Investment Decisions of Indian

Companies
 Capital Budgeting Practices of Indian Companies
 The Indian practice is also influenced considerably by
accounting conventions and tax regulations.
 Large expenditures on items such as research and
development, advertisement, or employees training, which
tend to create valuable intangible assets, are generally not
included in the definition since most of them are allowed to
be expensed for tax purposes in the year in which they are
incurred.
 Some companies classification was in terms of capital
expenditures for: (i) replacement (ii) modernization, (iii)
expansion, (iv) new projects, (v) research and development,
(vi) diversification, and (vii) cost reduction.
 Expenditure Planning Phases
 We have identified five phases of capital expenditure
planning and control:
 (1) identification or origination of investment opportunities,
 (2) development of forecasts of benefits and costs
 (3) evaluation of the net benefit,
 (4) authorisation for progressing and spending capital
expenditures, and
 (5) control of capital projects.
 The available literature emphasises the evaluation phase.
Two reasons may be attributed to this bias.
 First, this phase is easily amenable to a structured,
quantitative analysis,
 Second, it is considered to be the most important phase by
academicians.
 Practitioners, on the other hand, consider other phases to
be more important.
 Past surveys of capital budgeting practices in India and
abroad have not focussed adequately on all phases.
 Since phases other than evaluation are important, research
on those phases of capital budgeting is also needed
 Investment ideas: W ho G enerates

 Investment opportunities have to be identified or created; they do

not occur automatically.
 In some companies surveyed; more than 50 per cent of the
investment ideas were generated at the plant level. The contribution
of the board in idea generation was relatively insignificant.
 However, eight of the companies depended on the board upto 20 per
cent of the investment ideas.
 Two companies depended on research centres for about 10-20 per
cent of the investment ideas.
 These findings give an impression that the investment idea
generation is primarily a bottom-up process in India. In UK, both
bottom-up as well as top-down processes exist. Indian practice, is
more like that in USA
 METHODS OF IDEA GENERATION
 Most companies used a combination of methods. The offer of
financial incentives for generating investments ideas, was not
a popular practice.
 Other efforts employed by companies in searching
investment ideas were:
 (a) review of researches done in the country or abroad,
 (b) conducting market surveys, and
 (c) deputing executives to international trade fairs for
identifying new products/technology.
 Once the investment proposals have been identified, they
could be submitted for scrutiny any time.
 Cash Flow Estimation

 We found that executives did not always have clarity about estimating
cash flows.
 Half of our sample companies did not include additional working capital
while estimating the investment project cash flows.
 A number of companies also mixed up financial flows with operating
flows.
 The prevalence of such conceptual confusion has been observed even in
the developed countries. In UK, it was found half of the companies
treating depreciation as cash flow.
 Most Indian companies in our survey chose an arbitrary period of 5 or
10 years for forecasting cash flows.
 This was because companies in India largely depend on government
owned financial institutions for financing their projects, and these
institutions require 5 to 10 years forecasts of the project cash flows.
Evaluation of Proposals
 A formal financial evaluation of proposed capital
expenditures has become a common practice among
companies in India.
 About three-fourths of the companies subjected more than
50 per cent of the projects to some kind of formal financial
evaluation.
 Many companies stated that projects, such as replacement
of worn out equipment, welfare and statutorily required
projects below certain limit, small value items like office
equipment or furniture, replacement of assets of immediate
requirements, etc., were not formally evaluated.
 Cut-off Rate:
 In the implementation of a sophisticated evaluation system, the use
of a minimum required rate of return is necessary.
 Many companies specified the minimum acceptable rate of return.
 Few of them computed the weighted average cost of capital
(WACC) as the discount rate.
 In USA, a little more than 50 per cent companies have been found
using WACC as cut-off rate.
 In UK, only 14 per cent firms were found to attempt any calculation
of the cost of capital. As in USA and UK, companies m India have a
tendency to equate the minimum rate with interest rate or cost of
specific source of finance.
 The phenomenon of depending on management judgement for the
assessment of the cost of capital is prevalent as much in USA and
UK as in India.
Methods of Evaluation
 Almost all the companies, were found to use payback criterion.
 In addition to payback and/or other methods, companies also*
used internal rate of return (IRR) and net present value (NPV)
methods.
 Few companies were also found using accounting rate of return
(ARR) method.
 Thus, IRR was found to be the second most popular technique.
 It was found that many of companies insisted on computation
of payback for all projects, many for majority of projects, and
few for some of projects.
 In the case of slightly more than half of companies, standard
payback period ranged between three and five years.
 Recognition of Risk
 The assessment of risk is an important aspect of an investment evaluation.
Every companies considers risk and uncertainty while evaluating their
investment proposals.
 The four most important contributors of investment risk stated by the
Indian companies are: selling price, product demand, technological
changes and government policies.
 India is fast changing from sellers market to buyers market as competition
is intensifying in a large number of products; hence uncertainty of selling
price and product demand are being realised as important risk factors.
 Uncertain government policies (in areas such as custom and excise duty
and import policy), of course, are a continuous source of investment risk
in developing countries such as India.
 Sensitivity analysis and conservative forecasts are two equally important
and widely used methods of handling investment risk in India.
Capital Rationing
 A significant finding is that Indian companies, by and large, do
not have to reject profitable investment opportunities for lack of
funds, despite the capital markets not being so well developed.
 This may be due to the existence of the government-owned
financial system which is always ready to finance profitable
projects.
 Indian companies do not use any mathematical technique to
allocate resources under capital shortage which may sometimes
arise on account of internally imposed restrictions or
management's reluctance to raise capital from outside.
 Priorities for allocating resources are determined by
management, based on strategic need for and profitability of
projects.
 Authorisation
 In India, as in the power to commit a company to specific
capital expenditure and to examine proposals is limited to a
few top corporate officials.
 However, the duties of progressing the examination and
evaluation of a proposal was somewhat spread throughout
the corporate management staff in case of a few of the
companies.
 Thus, senior management tightly controls capital spending.
Budgetary controls are also exercised rigidly.
 The expected capital expenditure proposals invariably
become a part of the annual capital budget in all companies
 Control
 Indian companies practise control of capital expenditure
through the use of regular project reports.
 Most of the companies reported that in reappraising
investment proposals, they considered comparison between
actual arid forecast capital costs, savings and rate of return.
 They pointed out the following advantages of reappraisal:
 (i) improvement in profitability by positioning the project as
per the original plan;
 (ii) ascertainment of errors in investment planning which can
be avoided in future;
 (iii) guidance for future evaluation of projects; and
 (iv) generation of cost consciousness among the project
team.
 Qualitative Factors and Judgement

 In theory, the use of sophisticated techniques is emphasized since they

maximize value to shareholders.
 In practice, however, companies, although tending to shift to the formal
methods of evaluation, give considerable importance to qualitative
factors.
 Almost all companies were guided, one time or other, by three
qualitative factors: urgency, strategy, and environment
 All companies stated that urgency is the most important consideration
while more than three-fourths of the companies thought that strategy
played a significant role.
 Many of the companies also found intuition, security and social
considerations as important qualitative factors.
 Qualitative factors like employees' morals and safety, investor and
customer image, or legal matters are considered important in investment
analysis by companies in USA.
 Strategic Aspects of Investment
Decision
 Recently, a lot of emphasis has been placed, on the view
that a business firm facing a complex and changing
environment will benefit immensely in terms of improved
quality of decision-making if capital budgeting decisions
are taken in the context of its overall strategy.
 This approach provides the decision-maker with a central
theme or a big picture to keep in mind at all times as a
guideline for effectively allocating corporate financial
resources.
 As argued by a chief financial officer: Allocating resources
to investments without a sound concept of divisional and
corporate strategy is a lot like throwing darts in a dark
room.
Decision-making Levels
 For planning and control purposes, three levels of
decision-making have been identified:
 operating
 administrative,
 strategic.
 Capital budgeting could be categorized into those three
levels.
 Operating capital budgeting may include routine minor
expenditures, such as on office equipment, and it can be
easily handled by lower level management.
 Strategic capital budgeting involves large investments
such as acquisition of a new business or expansion in a
new line of business.
 Strategic investments are unique and unstructured, and
they cast a significant influence on the direction of the
business. Such investments are, therefore, generally
handled by top management.
 Administrative capital budgeting falls in-between these
two levels. It involves medium-size investments such as
expenditure on expansion of existing line of business.
 Administrative capital budgeting decisions are semi-
structured in nature, and can be handled by middle
management.
THANK YOU