether,
the amount invested on the project at certain rate of return is more or less when compared to the
required rate of return

At HDFC internal rate of return method is used to appraise an industrial project.

The internal rate of return calculated is compared with the required rate of return. If the internal
rate of return calculated is more than the required rate of return, the project is accepted if not, it
should be rejected. Here it needs to be explained the meaning of required rate of return.
Generally, the concern’s required rate of return is the concern’s cost of capital and the cost of
capital is the rate of return on a project that will have unchanged the market price of shares.
Thus, the cost of capital is the required rate of return needed to justify the use of capital.

The cost of capital on term loans is the interest rate that is changed on disbursal of funds.
HDFC change interest rates ranging from 11% to 14.5% depends upon the nature of the project
and scheme of financial assistance. Therefore the cost of capital on loans and advances is the
interest rate changed by the term lending institutions. Hence, the required rate of return is the
interest rate changed by the financial institutions for extending term loan assistance. For
example, if the HDFC changes interest at 14%, then the concern’s cost of capital or required rate
of return is 14%. This required rate is compared at the concern’s internal rate of returns.
Extending or rejecting the proposal depends upon the more or less of the IRR over the cost of
capital. Therefore the viability of the project is determined among other parameters with
reference to the rate of earnings over the desired rate of return that is the earnings expected over

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the cost of capital of the project that is interest rate. It is always seen that the earnings made by
the project is more than the interest rate to accept the project other wise the project is rejected.

CAPITAL BUDGETING

The term Capital Budgeting refers to long term planning for proposed capital outlay and their
financial. It includes raising long-term funds and their utilization. It may be defined as a firm’s
formal process of acquisition and investment of capital.

Capital budgeting may also be defined as “The decision making process by which a firm
evaluates the purchase of major fixed assets”. It involves firm’s decision to invest its current
funds for addition, disposition, modification and replacement of fixed assets.

It deals exclusively with investment proposals, which is essentially long-term projects and is
concerned with the allocation of firm’s scarce financial resources among the available market
opportunities.

Some of the examples of Capital Expenditure are

 Cost of acquisition of permanent assets as land and buildings.
 Cost of addition, expansion, improvement or alteration in the fixed assets.
 R&D project cost, etc.,

1.1 Theoritical Frame Work

An efficient allocation of capital is the most important finance function in the modern times. It
involves decisions to commit the firm’s funds to the long term assets. Such decisions are of
considerable importance to the firm since they tend to determine its size by influencing its
growth, profitability and risk.

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MEANING:

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

DEFINITION:
According to Charles T.Horngreen, “Capital budgeting is long term planning for making and
financing proposed capital outlays.”

According to Lynch,“Capital budgeting consists in planning development of available capital for

the purpose of maximising the long term profitability of the concern.”

NATURE OF INVESTMENTS:

The investment decisions of a firm are generally known as the capital budgeting, or capital
expenditure decisions. A capital budgeting decision may be defined as the firm’s decisions to
invest its current funds most efficiently in the long term assets in anticipation of an expected
flow of benefits over a series of years. The long term assets are those which affect the firm’s
operations beyond the one year period
CONCEPT OF CAPITAL BUDGETING:

The term capital budgeting refers to long term planning for proposed capital outlays and their
financing. Thus, it includes both rising of long term funds as well as their utilization. It is the
decision making process by which the firm evaluate the purchase of major fixed assets firm’s
decision to invest its current funds of. It involves addition, disposition, modification and

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replacement of long term or fixed assets. However, it should be noted that investment in current
assets necessitated on account of investment in a fixed asset, it also to be taken as a capital
budgeting decision.

Capital budgeting is a many sided activity. It includes searching for new and more profitable
investment proposals, investigating engineering and marketing considerations predict and
making economic analysis to determine the potential of each investment proposal.

CHARACTERISTICS OF CAPITAL BUDGETING:

1. GROWTH: A firm’s decision to invest in long term assets has a decisive influence on
the rate and the direction of growths. A wrong decision can prove disastrous for the
continued survival of the firm. Unwanted or profitable expansion of assets will result in
heavy operating costs to the firm. On the other hand, inadequate investment in assets
would make it difficult for the firm to compete successfully and maintain its market
share.

2. RISK: A long term commitment of funds may also change the risk complexity of the
firm. If the adoption of the investment increases average gain but causes frequent
fluctuations in its earnings the firm will become more risky. Thus investment decisions
shape the basic risk character of the firm.

3. FUNDING: Investment decisions generally involve large amount of funds which make
it necessary for the firm to plan its investment programmes very carefully and make an
advance arrangement for procuring finances internally or externally.

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 4. IRREVERSIBILITY: Most investment decisions are irreversible. It is difficult to
find a market for such capital items once they have been acquired. The firm will incur
heavy losses if such assets are scrapped. Investments decisions once made cannot be
reversed or may be reversed but a substantial loss.

5. COMPLEXITY: Another important characteristic feature of capital investment

decision is that it is the most difficult decision to make. Such decision are an assessment
of future events which are difficult to predict. It is really a complex problem to correctly
estimate the future cash flow of an investment. The uncertainty in cash flow is caused by
economic, political and technological forces.
NEED AND IMPORTANCE OF CAPITAL BUDGETING

The capital budgeting decisions are often said to be the most important part of corporate
financial management. Any decision that requires the use of resources is a capital budgeting
decision; thus the capital budgeting cover everything from abroad strategic decisions at one
extreme to say computerization of the office, at the other. The capital budgeting decisions affect
the profitability of a firm for a long period, therefore the importance of these decisions are
obvious. There are several factors and considerations which make the capital budgeting decisions
as the most important decisions of a finance manager. The need and importance of capital
budgeting may be stated as follows:
1. LONG TERM EFFECTS : perhaps, the most important features of a
capital budgeting decisions and make the capital budgeting so significant is that
these decisions have long term effects on the risk and return composition of the
firm. These decisions affect of the firm to a considerable extent as the capital
budgeting decisions have long term implications and consequences. By taking a
capital budgeting decision, a finance manager in fact makes a commitment to its
future implications.
2. SUBSTANTIAL COMMITMENTS: The capital budgeting decisions
generally involve large commitment of funds as a result substantial portion of
capital are blocked in the capital budgeting decisions. In relative terms therefore,

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 more attention is required for capital budgeting decisions, otherwise the firm may
suffer from the heavy capital losses in time to come. It is also possible that the
return from a projects may not be sufficient enough to justify the capital
budgeting decision.

3. IRREVERSIBLE DECISIONS: Most of the capital budgeting decisions

are irreversible decisions. Once taken, the firm may not be in a position to revert
back unless it is ready to absorb heavy losses which may result due to abandoning
a project in midway. Therefore, the capital budgeting decisions should be taken
only after considering and evaluating each and every minute detail of the project,
otherwise the financial consequences may be far reaching.

4. AFFECT CAPACITY AND STRENGTH TO COMPETE : The

capital budgeting decisions affect the capacity and strength of a firm to face the
competition. A firm may loose competitiveness if the decision to modernize is
delayed or not rightly taken. Similarly, a timely decision to take over a minor
competitor may ultimately result even in the monopolistic position of the firm.

Thus the capital budgeting decisions involve a largely irreversible commitment of Resources
i.e., subject to a significant degree of risk. These decisions may have far reaching effects on the
profitability of the firm. These decisions making process and strategy based on a reliable
forecasting system.
5. LARGE INVESTMENTS: Capital budgeting decisions, generally, involves
large investment of funds. But the funds available with the firm are always limited
and the demand for funds far exceeds the resources. Hence, it is very important
for a firm to plan and control its expenditure.

6. NATIONAL IMPORTANCE: Investment decision though taken by

individual concern is of national importance because it determined employment,
economic activities and economic growth.

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 Thus, we may say that without using capital budgeting techniques a firm involve
itself in a losing project. Proper timing of purchase, replacement, expansion and
alteration of assets is essential

CAPITAL BUDGETING PROCESS:

Capital budgeting is a complex process as it involves decisions relating to the

investment of current funds for the benefit to the achieved in future and the future is always
uncertain. However, the following procedure may be adopted in the process of capital budgeting:

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2
Identify
Screen
Investment
Proposals
proposals

7 3
Review CAPITAL Evaluate
Performanc BUDGET- Various
e ING proposals
PROCESS

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4
Implement
Fix
The
priorities
proposals

5
Final
approval

1. IDENTI FICATION OF INVESTMENT PROPOSALS:

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The capital budgeting process begins with the identification of investment proposals. Investment
opportunities have to be identified or created; they do not occur automatically. Investment
proposal of various types may originate at different levels within a firm. Most proposals, in the
nature of cost reduction or replacement or process or product improvement takes place at plant
level. The contribution of top management in generating investment ideas is generally confined
to expansion or diversification projects. The proposal may originate systematically in a firm.
In view of the fact that enough investment proposals should be generated to employ the
firm’s funds fully well and efficiently, a systematic procedure for generating proposal may be
evolved by a firm. In a number of Indian companies, more than 50% of the investment idea are
generated at the plant level. Indian companies uses a variety of methods to encourage idea
generation.

2. SCREENING THE PROPOSALS: The expenditure planning committee screens

the various proposals received from different departments. The committee views these
proposals from various angles to ensure that these are in accordance with the corporate
strategies, selection criterion of the firm and also do not lead to departmental imbalances.

3. EVALUATION OF VARIOUS PROPOSALS: The evaluation of projects

should be performed by group of experts who have no axe to grind. For example, the
production people may generally interested in having the most modern type of equipment
and increased production even of productivity is expected to be low and goods cannot be
sold this attitude can bias their estimates of cash flows of the proposed projects.

Similarly, marketing executives may be too optimistic about the sales prospects of
goods manufactured, and over estimate the benefits of a proposed new product. It is therefore,
necessary to ensure that projects are scrutinized by an impartial group and that objectivity is
maintained in the evaluation process.

A company in practice should take all care in selecting a method or methods of

investment evaluation. The criterion or criteria selected should be a true measure of evaluating if

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the investment is profitable(in terms of cash flows), and it should lead the net increase in the
company’s wealth(that is, its benefits should exceeds its costs adjusted for time value and risk).

4. FIXING PRIORITIES: After evaluating various proposals, the unprofitable or

uneconomic proposals may be rejected straight away. But it may not be possible for the
firm to invest immediately in all the acceptable proposals due to limitation of funds.
Hence, it is very essential to rank the various proposals and to establish priorities after
considering urgency, risk and profitability involved therein.

5. FINAL APPROVAL AND PREPARATION OF CAPITAL EXPENDITURE

BUDGET: Proposals meeting the evaluation and criteria are finally approved to be
included in the capital expenditure budget. However, proposals involving smaller
investment may be decided at the lower for expenditure action. The capital expenditure
budget lays down the amount of estimated expenditure to be incurred on fixed assets
during the budget period.
6. IMPLEMENTING PROPOSAL: Preparation of a capital expenditure budgeting
and incorporation of a particular proposal in the budget does not itself authorize to go
ahead with the implementation of the project a request for authority to spend the amount
should further be made to the capital expenditure committee which may like to review the
profitability of the project, in the changed circumstances.
Further, while implementing the project, it is better to assign responsibilities for
completing the project within the given time frame and cost limit so as to avoid unnecessary
delays and cost over runs. Network techniques used in the project management such as PRRT
and CPM can also be applied to control and monitor the implementing of the projects.
7. PERFORMANCE REVIEW: A capital projects reporting system is required to
review and monitor the performance of investment projects after the completion and
during their life. The follow up comparison of the actual performance with original
estimate not only ensure better forecasting. Based on the follow up feedback, the
company may reappraise its projects and take remedial action. Indian company’s
practices control of capital expenditure through the use of regular project reports. Some
companies required quaterly reporting, monthly, half yearly and yet a few companies

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 require continuous reporting. Inmost of the companies the evaluation reports include
information on expenditure to date stage of physical completion, and revised total cost.

CAPITAL BUDGETING TECHNIQUES

CAPITAL BUDGETING APPRAISAL METHODS/TECHNIQUES:

There are several methods for evaluating and ranking the capital investment proposals. In case of
all these method the main emphasis is on the return which will be derived on the capital invested
in the projects. In other words, the basic approach is to compare the investment in the project
with the benefits derived there from.

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 Capital budgeting techniques

Time- adjusted or discounted cash

Traditional or non-discounting
flows

Net present value

Pay back period Profitability index
Accounting rate of return Internal rate of return

TRADITIONAL OR NON-DISCOUNTING:

a. PAY BACK PERIOD:

The payback is one of the most popular and widely recognized traditional methods of
evaluating investment proposals. It is defined as the number of years required to recover the
original cash outlay invested in a project. If the project generates constant annual cash inflows,
the pay back period can be computed by dividing cash outlay by the annual cash inflows.

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 Initial investment
Pay back period =________________
Annual cash flow

Accept reject rule:

Many firms use the pay back period as accept/reject criterion as well as a method of ranking
projects.
a) If the pay back period calculated for the project is less than the maximum or
standard payback period set by the management, it would be accepted
b) If not it would be rejected
c) As a ranking method it gives highest to the project which has the shortest
payback period and lowest ranking to the project with highest payback period
d) In case of two mutually exclusive projects, the project with the shortest
payback period will be selected

EVALUATION OF PAYBACK PERIOD:

a) It is simple to understand and easy to calculate

b) It is costless than most of the sophisticated techniques which require a lot of the time the
use of computers

ADVANTAGES:
a) Simple to understand and easy to calculate.
b) It saves in cost; it requires lesser time and labour as compared to other
methods of capital budgeting.
c) In this method, as a project with a shorter pay back period is preferred to the
one having a longer pay back period, it reduces the loss through
obsolescence.

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 d) Due to its short- time approach, this method is particularly suited to a firm
which has shortage of cash or whose liquidity position is not good.

DISADVANTAGES:

a) It does not take into account the cash inflows earned after the pay
back period and hence the true profitability of the project cannot be
correctly assessed.
b) This method ignores the time value of the money and does not
consider the magnitude and timing of cash inflows.
c) It does not take into account the cost of capital, which is very
important in making sound investment decision.
d) It is difficult to determine the minimum acceptable pay back period,
which is subjective decision .
e) It treats each assets individual in isolation with other assets, which is
not feasible in real practice.

B. ACCOUNTING RATE OF RETURN METHOD:

The accounting rate of return (ARR), also known as the return on investment (ROI),
used accounting information, as revealed by financial statements, to measure the profitability of
an investment.
The accounting rate of return is found out by dividing the average after tax profit
by the average investment. The average Investment would be equal to half of the original
investment if it is deprecited constantly.

Alternatively, it can be found out dividing the total of the investment’s book value after
depreciation by the life of the project. The accounting rate of return, thus, is an average rate and
can be determined by the following equation:
Average annual income (after tax & depreciation)
ARR= ____________________ x 100

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 Average investment

Where, average investment = original investment

______________
2
ACCEPT OR REJECT CRITERION

As an accept or reject criterion, this method will accept all those projects whose ARR is higher
than the minimum rate established by the management and reject those projects which have ARR
less than the minimum rate.

This method would rank a project as number one if it has highest ARR and lowest
rank would be signed to the project with lowest ARR.

EVALUATION OF ARR METHOD

 It is simple to understand and use

 The ARR can be readily calculated form the accounting data; unlike in the NPV and IRR
methods, no adjustments are required to arrive at cash flows of the project.
 The ARR rule incorporates the entire stream of in calculating the
project’s profitability.

ADVANTAGES:

a) It is very simple to understand and easy to calculate.

b) It uses the entire earnings of a project in calculating rate of return and hence gives a true
view of profitability.
c) As this method is based upon accounting profit, it can be readily
d) calculated from the financial data

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DISADVANTAGES:
a) It ignores the time value of money.
b) It does not take in to account the cash flows, which are more important than the
accounting profits.
c) It ignores the period in which the profit are earned as a 20% rate of return in 2 ½ years is
considered to be better than 18%rate of return in 12 years.
d) This method cannot be applied to a situation where investment in project is to be made in
parts.

DISCOUNTED CASH FLOW METHOD

Discounted cash flow method or time adjusted technique is an improvement over pay
back method and ARR. In evaluating investment projects, it is important to consider the timing
of returns on investment. Discounted cash flow technique takes into account both the interest
factor and the return after the pay back period. Following are the methods of discounted cash
flow method:

1. NET PRESENT VALUE METHOD:

Net present value method is the classic economic method of evaluating the
investment proposals. It is considered as the best method of evaluating the capital investment
proposal. It is widely used in practice. The cash inflow to be received at different period of time
will be discounted at a particular discount rate.

It is one of the discounted cash flow techniques explicitly recognizing the time value
of money. It correctly postulates that cash flows arising at different time periods differ in value
and are comparable only when their equivalent present values are found out.

The following steps are involved in the calculation of NPV:

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 a) An appropriate rate of interest should be selected to discount cash flows. Generally it is
referred to the cost of capital.
b) The present value of cash inflow will the calculated by using this discounted rate.
c) Net present value should be found out by subtracting present value of cash out flows
from present value of cash inflows.

The net present value is the difference between the total present value of future cash inflows and
the present value of future cash outflows.

ACCEPT OR REJECT CRITERION:

Net present value is used as an accept or reject criteria.

In case NPV is positive (NPV›0) the project is selected for investment
If NPV is negative (NPV<0) the project is rejected
A project may be accepted if NPV=0
The positive net present value is contribute to the net wealth of the shareholders which should
result in the increased price of a firm’s share.

The NPV method can be used to select between mutually exclusive projects the one with
the higher NPV should be selected. Using the NPV method, project would be ranked in order
of net present values; that is first rank will be given to the project with highest positive
present value and so on.

ADVANTAGES:
a) It recognizes the time value of money and is suitable to apply in a situation with uniform
cash outflows and uneven cash inflows.
b) It takes in to account the earnings over the entire life of the project and gives the true
view if the profitability of the investment
c) Takes in to consideration the objective of maximum profitability.

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 DISADVANTAGES:
a) More difficult to understand and operate.
b) It may not give good results while comparing projects with unequal investment of
funds.
It is not easy to determine an appropriate discount rate
2. INTERNAL RATE OF RETURN METHOD:

The internal rate of return (IRR) method is another discounted cash flow technique
which takes account of the magnitude and timing of cash flows. Internal rate of return is that rate
at which the sum of discounted cash inflows equals the sum of discounted cash outflows.

It is the rate of discount which reduces the net present value of an investment to zero. It is called
internal rate because it depends mainly on the outlay and proceeds associated with the project
and not on any rate determined outside the investment.

Other terms used to describe the IRR method are yield of an investment, marginal efficiency of
capital, rate of return over cost, time adjusted rate of return and so on. The concept of internal
rate of return is quite simple to understand in the case of a one period project.

CALCULATION OF INTERNAL RATE OF RETURN:

1) Calculate cash flow after tax

2) Calculate fake pay back period or factor by dividing the initial investment by average
cash flows.
3) Look for the factor in the present value annuity table in the year’s column until you arrive
at a figure which is closest to the fake pay back period.

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 4) Calculate npv at that percentage
5) If NPV is positive take a rate higher and if NPV is negative take a rate lower and once
again calculate NPV
6) Continue step4 until you arrive two rates, one giving positive NPV and another negative
NPV.
7) Use interpolating to arrive at the actual IRR i.e…. actual IRR can be calculated by using
the following formula.

Present value at
Lower rate __ cash out flow
Lower rate + ____________________________ X diff. in the
Present value __ present value rates
At lower rate at higher rate

The more simple words, IRR can be calculated by trial an error method
Which means the unknown discount factor which makes NPV=0 con be calculated by
substituting various values which is tedious process. Therefore the above method may be
used.
ACCEPT OR REJECT CRITERION:

The accept or reject rule, using the IRR method, is to accept the project if its internal rate of
return is higher than the opportunity cost of capital(r>k) note k is also known as the required rate
of return, or cutoff, or hurdle rate.
The project shall be rejected if its internal rate of return is lower than the opportunity cost of
capital (r<k). The decision maker may be indifferent if the internal rate of return is equal to
opportunity cost of capital.
Thus, the IRR rule is
Accept if r>k
Reject if r<k
May accept if r=k

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 EVALUATION OF IRR METHOD:

 It recognizes the time value of money

 It considers all cash flows occurring over the entire life of the project to calculate its rate
of return
 It is consistent with the share holder’s wealth maximization objective

ADVANTAGES:
a) It takes into account, the time value of money and can be applied in situation with even
and even cash flows.
b) It considers the profitability of the projects for its entire economic life.
c) The determination of cost of capital is not a pre-requisite for the use of this method.
d) It provide for uniform ranking of proposals due to the percentage rate of return.
e) This method is also compatible with the objective of maximum profitability.

DISADVANTAGES:
a) It is difficult to understand and operate.
b) The results of NPV and IRR methods may differ when the projects under evaluation
differ in their size, life and timings of cash flows.
c) This method is based on the assumption that the earnings are reinvested at the IRR for
the remaining life of the project, which is not a justified assumption.

3. PROFITABILITY INDEX:

Yet another time adjusted method of evaluating the investment proposals is the
benefit cost ratio or profitability index(PI).

It is the ratio of the present value of cash inflows, at the required rate of return, to the initial
cash out flow of the investment. It may be the gross or net. Net=gross-1

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The formula to calculate benefit cost ratio or profitability index is as follows:
PRESENT VALUE OF CASH INFLOWS
______________________________
PI= INITIAL CASH OUTLAY

ACCEPT OR REJECT CRITERION:

The following are the PI acceptance rules:

a) Accept if PI>1
b) Reject if PI<1
c) May accept if PI=1

When PI is greater than one, then the project will have net present value.

EVALUATION OF PI METHOD:

a) It recognizes the time value of money

b) It is a variation of the NPV method, and requires the same computation as the NPV
method.
c) In the PI method, since the present value of cash inflows is divided by the initial cash
out flows, it is a relative measure of projects profitability.

ADVANTAGES:
a) Unlike net present value, the profitability index method is used to rank the projects even
when the costs of the projects differ significantly.
b) It recognizes the time value of money and is suitable to applied in a situation with uniform
cash outflow and uneven cash inflows.

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c) It takes into account the earnings over the entire life of the project and gives the true view of
the profitability of the investment.
d) Takes into consideration the objectives of maximum profitability.

DISADVANTAGES:
a) More difficult to understand and operate.
b) It may not give good results while comparing projects with unequal investment funds.
c) It is not easy to determine and appropriate discount rate.
d) It may not give good results while comparing projects with unequal lives as the project
having higher NPV but have a longer life span may not be as desirable as a project having
some what lesser NPV achieved in a much shorter span of life of the asset.

PROBLEMS AND DIFFICULTIES IN CAPITAL BUDGETING:

The capital budgeting decisions are not critical and analytical in nature, but also involve various
difficulties which a finance manger may come across. The problems in capital budgeting
decision may be as follows:

1) FUTURE UNCERTAINTY: All capital budgeting decisions involve long term

which is uncertain. Even if every care is taken and the project is evaluated to every
minute detail, still 100% correct and certain forecast is not possible. The finance
manager dealing with the capital budgeting decision, therefore, should try to be as
analytical as possible. The uncertainity of the capital budgeting decisions may be with
reference to cost of the project, future expected returns from the project, future
competition, expected demand in future, legal provisions, political situation etc.

2) TIME ELEMENT: The implication of a capital budgeting decision are scattered

over a long period, the cost and benefit of a decision may occur at different point of

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 time. As a result, the cost and benefits of a capital budgeting decision are generally
not comparable unless adjusted for time value of money. These total returns may be
than the cost incurred, still the net benefit cannot be ascertained unless the future
benefits are adjusted to make them comparable with cost. Moreover, the longer the
time period involved, the greater would be the uncertainty.

3) MEASUREMENT PROBLEM: Some times a finance manager may also face

difficulties in measuring the cost and benefits of a project’s in quantitative terms. For
example, the new product proposed to be launched by a firm may result in increase or
decrease in sales of other products already being sold by the same firm. This is very
difficult to ascertain because the sales of other products may increase or decrease due
to other factors also.

ASSUMPTION IN CAPITAL BUDGETING:

The capital budgeting decision process is a multi-faceted and analytical process. A
number of assumptions are required to be made. These assumptions constitute a general set of
condition within which the financial aspects of different proposals are to be evaluated. Some of
these assumptions are:
1.Certainity with respect to cost and benefits: it is very difficult to estimate the
cost and benefits of a proposal beyond 2-3 years in future. However, for a capital budgeting
decision, it is assumed that the estimate of cost and benefits are reasonably accurate and
certain.
2 Profit motive: Another assumption is that the capital budgeting decisions are taken with a
primary motive of increasing the profit of the firm. No other motive or goal influences the
decision of the finance manager.

3 No Capital Rationing: The capital Budgeting decision in the present chapter assume that
there is no scarcity of capital. It assumes that a proposal will be accepted or rejected in the
strength of its merits alone. The proposal will not be considered in combination with other
proposals to the maximum utilization of available funds.

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TYPES OF CAPITAL BUDGETING DECISIONS:

1. FROM THE POINT OF VIEW OF FIRM’S EXISTENCE:

a) NEW FIRM: A newly incorporated firm may be required to take different decisions such
as selection of a plant to be installed, capacity utilization at initial stages, to set up or not
simultaneously the ancillary unit etc.

b) EXISTING FIRM: A firm which is already existing may also required to take various
decisions from time to time to meet the challenges of competition or changing
environment. These decision may

I. REPLACEMENT AND MODERNIZATION DECISION: The main objective of

modernization and replacement is to improve operating efficiency and reduce costs. Cost
savings will reflect in the increased profits, but the firm’s revenue may remain
unchanged. Assets become outdated and obsolete with technological changes. The firm
must decide to replace those asserts with new assets that operate more economically.

If cement company changes from semi automatic drying equipment to fully

automatic drying equipment, it is an example of modernization and replacement. Replacement
decisions help to introduce more efficient and economical assets and therefore, are also called
reduction investments. However, replacement decisions which involve substantial modernization
and technological improvements expand revenues as well as reduced costs.

II. EXPANSION: Some times, the firm may be interested in increasing the installed
production capacity so as to increase the market share. In such a case, the finance
manager is required to evaluate the expansion program in terms of marginal costs and
marginal benefits.

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 III. DIVERSIFICATION: Some times, the firm may be interested to diversify into new
product lines, markets, production of spare parts etc. in such case, the finance manager is
required to evaluate not only the marginal cost and benefits , but also the effect of
diversification on the existing market share and profitability. Both the expansion and
diversification decisions may also be known as revenue increasing decisions.

2. FROM THE POINT OF VIEW OF DECISION SITUATION:

The capital budgeting decision may also classified from the point of view of the decision
situation as follows:

a) MUTUALLY EXCLUSIVE DECISIONS:

Two or more alternative proposals are said to be mutually exclusive when acceptance of
one alternative result in automatic rejection of all other proposals. The mutually exclusive
decisions occur when a firm has more than one alternative but competitive proposals before it.
For example, if a company is considering investment in one of two temperature control system,
acceptance of one system will rule out the acceptance of another.

Thus, two or more mutually exclusive proposals cannot both or all be accepted. Some
technique has to be used for selecting the better or the one. Once this is done, other
alternative automatically get eliminated.

b) CONTINGENT DECISIONS OR DEPENDENT PROPOSALS:

These are proposals whose acceptance depends on the acceptance of one or more other
proposals. For example a new machine may have to be purchased on account of substantial
expansion of plant.

24
 In this case investment in the machine is dependent upon expansion of plant. When a
contingent investment proposal is made, it should also contain the proposal on which it is
dependent in order to have a better perspective of the situation. Any capital budgeting decision
must be evaluated by the finance manager in its totality. The contingent decision, if any, must be
considered and evaluated simultaneously.

c) INDEPENDENT PROPOSALS:

These are proposals which do not compete with one another in a way that acceptance of
one precludes the possibility of acceptance of another. In case of such proposals the firm may
straight “accept or reject” a proposal on the basis of a maximum return on investment
required.
d) ACCEPT-REJECT DECISIONS:

An accept-reject decision occurs when a proposal is independently accepted or rejected

with out regard any other alternative proposal. This type of decision is made when (i)
proposal’s cost and benefit neither affect nor are affected by the cost and benefits of other
proposals, and (ii) accepting or rejecting one proposal has not impact on the desirability of
other proposals, and (iii) the different proposals being considered are competitive.

RATIONALE FOR CAPITAL EXPENDITURE:

Efficiency is the rationale underlying all capital decisions. A firm has to continuously
invest in new plant or machinery for expansion of its operations or replace worn-out

25
 machinery for maintaining and improving its efficiency. The over all objectives and to
maximize the profits and thus optimizing the return on investment. Thus capital expenditure
can be of two types:

1) EXPENDITURE INCREASING REVENUE:

Such a capital expenditure brings mire revenue to the firm either by expansion of
present operations or development of a new product line. In both the cases new fixed assets are
required.

2) EXPENDITURE REDUCING COSTS:

Such capital expenditure reduces the total cost and there by adds to the total earnings
of the firm. For example, when an asset is worn out becomes obsolete, the firm has to decide
whether to continue with it or replace it by a new machine.

While taking such a decision the firm compares the required cash outflows for the new
machine with the benefit in the form of reduction in operating costs as a result of replacement of
the old machine by a new one. The firm will replace the machine only when it finds it beneficial.

CAPITAL RATIONING DECISION:

In situations where the firm has unlimited funds, all independent investment proposals yielding
return greater than some predetermined level are accepted. However this situation does not occur
in the practical business scenario. They have fixed capital budget, a large number of projects
compete for these limited funds and the firms try to ration them. The firm allocates the funds to
the projects in a manner that maximizes long-run returns. Thus, capital rationing refers to a
situation in which a firm has more acceptable investments than it can finance. It is concerned
with the selection of the proposal among various projects based on their accept-reject decision.

26
 Capital rationing employs ranking of the acceptable investment projects. The projects
can be ranked on the basis of a predetermined criterion such as the rate of return. The projects are
ranked in the descending order of the rate of return.

Capital rationing involves choice of combination of available projects in a way to

maximize the total net present value, given the capital budget constraint. The ranking of the
project can be done on the basis of profitability index or IRR. The procedure to select the
package of projects will relate to whether the project is divisible or indivisible, the objective
being the maximization of total NPV by exhausting the capital budget is as far as possible.

INVESTMENT EVALUATION CRITERIA:

The three steps are involved in the evaluation of an investment:

a) Estimation of cash flows
b) Estimation of required rate of return
c) Application of a decision rule for making the choice

The investment decision rules may be referred to as capital budgeting techniques, or investment
criteria. A sound appraisal technique should be used to measure the economic worth of the
investment project. The essential property of a sound technique is that it should maximize the
shareholder’s wealth.

The following are characteristics should be possessed by the sound investment criterion:

a) It should consider all the cash flows to determine the true profitability of the project.
b) It should provide for an objective and unambiguous way of separating good projects from
bad projects
c) It should help ranking of projects according to their profitability.

27
 d) It should recognize the fact that bigger cash flows are preferable to smaller ones and early
cash flows are preferable to later ones.
e) It should help to choose among mutually exclusive projects that project which maximizes
the shareholder’s wealth.
f) It should be a criterion which is applicable to any conceivable investment project
independent of others.
g) Choosing among several alternatives.
h) A criterion which is applicable to any conceivable project.

1.2 NEED FOR THE STUDY

1) The Project study is undertaken to analyze and understand the Capital Budgeting
process in financial sector, which gives mean exposure to practical implication of
theory knowledge.
2) To know about the company’s operation of using various Capital Budgeting
techniques.
3) To know how the company gets funds from various resources.

1.3 SCOPE OF THE STUDY:

Performance in terms of profitability in a benchmark for any business enterprise including the
banking industry. However, increasing NON-PERFORMING ASSETS s have direct impact on
bank profitability as legally banks are not allowed to book income on such accounts and at the
same time banks are forced to make provision on such assets as per reserve bank of India (RBI)
guidelines.

The scope of study is wide and covers all the financial institutions in the country. As it is a vast
subject, it is not possible to study the NON-PERFORMING ASSETS s of all banks in the
country/state. So the study is limited to analysis of NON-PERFORMING ASSETS s of HDFC
Bankagain the Bank has 30 branches spreading over few states and hence study is limited to

28
analysis of NON-PERFORMING ASSETS s at HDFC branches. And also the scope of the study
is for analyzing the NON-PERFORMING ASSETS . of HDFC Bankfor a period of 4 year and to
find out how much amount is transferred to ARC and LPWA (loan pending to arbiter).

1.4 OBJECTIVES OF THE STUDY

1) To study the relevance of capital budgeting in evaluating the project for project
finance
2) To study the technique of capital budgeting for decision- making.
3) To measure the present value of rupee invested.
4) To understand an item wise study of the company financial performance of the
company.
5) To make suggestion if any for improving the financial position if the company.
6) To understand the practical usage of capital budgeting techniques
7) To understand the nature of risk and uncertainty
1.5 METHODOLOGY

To achieve aforesaid objective the following methodology has been adopted. The
information for this report has been collected through the primary and secondary sources.

a) Primary sources

It is also called as first handed information; the data is collected through the
observation in the organization and interview with officials. By asking question with the
accounts and other persons in the financial department. A part from these some information is
collected through the seminars, which were held by HDFC

b) Secondary sources

29
 The secondary data have been collected through the various books, magazines,
brouchers & websites
1.6 LIMITATION OF THE STUDY :

1. Lack of time is another limiting factor, ie., the schedule period of 8 weeks are not
sufficient to make the study independently regarding Capital Budgeting in HDFC.
2. The busy schedule of the officials in the HDFC is another limiting factor. Due to
the busy schedule officials restricted me to collect the complete information about
organization.
3. Non-availability of confidential financial data.
4. The study is conducted in a short period, which was not detailed in all aspects.
5. All the techniques of capital budgeting are not used in HDFC. Therefore it was
possible to explain only few methods of capital budgeting.

1.7 CHAPTERIZATION OF SCHEME

Keeping the objectives mentioned above, in view, the present study is organized into 4

chapters

1. The first chapter is introductory in nature; it also deals with presentation of

importance, scope, objectives and limitations of the study.

2. The second chapter is Company Profile of the organization.

3. The third chapter deals with Data Analysis and Interpretation

4. The fourth chapter deals with Findings and Suggestions

30
 CHAPTER II
COMPANY PROFILE

31
 COMPANY PROFILE

INTRODUCTION:
SLOGAN: “With you right through”.
” Helping Indians experience the joy of home ownership”.
The road to success is a tough and challenging journey in the dark where only obstacles light the
path. However, success on a terrain like this is not with out a solution.
As HDFC found out over two decades ago, in 1977 the solution for success is costumer
satisfaction. All you need is the courage to innovate, the skill to understand your clients and the
desire to give them your best. HDFC’s objective from the beginning has been to enhance
residential housing stock and promote home ownership. Now, HDFC’s offerings range from
hassle free home loans and deposit products, to property related services and a training facility.
HDFC also offers specialized financial services to their customer base through partnerships with
some of the best financial institutions worldwide.

OBJECTIVES AND BACKGROUND:

Against the trend of rapid urbanization and a changing socio-economic scenario, the demand for
housing has grown explosively. The importance of housing sector in the economy can be
illustrated by a few key statistics. According to the National Building Organization (N.B.O), the
demand for housing is estimated at two million units per year and the total housing short fall of
estimated to be 19.4 million units, of which 12.76 million units is from rural areas and 6.64
million units is from urban areas. The housing industry is second largest employment generator
in the country. It is estimated that the budgeted two million units would lead to the creation of an
additional ten million man-years of direct employment and another 15 million man-years of
indirect employment

32
BACKGROUND:
HDFC was incorporates in the year 1977, with the primary objective of meeting a social need
that of promoting home ownership by providing long-term finance to house holds for their
housing needs. HDFC was promoted with an initial share capital of Rs.100 millions.

BUSINESS OBJECTIVES:
The primary objective of HDFC is to enhance residential housing stock in the country through
the provision of housing finance in a systematic and professional manner and to promote home
ownership. Another objective is to increase the flow of resources to the housing sector by
integrating housing finance sector with overall domestic financial markets.

ORGANIZATIONAL GOALS:
1. Develop close relationships with individual households.
2. Maintain its position has a premier housing finance institution in the country.
3. Transform ideas into viable and creative solutions
4. Provide consistently high returns to shareholders.
5. To grow through diversification, by leveraging off the existing client base.

CONSULTANCY SERVICES:
HDFC is a unique example of housing finance company that has demonstrated the viability of
market oriented housing finance in a developing country. It is viewed as a market leader in the
Housing finance sector in India. The World Bank considers HDFC a model private sector
housing finance company in developing countries and a provider of technical assistance for new
and existing institutions in India and abroad. HDFC’s executives have undertaken consultancy
assignments related to housing finance and urban development on behalf of multi lateral
agencies allover the world.
HDFC has also served as consultant to international agencies such as World Bank, United States’
Agency for International Development (USAID), Asian Development Bank, United Nations’
Centre for Human Settlements, Common wealth Development Corporation (CDC) and United
Nations Development Programme (UNDP).

33
At the national level, HDFC’s executives have played a key role in formulating national housing
policies and strategies. Recognizing HDFC’s executives to join a number of comities and task
force related to housing finance, urban development and capital markets.

SUBSIDARY & ASSOCIATE COMPANIES:

HDFC Bank.
HDFC Mutual Fund.
HDFC Standard Life Insurance Company.
HDFC Securities.
HDFC Reality.
HDFC Chubb General Insurance Company ltd.
Intel net Global services.
Credit Information Bureau (India) Ltd.
Other Companies Co-Promoted by HDFC.

HOUSING DEVELOPMENT FINANCE CORPORATION

HDFC Bank was incorporated in August 1994 in the name of ‘HDFC Bank Limited’, with its
registered office in Mumbai, India. The Bank commenced operations as a Scheduled
Commercial Bank in January 1995. The Housing Development Finance Corporation Limited
(HDFC) was amongst the first to receive an ‘in principle’ approval from the Reserve Bank of
India (RBI) to set up a bank in the private sector, as part of the RBI’s liberalization of the Indian
Banking Industry in 1994. Headquartered in Mumbai, HDFC Bank, has a network of over 531
branches spread over 228 cities across India. All branches are linked on an online real-time
basis. Customers in over 120 locations are serviced through Telephone Banking. The Bank also
has a network of about over 1054 networked ATMs across these cities. HDFC Bank’s ATM
network can be accessed by all domestic and international Visa, MasterCard, Visa Electron,
Maestro, Plus, Cirrus and American Express Credit, Charge cardholders. The Bank’s expansion
plans take into account the need to have a presence in all major industrial and commercial

34
centers where its corporate customers are located as well as the to build a strong retail customer
base for both deposits and loan products. Being a clearing settlement bank to various leading
stock exchanges, the Bank has branches in the centers where the NSE/BSE has a strong and
active member base. HDFC Bank also has Private Banking Group which offers investment
advisory and portfolio management services to its clients.

HDFC Bank has won many awards for its excellent service. Major among them are “Best Bank
in India” by Hong Kong-based Finance Asia magazine in 2005 and “Company of the Year”
Award for Corporate Excellence 2004-05. Business Today has declared HDFC Bank the “Best
Bank” for the year 2006. Net Profit for the nine months ended 31st December 2006 up by 31.3%.

PROMOTERS
HDFC is India's premier housing finance company and enjoys an impeccable track record in
India as well as in international markets. Since its inception in 1977, the Corporation has
maintained a consistent and healthy growth in its operations to remain the market leader in
mortgages. Its outstanding loan portfolio covers well over a million dwelling units. HDFC has
developed significant expertise in retail mortgage loans to different market segments and also has
a large corporate client base for its housing related credit facilities. With its experience in the
financial markets, a strong market reputation, large shareholder base and unique consumer
franchise, HDFC was ideally positioned to promote a bank in the Indian environment

BUSINESS FOCUS
HDFC Bank's mission is to be a World-Class Indian Bank. The objective is to build sound
customer franchises across distinct businesses so as to be the preferred provider of banking
services for target retail and wholesale customer segments, and to achieve healthy growth in
profitability, consistent with the bank's risk appetite. The bank is committed to maintain the
highest level of ethical standards, professional integrity, corporate governance and regulatory
compliance. HDFC Bank's business philosophy is based on four core values - Operational
Excellence, Customer Focus, Product Leadership and People.

35
BUSINESS STRUCTURE

The authorized capital of HDFC Bank is Rs.450 crore (Rs.4.5 billion). The paid-up capital is
Rs.311.9 crore (Rs.3.1 billion). The HDFC Group holds 22.1% of the bank's equity and about
19.4% of the equity is held by the ADS Depository (in respect of the bank's American Depository
Shares (ADS) Issue). Roughly 31.3% of the equity is held by Foreign Institutional Investors
(FIIs) and the bank has about 190,000 shareholders. The shares are listed on the Stock Exchange,
Mumbai and the National Stock Exchange. Shares are listed on the New York Stock Exchange
(NYSE) under the symbol "HDB".

MANAGEMENT

Mr. Jadish Capoor took over as the bank's Chairman in July 2001. Prior to this, Mr. Capoor was a
Deputy Governor of the Reserve Bank of India.The Managing Director, Mr. Aditya Puri, has
been a professional banker for over 25 years and before joining HDFC Bank in 1994 was
heading Citibank's operations in Malaysia. The Bank's Board of Directors is composed of
eminent individuals with a wealth of experience in public policy, administration, industry and
commercial banking. Senior executives representing HDFC are also on the Board. Senior
banking professionals with substantial experience in India and abroad head various businesses
and functions and report to the Managing Director. Given the professional expertise of the
management team and the overall focus on recruiting and retaining the best talent in the industry,
the bank believes that its people are a significant competitive strength.

TECHNOLOGY
HDFC Bank operates in a highly automated environment in terms of information technology and
communication systems. All the bank's branches have online connectivity, which enables the
bank to offer speedy funds transfer facilities to its customers. Multi-branch access is also
provided to retail customers through the branchnetworkandAutomatedTellerMachines.(ATMs).

36
BUSINESSES
WHOLESALEBANKING:

The Bank's target market ranges from large, blue-chip manufacturing companies in the Indian
corporate to small & mid-sized corporate and agri-based businesses. For these customers, the
Bank provides a wide range of commercial and transactional banking services, including
working capital finance, trade services, transactional services, cash management, etc. The bank is
also a leading provider of structured solutions, which combine cash management services with
vendor and distributor finance for facilitating superior supply chain management for its corporate
customers. Based on its superior product delivery / service levels and strong customer
orientation, the Bank has made significant inroads into the banking consortia of a number of
leading Indian corporate including multinationals, companies from the domestic business houses
and prime public sector companies. It is recognized as a leading provider of cash management
and transactional banking solutions to corporate customers, mutual funds, stock exchange
members and banks.

RETAILBANKINGSERVICES

The objective of the Retail Bank is to provide its target market customers a full range of financial
products and banking services, giving the customer a one-stop window for all his/her banking
requirements. The products are backed by world-class service and delivered to the customers
through the growing branch network, as well as through alternative delivery channels like ATMs,
Phone Banking, and Net Banking and Mobile Banking.
The HDFC Bank Preferred program for high net worth individuals, the HDFC Bank Plus and the
Investment Advisory Services programs have been designed keeping in mind needs of customers
who seek distinct financial solutions, information and advice on various investment avenues. The
Bank also has a wide array of retail loan products including Auto Loans, Loans against
marketable securities, Personal Loans and Loans for Two-wheelers. It is also a leading provider
of Depository Participant (DP) services for retail customers, providing customers the facility to
hold their investments in electronic form.
37
HDFC Bank was the first bank in India to launch an International Debit Card in association with
VISA (VISA Electron) and issues the MasterCard Maestro debit card as well. The Bank launched
its credit card business in late 2001. By September 30, 2005, the bank had a total card base (debit
and credit cards) of 5.2 million cards. The Bank is also one of the leading players in the
"merchant acquiring" business with over 50,000 Point-of-sale (POS) terminals for debit / credit
cards acceptance at merchant establishments.
Treasury
Within this business, the bank has three main product areas - Foreign Exchange and Derivatives,
Local Currency Money Market & Debt Securities, and Equities. With the liberalization of the
financial markets in India, corporate need more sophisticated risk management information,
advice and product structures. These and fine pricing on various treasury products are provided
through the bank's Treasury team. To comply with statutory reserve requirements, the bank is
required to hold 25% of its deposits in government securities. The Treasury business is
responsible for managing the returns and market risk on this investment portfolio

CREDIT RATING
HDFC Bank has its deposit programmers rated by two rating agencies - Credit Analysis &
Research Limited. (CARE) and Fitch Ratings India Private Limited. The Bank's Fixed Deposit
programme has been rated 'CARE AAA (FD)' [Triple A] by CARE, which represents instruments
considered to be "of the best quality, carrying negligible investment risk". CARE has also rated
the Bank's Certificate of Deposit (CD) programme "PR 1+" which represents "superior capacity
for repayment of short term promissory obligations". Fitch Ratings India Pvt. Ltd. (100%
subsidiary of Fitch Inc.) has assigned the "tAAA (ind)" rating to the Bank's deposit programme,
with the outlook on the rating as "stable". This rating indicates "highest credit quality" where
"protection factors are very high". HDFC Bank also has its long term unsecured, subordinated
(Tier II) Bonds of Rs.4 billion rated by CARE and Fitch Ratings India Private Limited. CARE
has assigned the rating of "CARE AAA" for the Tier II Bonds while Fitch Ratings India Pvt. Ltd.
has assigned the rating "AAA (Ind)" with the outlook on the rating as "stable". In each of the
cases referred to above, the ratings awarded were the highest assigned by the rating agency for
those instruments.

38
Corporate Governance Rating

The bank was one of the first four companies, which subjected itself to a Corporate Governance
and Value Creation (GVC) rating by the rating agency, The Credit Rating Information Services
of India Limited (CRISIL). The rating provides an independent assessment of an entity's current
performance and an expectation on its "balanced value creation and corporate governance
practices" in future. The bank has been assigned a 'CRISIL GVC Level 1' rating which indicates
that the bank's capability with respect to wealth creation for all its stakeholders while adopting
sound corporate governance practices is the highest.

HDFC was incorporated in 1977 as the first specialized Mortgage Company in India. HDFC
provides financial assistance individuals, corporate and developers for the purchase or
construction of residential housing. It also provides property services (e.g. property
identification, sales services and valuation), training and consultancy. Of these activities,
housing finance remains the dominant activity. HDFC has a client base of around 10, 00,000
borrowers, around 8, 50,000 depositors, over 92,000 shareholders and 50,000 deposit agents, as
at December 31, 2006. HDFC has raised funds from international agencies such as the World
Bank, IFC (Washington), USAID, DEG, ADB and KfW, international syndicated loans, domestic
term loans from banks and insurance companies, bonds and deposits. HDFC Standard Life
Insurance Company Limited, promoted by HDFC was the first life insurance company in the
private sector to be granted Certificate of Registration (on October 23, 2000) by the Insurance
Regulatory and Development Authority to transact life insurance business in India.

39
AWARDS AND ACCOLADES:

1) HDFC ranked no.3-‘ India’s Best managed Companies’ by Finance Asia Clean Sweep by
HDFC at the 43rd ABCI Awards.
2) National Award for Excellence in Corporate Governance by the Institute Of Companies
Secretaries of India.
3) 2nd best company for Corporate Governance in India by The Asset Magazine.
4) The Economic Times Lifetime achievement Award – 2003
(Mr. Deepak Parekh, Chairman, HDFC ltd.).
5) One of the top ten- Most Admired Companies in India’ – 2003 by Business barons.
6) One of the top ten – Most Admired CEO’s in India – 2003 by Business Barons
(Mr. Deepak Parekh).
7) India’s second Best Managed Company-2003 by Financial Asia.
8) India’s biggest wealth creator in the banking and financial services by the fourth
Business Today-Stern Steward Survey.
9) Highest rating for ‘ Governance and Value Creation ‘ by CRISIL>
10) Best ‘Managed Financial Institutions in India’ by Fox Pitt Survey.
11) HDFC Bank began operations in 1995 with a simple mission: to be a "World-class Indian
Bank".
12) As part of the Asian Banker Awards 2003.
13) In 2004, HDFC Bank was selected by Business World as "One of India's Most Respected
Companies" as part of The Business World Most Respected Company Awards 2004.
14) In 2004, HDFC Bank won the award for "Operational Excellence in Retail Financial
Services" – India.

40
 CHAPTER III
DATA ANALYSIS AND INTERPRETATION

41
DATA ANALYSIS
Various methods are used for ascertainment of profitability of capital expenditure. The practical
usage of these methods discussed here under:
1) AVERAGE RATE OF RETURN:
This method represents the ratio of average annual profit (after taxes) to the
average investment in the project. It is calculated
Average Annual Profit after taxes
A.R.R = ----------------------------------------------X100
Annual Average investment
TO ILLUSTRATE:
The purchase price of a new machine is RS.100000 and it will require additional
amount of RS.10000 to install bringing the total cost to RS.110000. The old machine to be
replaced can be sold for RS.10000 the initial cash out flow for the machine, therefore is RS.
100000 - (110000+10000-10000). The new machine expected to earn RS.10000 per year after
taxes for the next 5 years after which it is not to be used, nor is it expected to have an average
value.
The average investment in the machinery, assuming straight line depreciation is
RS50000 That is RS.10000/2
10000
Average rate of return = ------- * 100 = 20%
50000
This method is based on accounting information rather upon cash flows. This method is
simple and makes use of readily available accounting information. Once average return is
expected it can be readily compared with the expected return, to determine whether a particular
proposal for capital expenditure should be accepted or rejected.

42
PAY BACK METHOD:
This method tells us the number of years required to recover the initial investment
of that asset. It is calculated

Initial investment
Pay back period =________________
Annual cash flow
The shorter the payback period, the less risky the investment and greater its liquidity.

TO ILLUSTRATE:
Table :3.1
YEAR 2013-14 2014-15 2015-16 2016-17 2017-18
CFS(LAKHS) 60 80 50 40 40
Initial investment = 200000
The annual cash inflows are not constant so we calculate cumulative cash inflows in order to
compute the pay back period.

Year Cash inflows Cumulative cash inflows

2013-14 600000 600000
2014-15 800000 (600000+800000)
2015-16 500000 (1400000+500000)
2016-17 400000 (1900000+400000)
2017-18 400000 (2300000+400000)
Source Annual Report

43
 Initial investment = 2000000
Amount received up to the 3rd year = 1900000
Amount to be received in 4th year = 10000
(2000000-1900000)
Cash flows after taxes in 4th year = 400000
100000
PBP = 3Yrs + ----------------
400000
= 3 + 0.25 years
= 3 years and 3 months
DISCOUNTED PAY BACK PERIOD
Discounted cash flow method or time adjusted technique is an improvement over pay
back method and ARR. In evaluating investment projects, it is important to consider the timing
of returns on investment. Discounted cash flow technique takes into account both the interest
factor and the return after the pay back period.

44
COMPUTATION OF DISCOUNTED PAY BACK PERIOD

Table :3.2

Year Cash inflows PV @ 10% Pv of cash Cumulative cash

inflow inflow
2013-14 600000 0.909 545400 54500
2014-15 800000 0.826 660800 (545400+660800)
2015-16 500000 0.751 375500 (1206200+375500)
2016-17 400000 0.683 273200 (1581700+273200)
2017-18 400000 0.621 248400 (1854900+248400)
Source Annual Report

Initial investment = 2000000

Amount to be received up to the end of 4th year = 1854900
Amount to be received in 5th year = 145100
(2000000-1854900)
Cash flow after tax in 5th year = 248400
145100
PBP = 4Yrs + ---------------- = 4.58 years
248400
NET PRESENT VALUE :
The Net present Value (NPV) method is the classic economic method of evaluating the
investment proposals. It is one of the discounted cash flow technique explicitly recognizing the

45
time value of money. It correctly postulates that cash flows arising at different time periods differ
in value and the comparable only when their equivalent present values are found out.
NPV = PRESENT VALUE OF CASH INFLOWS – PRESENT VALUE OF CASH OUTFLOW
To illustrate:
A project requires an initial investment of RS. 50000 and is likely to generate the following
CFATS.
Table 3.3
Year 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18
CFATS 10000 12000 18000 25000 8000 4000
Cost of capital= 10%
NET PRESENT VALUE:
YEAR CASH INFLOW PV @ 10% PV OF CASH
INFLOW
2012-13 10000 0.909 9,090
2013-14 12000 0.826 9,912
2014-15 18000 0.751 13,518
2015-16 25000 0.683 17,075
2016-17 8000 0.621 4,968
2017-18 4000 0.564 2,256
Source Annual Report

NPV = 56,819 – 50000

46
 = 6,819

The net present value of the project is 6,819

PROFITABILITY INDEX METHOD:

It is also a time-adjusted method of evaluating the investment proposals. PI also
called benefit cost ratio or desirability factor is the relationship between present value of cash
inflows and the present values of cash outflows. Thus
PV of cash inflows
Profitability index = -----------------------------
PV of cash outflows
TO ILLUSTRATE:
A firm is evaluating a proposal which requires a cash outlay of RS.40000 at present
and of RS.20000 and at the end of third from now. It is expected to generate cash inflows of
RS.40000 and RS.20000 at the end of 1 st year and 4th year respectively. The rate of discount of
10%
CALCULATION OF THE PROFITABILITY INDEX
Table 3.4
YEAR CASH FLOWS RS PVF(10%) PRESENTVALUE
RS
2013-14 -40000 1.000 -40,000
2014-15 20000 0.909 13,180
2015-16 40000 0.826 33,040
2016-17 -20000 0.751 -15,020
2017-18 20000 0.683 13,660
Source Annual Report

47
Present value of cash outflows= RS.40,000+15,020=55,020
Present value of cash outflows= RS.18,180+33,040+13,660=64,88O
RS.64,880
PI= ------------- = 1.18
RS.55,O20
INTERNAL RATE OF RETURN (IRR):
The Internal Rate of Return (IRR) method is another discounted cash flow technique, which
makes account of the magnitude and timing of cash flows. Others terms used to describe the IRR
Method are yield on investment, marginal efficiency of capital, rate of return over cost and so on.
The concept of internal rate of return is quite simple to understand in the case of one-period
projects
TO ILLUSTRATE:

A project requires an initial investment of RS. 5000 and is likely to generate the following
CFATS
Table 3.5
YEAR 2013-14 2014-15 2015-16 2016-17 2017-18
CF’S(RS 1000 1045 1180 1225 1675
000)

In this project as the cash inflows are not constant we calculate fake back period.

48
 INITIAL INVESTMENT
FAKE PBP= AVERAGE CASH INFLOW

TOTAL CASH INFLOWS

AVERAGE CASH INFL OWS = NUMBER OF YEAR

= 6125 = 1225
5
FAKE PBP = 5000 = 4.0816 YEARS
1225
Locate a discount factor in PV of annuity table nearest to 4.0816 against 5 years
At 6% 4.0816

Therefore our starting rate is 6%

Year CASH INFLOW PV @ 7% PV OF CASH

INFLOWS
2013-14 1000 0.935 935
2014-15 1045 0.873 912
2015-16 1180 0.816 963
2016-17 1125 0.763 935
2017-18 1675 0.713 1194

YEAR CASH INFLOW PV @ 6% PV OF CASH

49
 INFLOW
2013-14 1000 0.943 943
2014-15 1045 0.890 930
2015-16 1180 0.840 991
2016-17 1125 0.792 970
2017-18 1675 0.747 1251
To increase the PV of cash inflow, we decrease the rate let the new rate be 6%

Source Annual Report

PV OF CASH OUTFLOW = 5000

PV OF CASH INFLOW @ 7% = (61)
PV OF CASH INFLOW @ 6% = 85

Therefore IRR lies between 7-6%

PV of cash inflows at lower rate – PV of cash outflows

IRR = LR + ----------------------------------------------------------------------(HR-LR)
PV of cash inflows at lower rate–PV of cash inflows at higher rate
WHERE,
LR= Rate of interest that is lower of the two rates at which PV of Cash inflows have been
calculated.
LR = lower rate of discount= 6%

PVC fat= PV of cash inflow at lower rate = 5085

PVC = PV of cash outflow = 5000

Difference in PV of cash inflow

= 5085 - 5000

50
 = 85
Difference in discounting rate
=7–6
=1
85
IRR = 6% + ----- * 1
146

= 6 + 0.58
= 6.58%
SUMMARY

PARTICULARS COMPUTATIONS
AVERAGE RATE OF RETURN 20
PAY BACK RERIOD 3.25
DISCOUNTED PAY BACK PERIOD 4.58
NET PRESENT VALUE 6,819
PROFITABILITY INDEX 1.18
INTERNAL RATE OF RETURN 6.58

OBSERVATIONS:

1) The PBP of the project is 3.25 and the discounted payback period is 4.58 yrs which is less
than the life of the project
2) The ARR of the project is 20%
3) The NPV of the project is more than the “0” i.e. 6,819
4) The PI is more than 1 i.e. 1.18
5) The IRR is 6.58%

In consideration with the above points it can be said that the project can be accepted as it is
satisfying all the required conditions.

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USE OF IRR TECHNIQUE IS EXPLAINED WITH THE HELP OF THE FOLLOWING
EXAMPLE
M/S ventech private limted has approached HDFC for a term loan RS. 1500 lakhs for expansion
of their existing paper mill at hyderabad. The total project cost of the expansion is worked at
RS.2060 lakhs and the over all project cost is worked at RS.3003 lakhs as given below:
(RS in lakhs)
Project cost Existing Proposed Total
Land 70.00 --- 70.00
Buildings 233.00 200.00 433.00
Plant & machinery 518.00 1580.00 2098.00
Factory equipment 4.00 --- 4.00
Electricals 20.00 --- 20.00
Computers & furniture 7.00 --- 7.00
Vehicles 21.00 --- 21.00
Deposits 30.00 --- 30.00
Working capital margin 40.00 280.00 320.00
------- --------- ---------
943.00 2060.00 3003.00
-------- ---------- ----------
The project has been appraised by HDFC and worked out the following economics for the
project:

Capacity utilisation = 90% Sales = RS.3314 lakhs

MANUFACTURING EXPENSES (A)
(RS. In lakhs)
Raw materials 1553.00
Con 31.00
Power & fuel 303.00
Wages 50.00
Repairs & maintenance 54.00
Taxes 42.00

52
Other inputs 42.00
2076.00

(RS. In lakhs)
ADMINISTRATIVE EXPENSES (B)

Management remunerating 12.00

Salaries 22.00
Other expenses 42.00 76.00
Total cost of production (A+B) 2151.00
Gross profit 1163.00

FINANCIAL EXPENSES
Interest on term loans 230.00
Interest on bank borrowing 65.00 295.00
868.00
Depreciation 355.00
Operating profit 513.00
Provision for taxation 173.00
Profit after tax 340.00

Net profit before taxes 808.00

Interest added back, but after
Depreciation

The project cost is met as under:

(RS. In lakhs)
Existing proposed Total
Equity share capital 175.00 407.00 582.00
Reserves & surplus 76.00 153.00 229.00
Term loan fromNTPC 494.00 1500.00 1994.00

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Unsecured loans 198.00 --- 198.00
---------- --------- ----------
943.00 2060.00 3003.00
---------- ----------- -----------
The cash flows are generated for 8years at follows:
Table 3.6 (RS. In lakhs)
CASH INFLOW 2011 2012 2013 2014 2015 2016 2017 2018
E.B.I.T 808 914 937 963 981.01 995 1003 1008
DEPRECIATION 355 311 267 229 196.35 169 145 124
TOTAL 1163 1225. 1204 1191 1177.37 1163 1148 1132

The procedure adopted for calculating IRR is as given:

3) The project cost is arrived at, which consists of both fixed and current assets. In
the instant case, the fixed assets comprised of RS.2683.00 lakhs and current assets
comprised of RS.320.00 lakhs.
4) The following assumptions are made:

a) The life of the project is assumed at 15 years

b) The residual value of fixed assets at the end of 15 years is taken as ‘NIL’
excluding cost at lond.
c) The realizable value of current assets is at 100%

54
 d) The interest rate changed for the term loan being sanctioned is assumed
at 12%.
e) The term loan being sanctioned is expected to be repaid in a period of 8
years.
5) The outlay is expected to be spend in a period of 3 years as
Follows:
(RS. In lakhs)

O year 2683
1st year 920
3rd year 52
------
3655
-----
IRR can be calculated manually or by using computers. The IRR is calculated by using computer
as follows is as under:

Table 3.7
year Capital out lay benefits Net benefits Discnted bnfts
constrn 2683.25 0.00 -2683.25 -2683.25
2004 920.00 1162.57 242.57 180.34
2005 51.00 1225.45 1174.34 649.05
2006 0.00 1203.76 1203.76 494.62
2007 0.00 1190.87 1190.87 363.78
2008 0.00 1177.37 1177.37 267.38
2009 0.00 1163.16 1163.16 196.38
2010 0.00 1148.28 1148.28 144.13
2011 0.00 1132.62 1132.62 105.69
2012 0.00 1132.62 1132.62 78.57
2013 0.00 1132.62 1132.62 58.41
2014 0.00 1132.62 1132.62 43.43
2015 0.00 1132.62 1132.62 32.39
2016 0.00 1132.62 1132.62 24.00
2017 0.00 1132.62 1132.62 17.84

55
2018 0.00 2333.21 2333.21 27.33
Source Annual Report

Re projects IRR is worked at 34.5%

Observations:

1) The IRR for the instant project proposal is worked out at 34.5%
2) The cost of capital or cutt off rate is interest rate charged by HDFC that is 12%
3) Since the IRR is more than the cost of capital the project is accepted for financial
assistance

Suitability of IRR technique to project finance:

One of the discounted capital budgeting techniques, the IRR is widely used in
project finance proposals because of its suitability. It is defined rate of discount at which the
present value of inflows are equal to present value of out flows.

In project finance decisions it is easy to determine the cost of capital, which is

equivalent to the interest rate charged. Therefore it is easy to calculate the present values of
inflows and outflows by discounting the values at the cost of capital. The project’s whose IRR is
more than the cut off rate is accepted and vice versa. The data required for arriving at the cash
flows are easily calculated and thus the decision making is fast.

Where as another model, capital budgeting technique net present value methods is
most suitable for decisions involved buying machinery items etc. Selection of automatic or
manual machinery.

In view of the above HDFC is using IRR technique for their project finance proposals.

56
 CHAPTER IV

FINDINGS AND SUGGESTIONS

57
FINDINGS AND SUGGESTIONS

1) HDFC has been instrumental in industrial development of Andhra Pradesh.

2) During the 25th of its long saga, the corporation has financed above RS6000 cr to nearly
86000 cr enterprises.
3) The corporation has generated direct and indirect employement.
4) The corporation has completed 25 years of service and to mark this occasion Golden
Jubilee Celebration was conducted during 2015-2016
5) HDFC has achieved tremendous results during 2015-2016 in its key areas of operation.
There is a 26% growth in sanction, 21% in disbursements over the previous year.
6) The performance of the corporation is highest among all in the country As a result the
corporation has attained No. one position in the country for the 5th year
7) The evaluation techniques are broadly classified into two type’s i.e. traditional technique
and discounted cash flow technique.
8) The traditional technique includes net pay back period, average rate of return

58
9) The discounted cash flow technique includes Net Present Value, Internal Rate of Return,
and Profitability Index.
10) In HDFCC a project is appraised to examine the financial viability of the project.
11) HDFC workout Internal Rate of Return in appraisal of the project among the capital
budgeting technique.
12) An accept-reject criterion has been applied for all the capital budgeting methods.
13) The result in this case study suggests that the project can be accepted
14) The corporation may consider using of other capital budgeting techniques like Pay Back
Period, Average Rate of Return, Net Present Value, and Profitability Index in the
appraisal of the project, which will enhance the quality of the appraisal.

59
 BIBLIOGRAPHY

BIBLIOGRAPHY

Financial Management -- I.M. Pandey

Management Accountancy -- Khan & Jain
Financial Management -- S.N. Maheshwari
Advanced Accountancy -- S.P. Jain & K.V. Narayana
Financial Management -- Prasanna Chandra
Management Accountancy -- Sharma & Shashi K. Gupta

60
HDFC Annual reports
WWW.hdfc.com
WWW.HDFCINDIA.COM

61