THE EVALUATION OF CAPITAL BUDGETING DECISIONS
Capital budgeting refers to the process to make decisions concerning investments in the long-term assets of the firm. The general idea is that the capital, or long-term funds, raised by the firms are used to invest in assets that will enable the firm to generate revenues several years into the future. “Often the funds raised to invest in such assets are not unrestricted, or infinitely available; thus the firm must budget how these funds are invested. 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” (http://allinterview.com/showanswers/119355.html )
To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting.
“Capital budgeting refers to the process in which the investments are worth pursuing. Whether the project is based on long term investment or building a new plant. Frequently, the cash inflows and outflows are assessed in order to reach a decision whether the returns propagated meet a sufficient target. The title “Evaluation of capital Budgeting Decisions” at TNPL aims at expanding the plant using various non discounting capital budgeting evaluation methods”. (http://www.tnpl.com/tnpl/technology.htm)
REASON FOR DOING THIS STUDY:
At present TNPL has two paper machines, which produce both newsprint, and printing & writing paper with an installed capacity of 2,45,000 Tons per annum. “TNPL has now embarked on a Mill Expansion Plan (MEP) which aims to increase the paper production capacity to 4,00,000 Tons per annum. Since it involves a large capital outlay of approximately thousand crore rupee, this necessitates the need to evaluate the capital budgeting decision”. (http://www.tnpl.com/tnpl/technology.htm)
The process of determining which potential long-term projects are worth undertaking, by comparing their expected discounted cash flows with their internal rates of return. Capital budgeting decisions play a pivotal part in appraising and selecting capital investments in any business organization. The main purpose of the study is therefore to evaluate the capital budgeting decision of TNPL by using various tools and techniques of capital budgeting.
DCF Techniques and Nonfinancial Measures in Capital Budgeting: A Contingency Approach Analysis.
This study empirically examines capital budgeting methods. “Both discounted cash flow (DCF) techniques and nonfinancial measures are widely used in capital budgeting. However, DCF techniques are more important than nonfinancial measures, and nonfinancial measures appear to serve as a partial substitute when DCF analysis is less efficient.”
“The study shows that product standardization affects both capital budgeting methods, as hypothesized. Firms with high product standardization tend to place more emphasis on DCF analysis, while firms with low standardization are more likely to focus on nonfinancial measures”. An appropriate fit under contingency theory between product standardization and the two capital budgeting methods is significantly associated with a firm's satisfaction with the capital budgeting process. (Chen and Shimin, Behavioral research in accounting, 2008)
“Chen (1995) studied the use of different quantitative evaluation techniques across three types of investments. They are equipment replacement, expansion of existing products, and expansion into new products. The certainty of the related cash flows varies greatly when comparing proposals for routine equipment replacement and expansion into new products. He found DCF techniques are widely used than non-DCF techniques.”(Chen and Shimin, The engineering economics, 1995)
Capital Budgeting and the Financing Decision: An Exposition:
This article attempts to better integrate analysis of the capital structure and capital budgeting decisions on a relatively straightforward level. “The analysis in this article rests on a number of simplifying assumptions under which all of the valuation methods and capital budgeting procedures are equivalent. Most productive assets are not employed directly by individuals. Instead, the advantages of specialization and limited liability encourage corporations to act as intermediaries, holding and managing physical assets and issuing securities to individual investors. If firms are to evaluate projects in terms of investors' opportunities, they must be able to compare the characteristics of their own projects with those of financial claims available in the market. The article concludes that different approaches to the valuation problem lead to different cost of capital measures and that all of these may be used to construct a capital budgeting procedure.” Under the simplifying assumptions employed in the paper, there is no logical reason to prefer one procedure to another, and the financial manager could let his choice of procedures be governed by the form in which he finds it easiest to come up with a cost of capital estimate.
(Robert A, Taggart Jr, Financial Management, 1972)
CAPITAL BUDGETING DIFFERENCE:
This study breaks down the use of capital budgeting procedures between industries. While it is easy to state that the use of capital budgeting analysis has become more sophisticated over the decades, the question remains as to whether different industries have followed the same pattern. “Three hundred two Fortune 1,000 companies responded to a survey organized along industry lines. Chi-square independence of classification tests indicated that a null hypothesis of no significant relationship between industry classification and capital budgeting procedures could be rejected in a number of decision-making areas including goal setting, rates of return, and portfolio considerations. Just as industry patterns affect financing decisions (debt vs. equity), they also affect capital budgeting decisions, and this study emphasizes that point”. (Block, Stanley. Engineering Economist, 2005)
WHAT AM I GOING TO FIND OUT?
To analyze the capital budgeting decisions of TNPL using IRR, NPV, PI and other evaluation methods.
IRR- INTERNAL RATE OF RETURN
NPV-NET PRESENT VALUE
To study about the Mill Expansion Plan of TNPL
To estimate the cash flows so as to evaluate the MEP
To ascertain the principal risk associated with the project
To ascertain the sensitivity of the project
Who, where, when and how?
Answers to the questions who, what, when, where and sometimes how. The researcher attempts to describe of define a subject, often by creating a profile of group of problems, people or events. Although association can more be used to infer, they more often provide a sound basis for the solution of marketing problems. This study is more descriptive.
I searched in the internet, referred the books and discussed with my father to find this topic. With the help of my father i contacted the manager of the financial department and got an appointment. I explained him about my thoughts and got permission nearly after two months. I also got access to use the financial data of the firm.
The general idea is that the capital, or long-term funds, raised by the firms are used to invest in assets that will enable the firm to generate revenues several years into the future. 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.
Actually to minimize input value for a unit value of output lots of resources (money, time, materials and manpower) are needed.
The argument that capital is a limited resource is true of any form of capital, whether debt or equity short-term or long-term, common stock or retained earnings, accounts payable or notes payable, and so on. Even the best-known firm in an industry or a community can increase its borrowing up to a certain limit. Once this point has been reached, the firm will either be denied more credit or be charged a higher interest rate, making borrowing a less desirable way to raise capital.
Faced with limited sources of capital, management should carefully decide whether a particular project is economically acceptable. In the case of more than one project, management must identify the projects that will contribute most to profits and, consequently, to the value or wealth of the firm. It is the basis of capital budgeting.
This process involves projecting the profitability generated by the new machine and thereby projecting the cash flows. On this projected cash flow the various Capital Budgeting techniques will be applied.
Various Discounted cash flow techniques like Net Present Value (NPV), Profitability Index (PI), Internal Rate of Return (IRR) and Modified Internal Rate of Return (MIRR) will be calculated. Based on the result of these calculations the project will be evaluated.
To calculate the discount cash flow techniques i need to collect the financial data. I have already got the access to use the data. When i start doing my dissertation i can collect the data from the firm with the help of financial manager.
APPROPRIATE SAMPLING PROCEDURES:
In the former, the researcher knows the exact possibility of selecting each member of the population. But this type of sampling is more difficult and costly. Even though it is costly we have a big advantage in this type of sampling (i.e.) the type of population in which the results can be generalised from the sample to the population. In addition, this type of sampling allows to calculate the precision of the estimates obtained from the sample and to specify.
Systematic sampling is a type of probability sampling in which “sampling involves you selecting the sample at regular intervals from the sampling frame” (Adrian thorn hill, Mark Saunders, Philip Lewis, research methods for business students, 2009)
Sampling fraction for systematic sampling is actual sampling size divided by total population.
DATA COLLECTION PROCEDURE:
The data collection for this study is mainly based on the primary and secondary sources.
The primary data are based on the data collected from the firm (i.e.) the paper industry. The secondary data are collected from articles, journals and literature. In this study am going to use both these methods to collect the data. The data collected for this analysis has been mainly through secondary sources like company annual reports and records.
I am going to think about triangulation (literature, questioner and interview). By Comparing all these three in a triangular format i will get some new idea. So what i am coming to say is, am going to use the collected data in triangular form.
DATA ANALYSIS PROCEDURE:
There are different ways of analysis. Just for example i am taking sensitive analysis. Sensitivity Analysis is also known as “What If” analysis. It is useful in pinpointing the areas where forecasting risk is especially severe. The basic idea with a sensitivity analysis is to freeze all variables except one and see how sensitive our estimated cash flows to changes in that one variable. If our cash flow estimate turns out to be very sensitive to relatively small changes in the projected value of any one component of project cash flows, then forecasting risk associated with that variable is high.
In this project sensitivity analysis has been carried out on the cash flows under certain conditions or sensitivity factors. Under these conditions all the capital budgeting techniques will be implemented and their effects will be evaluated.
RELIABIALITY AND VALIDITY:
Reliability can be assessed by analysing whether the measures yield the same results on other occasions? Whether other observers reach similar observation and care should be taken when analysing the data to ensure that your data are telling you what you think they are telling you. (Adrian thorn hill, Mark Saunders, Philip Lewis, research methods for business students, 2009)
Validity can be assessed by analysing the relation between the program and the observed outcome. So if there is a relation, i have to check the kind of relation between the program and observed outcome. With the help of the outcome i am going to generalise and construct this concept so that it may be used by others.
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