Question

-Please provide an example from a real company that used capital budgeting for a particular product proposal.
-What were the results of that project?
-Can you think of any companies who didn't properly invest/innovate and are now defunct or on the way to closing?
-How can you use capital budgeting in your own lives?

Answer 1

Solution:

a) CAPITL BUDGETING

I) BSNL

MODEL PROJECT ESTIMATE:

NAME OF THE PROJECT        :EXPANSION OF MOBILE SERVICE IN A.P

COVERAGE                                                         :FOR 10 DISTRICTS

JUSTIFICATION : there has been tremendous increase in mobile usage after the Andhra state is divided

into two. In order to cater the need and improve the profitability ,this project is taken up. the necessary equipments and cables will be purchased by open tender.

CAPITAL OUTLAY (in ‘000 s)

LAND(FREE HOLD)	10900
LAND(LEASE HOLD)	1600
BUILDING	53050
APPARATUS AND PLANT	218400
MOTOR VECHICLES AND LAUNCHES	150
CABLES	136450
LINES AND WIRES	10300
INSTALATION TEST EQUIPMENT	2100
MASTS AND AERIALS	28100
OFFICE MACHINARY ND EQUIPMENT	600
ELECTRICAL FITTINGS	21000
FURNITURE AND FIXTURES	500
COMPUTERS	2250
DECOMMISSIONED ASSETS	10700
SUBSCRIBER INSTALLATION	3900
Total	500000

ANTICIPATED REVENUE IN ‘000 S :

CELLULAR
A)PRE PAID	81600
B)POST PAID	19200
C)VAS AND OTHERS	7200
D)INTER             CONNECTION           USAGE CHARGES	12000
TOTAL	12000

ANNUAL RECCURING EXPENDITURE IN ‘000:

REMUNARATION (STAFF)	4200
RENT (BUILDING)-TOWER SITES	3000
LEASE CHARGES	500
RATES AND TAXES	4800
POWER\FUEL\VECHICLE RUNNING EXP.	24000
REPAIRS AND MAINTANACE :
A)BUILDING	1325
B)PLANT AND NACHINARY	3400
C)CABLES	2050
D)OTHERS	2925
TOTAL	84000

NOTE:

1. capital outlay is taken in proportion to the figures in the bsnl fixed asets schedule 2014-15 .

2. anticipated revenue and expenditures is in proportion ton the expenditure of 2014-15.

Cash flows= total revenue – total expenses

In 000’s     =120000-84000

=36000

PAY BACK PERIOD

Pay back period = capital investment/ annual cash flows

= 500000/36000

=13.88 years

Interpretation:

From the   above we   observe that the   payback period   i.e.,   the   time period required   for   the   recovery of the initial investment in the project is   13 years and 10 months. The project can be accepted if the payback period is less than the maximum benchmark perod.if any .the lower the payback period,the better it is ,since the initial investment will be recouped faster.

ACCOUNTING RATE OF RETURN METHOD

ARR =  Average return during period / Average investment

Where,

Average investment = original investment /2

Avergage investment =500000/2

=250000

Average rate of return = average return during period / average investment

=(18000/250000)*100

=7.2%

NET PRESENT VALUE:

NPV = PRESENT VALUE OF CASH FLOWS – PRESENT VALUE OF CASH OUT FLOWS

NPV :

YEAR	CASH FLOWS	PVF @ 10%	PV OF CF’S
0	-500000	1	-500000
1	36000	0.909	32724
2	36000	0.826	29736
3	36000	0.751	27036
4	36000	0.683	24588
5	36000	0.621	22356
6	36000	0.564	20304
7	36000	0.513	18468
8	36000	0.467	16812
9	36000	0.424	15264
10	36000	0.386	13896
11	36000	0.350	12600
12	36000	0.319	11484
13	36000	0.290	10440
14	36000	0.263	9468
	NPV		234824

INTERPRETATION:

From the above table ,we observe that the npv is rs.234824.hence the project can be accepted as the NPV is positive and greater than zero.

INTERNAL RATE OF RETURN

IRR =lower rate + (Present value at lower rate/ {Present value at lower rate –present value at higher rate})*difference in rates

Year	Cash flows	pvf@10%	Pv of cf’s	pvf@15%	Pv of cf’s
0	-100000	1	-500000	1	-500000
1	36000	0.909	32724	0.870	31320
2	36000	0.826	29736	0.756	27216
3	36000	0.751	27036	0.658	23688
4	36000	0.683	24588	0.572	20592
5	36000	0.621	22356	0.497	17892
6	36000	0.564	20304	0.432	15552
7	36000	0.513	18468	0.376	13536
8	36000	0.467	16812	0.327	11772
9	36000	0.424	15264	0.284	10224
10	36000	0.386	13896	0.247	8892
11	36000	0.350	12600	0.215	7740
12	36000	0.319	11484	0.187	6732
13	36000	0.290	10440	0.163	5868
14	36000	0.263	9460	0.140	5040
			234824		(293936)

IRR = 10%+(234824{234824--293936})*(15%-10%)

=12.22%

Interpretation:

from the above ,we observe that the IRR is the rate of return earned on the initial investment made in the project. The project can be accepted if the IRR is greater than the cut off rate .

PROFITABILITY INDEX

PI =   1 + (NPV/INITIAL INVESTMENT)

= 1+(234824/500000)

=1.47

INTERPRETATION:

From the above ,we observe that profitability index is 1.47 which is greater than one. hence the project is accepted .

In   bsnl , capital    budgeting as a whole cannot be analyzed based on traditional methods mentioned above since projects are decentralized at SSA/circle levels accordingly.

Taking this as aconstraint ,the following analysis based on capital investment and physical performance is made.

II) CAPITAL BUDGETING OF RELIANCE

Reliance Industries Ltd. (RIL)

The Reliance Group is India’s largest private sector enterprise, with businesses in the energy and materials segment. Group’s annual revenues are over US$ 66 billion. The flagship company, Reliance Industries Limited, is a Fortune Global 500 company and is the largest private sector company in India.

It started with textiles in the late seventies, and then pursued a strategy of backward vertical integration—in polyester, fiber intermediates, plastics, petrochemicals, petroleum refining and oil and gas exploration, and production—to be fully integrated along the materials and energy value chain.

Reliance enjoys global leadership in its businesses, being the largest polyester yarn and fiber producer in the world and among the top five to ten producers in the world in major petrochemical products.1

Fixed Assets Management

The management of fixed assets involves generally following four aspects:

    a.   level of investment in fixed assets;

    b.   financing pattern of fixed assets;

    c.   utilization of fixed assets, and

    d.   adequacy of depreciation.

Here is a discussion regarding theoretical consideration and actual practice of the unit under study on these aspects.

A. Level of Investment in Fixed Assets

The investment in fixed assets involves application of funds for longer periods into the future and being in large increments, these are generally difficult and costly to reverse. So, the investment decision in fixed assets should be taken by a finance manager after a careful consideration of several factors, such as the amount of investment required capital budgeting techniques, nature and size of the business, recommendations of chief engineer and technical staff, guidelines issued by various committees appointed by the government or some national or international bodies like Chamber of Commerce, and so on. and the prevailing practices in other companies. Generally, fixed assets constitute 50 percent of the investment in total assets of a concern. The analysis of the level of investment in fixed assets of RIL is hereby follows in table 15.1.

Table 15.1 Fixed Assets’ Outlay of RIL (2011-12 to 2013-14)

Source: http://www.ril.com.

The table indicates that the share of investment in fixed assets has been showing a fluctuating trend over all these years, ranging from 2011–12 to 2013–14. It has declined and improved from time to time. The share of gross block in the total assets is on a continuous declining side during the period. It declined from 54.06 percent in 2011–12 to 34.63 percent in 2013–14. Now, the share of total fixed assets almost followed a zig-zag pattern of change during the respective period. It decreased from 55.16 percent in 2011–12 to 54.80 percent in 2012–13 and then increased to 63.18 percent in 2013–14.

The ups and downs in the size of fixed assets indicate that the management takes care to adjust the assets according to the needs of the undertaking. But, on the whole, the position of fixed assets is not very satisfying as fixed assets form just around 55 percent of total assets of the concern and RIL is a manufacturing company. In a manufacturing sector, fixed assets ideally should be around 70 percent of the total assets. So, taking into consideration the two facts, that is, the overall share of the fixed assets in the total assets of the undertaking on one hand and to maintain the steady growth in operational activities and sales on the other, it is suggested that it would be better to invest a little more in fixed assets.

B. Financing Pattern of Fixed Assets

Fixed assets have to be primarily financed by the proprietors of the enterprise. The funds provided by the owners should be sufficient not only to finance the entire amount of fixed assets required but also the current assets of permanent nature. If the owners’ funds are not sufficient enough, the other long-term funds may be used to finance the fixed assets. So, it is clear that short-term funds, in every circumstance, should be avoided to finance the fixed assets. Following ratios are used to analyze the financing pattern of fixed assets:

    (i)  fixed assets to net worth ratio, and

   (ii)  fixed assets to long-term funds ratio.

1. Fixed Assets to Net Worth Ratio

This ratio is used to describe the relationship between fixed assets and net worth. Net worth means the sum total of equity share capital, preference share capital, and reserves and surplus. It also indicates the margin of safety for long-term creditors. It is computed as:

If the ratio is less than 1, it means that the net worth is more than fixed assets. So, there is a margin of safety for long-term creditors. It also means that the working capital is being financed partly out of the shareholders’ funds. Conversely, if the ratio is more than 1 then it indicates that fixed assets are also financed by long-term debt and so margin of safety for the creditors is low. Also, no net worth is there to finance the working capital requirements. A ratio less than unity is treated as an ideal one. Table 15.2 contains the fixed assets to net worth ratio pertaining to RIL under study for the period 2011–12 to 2013–14.

Table 15.2 Fixed Assets to NET Worth Ratio of RIL (2011-12 to 2013-14)

Source: Computed based on Annual Reports of RIL.

A close look into the table reveals that RIL is in a quite promising state of affairs regarding using the net worth for financing the fixed assets. It has registered the average fixed assets to net worth ratio of mere 1.04. The ratio varies from 0.97 in 2012–13 to 1.18 in 2013–14, showing a fluctuating trend during the period. The ratio has been much lower than 1 over all these years, except in 2013–14 with ratio of 1.18. It signifies that fixed assets have been less than the net worth, implying they have been primarily financed by net worth, except in 2013–14 where long-term debt too has been used with net worth for financing fixed assets. It indicates a sound margin of safety for the creditors and also that there is net worth to finance the working capital requirements when needed. But, the ratio is showing an increasing trend which concerns the management not to increase this further and to improve the situation in this regard.

From the above discussion, it follows that RIL is not heavily dependent on long-term debt for financing its fixed assets. This is a safe position for RIL in regard to long-term stability.

2. Fixed Assets to Long-term Funds Ratio

Fixed assets should be financed primarily by the long-term funds, being representing a permanent investment. Long-term funds include both net worth plus long-term debt.

First, proprietors’ funds should be used to finance the fixed assets and if they fall short of the requirement of the assets then this gap may be filled up by the long-term loans. The short-term loans should not be used to finance the fixed assets in any condition as it may result in serious financial embarrassment.

The fixed assets to long-term funds ratio provides the information about the sufficiency of long-term funds in financing the fixed assets and the extent of fixed assets financed by current debt due to lack of long-term funds. It is computed as:

If the ratio is less than 1, it means that the long-term funds are more than the fixed assets. So, it signifies the proper financing of fixed assets by long-term funds. Also, the long-term funds are used to finance the working capital requirements too. Conversely, if the ratio is more than 1 then it means that the long-term funds are inadequate to finance the fixed assets and this gap is filled up by short-term loans. This is a very risky affair and is bound to result into acute shortage of working capital. Thus, this ratio is directly or indirectly linked to the concept of working capital too. Generally, the ratio of 0.65:1 is considered as an ideal one. Fixed assets to long-term funds ratio of the units under study has been recorded in Table 15.3.

Table: 15.3 Fixed Assets to Long-term Funds Ratio of RIL (2011-12 to 2013-14)

Source: Computed based on Annual Reports of RIL.

The table reveals that RIL quite satisfies the norm of fixed assets to long-term funds ratio with an average score of 0.81. The ratio has been on a continuous increasing trend during the period, from 0.76 in 2011–12 to 0.89 in 2013–14. The ratio has been less than 1, indicating that long-term funds have been adequate to finance the fixed assets throughout the period under study. The above analysis makes it clear that RIL has got sufficient long-term funds to finance its fixed assets requirements. But, there should not be any further increase over 1, otherwise it might be a concern for working capital and will affect the day-to-day functioning of the concern. So, it must be checked by the concerned management of the unit.

3. Utilization of Fixed Assets

The fixed assets should be utilized efficiently, being of permanent nature so that they can yield the required rate of return in the interest of the business. They are the most important assets of any business undertaking and to measure the efficiency in their utilization, fixed assets turnover ratio is used.

The fixed assets turnover ratio shows how well the fixed assets are being utilized. It is computed as follows:

Here, fixed assets are net of depreciation. If compared with a previous period, it indicates whether the investment in fixed assets has been judicious or not. If the corresponding increase in sales is greater than the increase in investment in fixed assets, then the investment is justified and it also ensures the efficient use of the fixed assets. However, this ratio cannot be a good indicator of efficiency in the short run because a firm cannot adjust its fixed assets for short-term market fluctuations.

The higher the turnover ratio, the more efficient the management and utilization of the assets while low turnover ratio is indicative of under-utilization of available resources and presence of idle capacity, that is, firm has an excessive investment in fixed assets in comparison to the volume of sale. However, if the ratio is very high then it indicates that the firm is over-trading on its assets. The standard for this ratio is 5 times in a manufacturing industry.2 In a manufacturing concern, it is very important and appropriate since sales are produced not only by use of working capital but also by the capital invested in fixed assets. The fixed assets turnover ratio of the units under study is cataloged in Table 15.4.

Table 15.4 Fixed Assets Turnover Ratio of RIL (2011-12 to 2013-14)

Source: Computed based on Annual Reports of RIL.

A close look into the table clearly spells out that RIL has been utilizing the fixed assets efficiently and this is evident from their increasing trend from 2011–2 to 2012–13. But, there is decline as well in 2013–14, indicating under-utilizing of the available resources. It does not satisfy the norm of a standard ratio of 5:1. So, the management can think to improve the performance in this area. First of all, it has to stop this decline in the ratio and after that; it has to think about the applicability of the standard ratio to the concern.

4. Adequacy of Depreciation

Depreciation refers to periodic allocation of the acquisition cost of tangible long-term assets, less salvage value (if any) over its estimated useful life in a systematic and rational manner. It is a process of allocation, not of valuation. From financial management’s point of view, depreciation denotes the measure of the contribution of fixed assets to circulating capital. It represents a measure of the services of fixed assets consumed or utilized. The Institute of Chartered Accountants of India defines depreciation as follows:

“Depreciation is a measure of the wearing out, consumption or other loss of value of depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes. Deprecation is allocated so as to charge a fair proportion of the depreciable amount in each accounting period during the expected useful life of an asset. Depreciation includes amortization of assets whose useful life is predetermined.”3

The financial executives may adopt either the straight-line method or any of the accelerated methods for charging depreciation. The accelerated methods include (i) written down value method, (ii) sum of-the-years digit method, and (iii) double declining method. The adequacy of depreciation fund at the time of replacement of an existing asset is the chief concern of the finance manager. Legal provisions prescribed under the Companies Act, 1956 and Income-Tax Act, 1961, nature of business, financial reporting, effects on managerial decisions, inflation, technology and capital maintenance, and so on. are the various factors influencing the selection of deprecation method and the rate thereof.

The adequacy of depreciation can be conveniently measured on the historical cost basis. For this, the trends of depreciation and gross block are compared with each other. If both the trends move in the same direction, it can be inferred that adequate depreciation has been provided. If the trend of gross block is increasing while that of depreciation is decreasing, it indicates that depreciation provided is not adequate. Tables 15.5 and 15.6 depict the depreciation practice of RIL.

Table 15.5 Depreciation Policy of RIL (2011-12 to 2013-14)

Source: http://www.ril.com.

Note: Tangible Assets include own assets and leased assets.

Table 15.6 Depreciation Trend of RIL (2011-12 to 2013-14)

Source: Computed based on Annual Reports of RIL.

Table 15.6 contains the trend of depreciation and gross block of RIL. The trends have been calculated by taking the figures of 2010–11 as base period. The table reveals that that the trends related to gross block as well as depreciation of the unit are showing contradictory picture. Gross block is increasing, whereas deprecation is decreasing, showing inadequacy of deprecation for the require replacement of assets in time. So, it can be inferred that adequate depreciation needs to be provided.

Tangible Assets and Depreciation Policy at RIL Tangible Assets

Tangible Assets are stated at cost net of recoverable taxes, trade discounts and rebates and include amounts added on revaluation, less accumulated depreciation and impairment loss, if any. The cost of tangible assets comprises its purchase price, borrowing cost and any cost directly attributable to bringing the asset to its working condition for its intended use, net charges on foreign exchange contracts and adjustments arising from exchange rate variations attributable to the assets.

Subsequent expenditures related to an item of tangible asset are added to its book value only if they increase the future benefits from the existing asset beyond its previously assessed standard of performance. Projects under which assets are not ready for their intended use are shown as Capital Work-in-Progress.

Depreciation

Depreciation on fixed assets is provided to the extent of depreciable amount on the Written Down Value (WDV) method except in case of assets pertaining to Refining segment and SEZ units/developer where depreciation is provided on straight-line method (SLM). Depreciation is prov