CHAPTER-1

INTRODUCTION

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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.,

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NEED FOR THE STUDY

 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.
 To know about the company’s operation of using various Capital
Budgeting techniques.
 To know how the company gets funds from various resources.

OBJECTIVES OF THE STUDY

 To study the relevance of capital budgeting in evaluating the project for

project finance

 To study the technique of capital budgeting for decision- making.

 To measure the present value of rupee invested.

 To understand an item wise study of the company financial performance of

the company.

 To make suggestion if any for improving the financial position if the

company.
 To understand the practical usage of capital budgeting techniques

 To understand the nature of risk and uncertainty

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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.

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 to
the officials and finance department. A part from these some information is collected
through the seminars, which were held by HDFC

Secondary sources

The secondary data have been collected through the various books,
magazines, broachers & websites

SCOPE OF THE STUDY:

The efficient allocation of capital is the most important financial function in the
modern times. it involves decision to commit the firm’s since they stand the long-term
assets such decision are of considerable importance to the firm since they send to
determine its value and size by influencing its growth, probability and growth.
The scope of the study is limited to collecting the financial data of HDFC for four
years and budgeted figures of each year.

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LIMITATION OF THE STUDY

 Lack of time is another limiting factor, i.e., the schedule period of 8 weeks
are not sufficient to make the study independently regarding Capital
Budgeting in HDFC.
 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.
 Non-availability of confidential financial data.
 The study is conducted in a short period, which was not detailed in all
aspects.
 All the techniques of capital budgeting are not used in HDFC. Therefore it
was possible to explain only few methods of capital budgeting.

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 CHATPER-2
REVIEW OF LITERATURE

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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 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:

 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.

 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.

 FUNDING: Investment decisions generally involve large amount of funds

which make it necessary for the firm to plan its investment programmes very

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 carefully and make an advance arrangement for procuring finances internally
or externally.

 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.

 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:

 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

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 a capital budgeting decision, a finance manager in fact makes a commitment
to its future implications.

 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, 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.

 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.

 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.

 LARGE INVESTMENTS: Capital budgeting decisions, generally, involves

large investment of funds. But the funds available with the firm are always

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 limited and the demand for funds far exceeds the resources. Hence, it is very
important for a firm to plan and control its expenditure.

 NATIONAL IMPORTANCE: Investment decision though taken by

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

Initial investment
Pay back period =________________
Annual cash flow

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Accept reject rule:
Many firms use the pay back period as accept/reject criterion as well as a method of
ranking projects.
 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
 If not it would be rejected
 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
 In case of two mutually exclusive projects, the project with the shortest
payback period will be selected.

EVALUATION OF PAYBACK PERIOD:

 It is simple to understand and easy to calculate

 It is costless than most of the sophisticated techniques which require a lot of
the time the use of computers.
ADVANTAGES:
 Simple to understand and easy to calculate.
 It saves in cost; it requires lesser time and labour as compared to
other methods of capital budgeting.
 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.
 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:

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  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.
 This method ignores the time value of the money and does
not consider the magnitude and timing of cash inflows.
 It does not take into account the cost of capital, which is
very important in making sound investment decision.
 It is difficult to determine the minimum acceptable pay
back period, which is subjective decision .
 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
Average investm

Where, average investment = original investment

______________
2

ACCEPT OR REJECT CRITERION

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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:

 It is very simple to understand and easy to calculate.

 It uses the entire earnings of a project in calculating rate of return and hence
gives a true view of profitability.
 As this method is based upon accounting profit, it can be readily
 calculated from the financial data
DISADVANTAGES:
 It ignores the time value of money.
 It does not take in to account the cash flows, which are more important than
the accounting profits.
 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.
 This method cannot be applied to a situation where investment in project is to
be made in parts.

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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:
 An appropriate rate of interest should be selected to discount cash flows.
Generally it is referred to the cost of capital.
 The present value of cash inflow will the calculated by using this discounted
rate.
 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:

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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:
 It recognizes the time value of money and is suitable to apply in a situation
with uniform cash outflows and uneven cash inflows.
 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
 Takes in to consideration the objective of maximum profitability.

DISADVANTAGES:
 More difficult to understand and operate.
 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:

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 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:

 Calculate cash flow after tax

 Calculate fake pay back period or factor by dividing the initial investment by
average cash flows.
 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.
 Calculate npv at that percentage
 If NPV is positive take a rate higher and if NPV is negative take a rate lower
and once again calculate NPV
 Continue step4 until you arrive two rates, one giving positive NPV and
another negative NPV.
 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

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 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

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:
 It takes into account, the time value of money and can be applied in situation
with even and even cash flows.
 It considers the profitability of the projects for its entire economic life.

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  The determination of cost of capital is not a pre-requisite for the use of this
method.
 It provide for uniform ranking of proposals due to the percentage rate of
return.
 This method is also compatible with the objective of maximum profitability.

DISADVANTAGES:
 It is difficult to understand and operate.
 The results of NPV and IRR methods may differ when the projects under
evaluation differ in their size, life and timings of cash flows.

 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
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:

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The following are the PI acceptance rules:
o Accept if PI>1
o Reject if PI<1
o May accept if PI=1

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

EVALUATION OF PI METHOD:

o It recognizes the time value of money

o It is a variation of the NPV method, and requires the same computation as the
NPV method.
o 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:
 Unlike net present value, the profitability index method is used to rank the
projects even when the costs of the projects differ significantly.
 It recognizes the time value of money and is suitable to applied in a situation with
uniform cash outflow and uneven cash inflows.
 It takes into account the earnings over the entire life of the project and gives the
true view of the profitability of the investment.
 Takes into consideration the objectives of maximum profitability.

DISADVANTAGES:
 More difficult to understand and operate.
 It may not give good results while comparing projects with unequal investment
funds.
 It is not easy to determine and appropriate discount rate.
 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

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 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:

 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.

 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 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.

 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.

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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.

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
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 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.

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:

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 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.

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.

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 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 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:

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  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.

 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.

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

26
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:
 Estimation of cash flows
 Estimation of required rate of return
 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:

 It should consider all the cash flows to determine the true profitability of the
project.
 It should provide for an objective and unambiguous way of separating good
projects from bad projects
 It should help ranking of projects according to their profitability.
 It should recognize the fact that bigger cash flows are preferable to smaller
ones and early cash flows are preferable to later ones.
 It should help to choose among mutually exclusive projects that project which
maximizes the shareholder’s wealth.
 It should be a criterion which is applicable to any conceivable investment
project independent of others.
 Choosing among several alternatives.
 A criterion which is applicable to any conceivable project.

27
 CHAPTER-3

COMPANY PROFILE

28
 COMPANY PROFILE:

HDFC Bank Ltd is a major Indian financial services company based in Mumbai. The

Bank is a publicly held banking company engaged in providing a wide range of

banking and financial services including commercial banking and treasury operations.

The Bank at present has an enviable network of 2201 branches and 7110 ATMs spread

in 996 cities across India. They also have one overseas wholesale banking branch in

Bahrain, a branch in Hong Kong and two representative offices in UAE and Kenya.

The Bank has two subsidiary companies, namely HDFC Securities Ltd and HDB

Financial Services Ltd. The Bank has three primary business segments, namely

banking, wholesale banking and treasury. The retail banking segment serves retail

customers through a branch network and other delivery channels. This segment raises

deposits from customers and makes loans and provides other services with the help of

specialist product groups to such customers. The wholesale banking segment provides

loans, non-fund facilities and transaction services to corporate, public sector units,

government bodies, financial institutions and medium-scale enterprises. The treasury

segment includes net interest earnings on investments portfolio of the Bank. The

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 shares are listed on the Bombay Stock

Exchange Limited and The National Stock Exchange of India Ltd. The Bank's

American Depository Shares (ADS) are listed on the New York Stock Exchange

(NYSE) and the Bank's Global Depository Receipts (GDRs) are listed on

Luxembourg Stock Exchange. HDFC Bank Ltd

Was incorporated on August 30, 1994 by Housing Development Finance Corporation

Ltd. In the year 1994, Housing Development Finance Corporation Ltd was amongst

29
the first to receive an 'in principle' approval from the Reserve Bank of India to set up a

bank in the private sector, as part of the RBI's liberalization of the Indian Banking

Industry. HDFC Bank commenced operations as a Scheduled Commercial Bank in

January 1995. In the year 1996, the Bank was appointed as the clearing bank by the

NSCCL. In the year 1997, the launched retail investment advisory services. In the

year 1998, they launched their first retail lending product, Loans against Shares. In the

year 1999, the Bank launched online, real-time NetBanking. In February 2000, Times

Bank Ltd, owned by Bennett, Coleman & Co. / Times Group amalgamated with the

Bank Ltd. This was the first merger of two private banks in India. The Bank was the

first Bank to launch an International Debit Card in association with VISA (Visa

Electron). In the year 2001, they started their Credit Card business. Also, they became

the first private sector bank to be authorized by the Central Board of Direct Taxes

(CBDT) as well as the RBI to accept direct taxes. During the year, the Bank made a

strategic tie-up with a Bangalore-based business solutions software developer, Tally

Solutions Pvt Ltd for developing and offering products and services facilitating on-

line accounting and banking services to SMEs. During the year 2001-02 the bank was

listed on the New York Stock Exchange. Also, they made the alliance with LIC for

providing online payment of insurance premium to the customers. During the year

2002-03, the Bank increased the number of branches from 171 Nos to 231 Nos and

the size of the Bank's ATM network expanded from 479 Nos to 732 Nos. They also

expanded their presence in the 'merchant acquiring' business. During the year 2003-

04, the Bank expanded the distribution network with the number of branches

increased from 231 Nos to 312 Nos and the size of the Bank's ATM network increased

from 732 Nos to 910 Nos. In September 2003, they entered the housing loan business

through an arrangement with HDFC Ltd, whereby they sell HDFC Home Loan

product. During the year 2004-05, the Bank expanded the distribution network with

the number of branches increased from 312 Nos to 467 Nos and the size of the Bank's

ATM network increased from 910 Nos to 1147 Nos. During the year 2005-06, the

Bank launched the 'no-frills account', a basic savings account offering to the customer.

30
Also, the distribution network was expanded with the number of branches increased

from 467 Nos (in 211 cities) to 535 Nos (in 228 cities) and the number of ATMs from

1147 Nos to 1323 Nos. During the year 2006-07, the distribution network was

expanded with the number of branches increased from 535 Nos (in 228 cities) to 684

Nos (in 316 cities) and the number of ATMs from 1323 Nos to 1605 Nos. They

commenced direct lending to Self Help Groups. Also, they opened a dedicated branch

for lending to SHGs, in Thudiyalur village (Tamil Nadu). In September 28, 2005, the

Bank increased their stake in HDFC Securities Ltd from 29.5% to 55%.

Consequently, HDFC Securities Ltd became a subsidiary of the Bank. During the year

2007-08, the Bank added 77 Nos new branches take the total to 761 Nos branches.

Also, 372 Nos new ATMs were also added taking the size of the ATM network from

1605 Nos to 1977 Nos. HDB Financial Services Ltd became a subsidiary company

with effect from August 31, 2007. In June 2, 2007, the Bank opened 19 branches in a

day in Delhi and the National Capital Region (NCR). During the year 2008-09, the

Bank expanded their distribution network from 761 branches in 327 cities to 1,412

branches in 528 Indian cities. The Bank's ATMs increased from 1,977 to 3,295 during

the year. As per the scheme of amalgamation, Centurion Bank of Punjab Ltd was

amalgamated with the Bank with effect from May 23, 2008. The appointed date for

the merger was April 01, 2008. In October 2008, the bank opened their first overseas

commercial branch in Bahrain. The branch offers the bank's suite of banking services

including treasury and trade finance products for corporate clients and wealth

management products for Non-resident Indians. During the year 2009-10, the Bank

expanded their distribution network from 1,412 branches in 528 cities to 1,725

branches in 779 cities. The Bank's ATMs increased from 3,295 Nos to 4,232 Nos

during the year. During the year 2010-11, the Bank expanded their distribution

network from 1,725 branches in 779 cities to 1,986 branches in 996 Indian cities. The

Bank's ATMs increased from 4,232 to 5,471 Nos.

PROMOTERS:

31
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, strong
market reputation, large shareholder base and unique consumer franchise, HDFC was
ideally positioned to promote a bank in the Indian environment.

Core Values

Awards and Achievements - Banking Services

2013
Dun & Bradstreet Polaris - Best Private Sector Bank Technology Adoption
Financial Technology - Best Private Sector Bank Retail
Banking Award 2013 - Overall Best Private Sector Bank

Institutional Investor
- Best Bank in Asia
- Mr. Aditya Puri - Best CEO
Forbes Asia

32
 Fab 50 Companies List for the 7th year
Sunday Standard Best
Banker Awards - Best Private Sector Bank: Large
- Safest Bank: Large
- Mr. Aditya Puri: Top Achiever

UTI Mutual Fund CNBC

TV 18 Financial Best Performing Bank - Private
Advisory Awards 2012
Asia Money 2013
- Best Domestic Bank in India
- Mr. Aditya Puri: Best Executive in India
MACCIA Awards 2013
Best in Financial Services: Bank Category
Dun & Bradstreet Best in Banking sector
Corporate Awards 2012
NDTV Profit Business Winner in the banking category
Leadership Awards 2012
NASSCOM CNBC– Best IT Driven Innovation in Banking
TV18 IT Innovation (COMMERCIAL)
Award
The National Quality Best Customer Service Result
Excellence Awards
FE Best Bank Awards - Best Bank: New Private sector
- Best in Strength & Soundness
- Mr. Aditya Puri: Best Banker
Skoch Financial Organisation of the Year
Inclusion Awards 2013

2012

DSCI Information Technology - Security in Bank (2nd time in a row)

Award 2012 - Security Leader of the Year (Banking)
Businessworld Awards for - Most tech-friendly Bank
Banking Excellence 2012 - Deal of the year (Rupee Bonds)
HT-Mars Customer satisfaction - Winner: Bank and Credit Card customer
survey satisfaction Survey
CSO Forum Information - Best Organisation for Information Security
Technology Award 2012 Practice (2nd time in a row)
Economic Times ET Awards for Corporate Excellence - Company

33

CNBC TV18's India Best
Banks and Financial
Institutions Awards 2012
Mint-Aon Hewitt study on
India's Best Managed Boards
2012
Forbes Asia
IBA Banking Technology
Awards 2011
Dun & Bradstreet Banking
Awards 2012
IDRBT Banking Technology
Excellence Awards 2011-12
Asia Money 2012
India's Top 500 Companies
-Dun & Bradstreet Corporate
Awards
Finance Asia
UTI Mutual Fund CNBC TV
18 Financial Advisor Awards
2011
Asian Banker International
Excellence in Retail Financial
Services Awards 2012
5th Loyalty Summit award
Skoch foundation 2012
ICAI Awards 2011
of the Year 2012
Best Private sector Bank
Our Bank among India's six best managed
Boards 2012
Fab 50 Companies - Winning for the 6th year
- Best Online Bank
- Best use of Business Intelligence
- Best Customer Relationship Initiative
- Best Risk Management & Security Initiative
- Best use of Mobility Technology in Banking
- Overall Best Bank
- Best Private Sector Bank
- Asset Quality - Private Sector
- Retail Banking -Private Sector
Best Bank in 'IT for Operational Effectiveness'
category
Best Domestic Bank in India
Best Bank in India
- Best Managed Company
- Best CEO - Mr. Aditya Puri
- Best Performing Bank - Private
- Best Retail Bank in India
- Best Bancassurance
- Best Risk Management
Customer and Brand Loyalty
SHG/JLG linkage programme
Excellence in Financial Reporting
34
FINANCIAL INFORAMTION:
Sales rise 16.35% to Rs 10093.34 crore
Net profit of HDFC Bank rose 27.07% to Rs 1982.32 crore in the quarter ended
September 2015 as against Rs 1559.98 crore during the previous quarter ended
September 2014. Total Operating Income rose 16.35% to Rs 10093.34 crore in the
quarter ended September 2015 as against Rs 8674.82 crore during the previous
quarter ended September 2014.

Particulars Quarter Ended

Sep. 2015 Sep. 2014 % Var.
Sales 10093.34 8674.82
OPM % 67.11 64.55
PBDT 3000.74 2278.42
PBT 3000.74 2278.42
NP 1982.32 1559.98

35
 CHATPER-4

DATA ANALYSIS &

INTERPRETATION

36
Various methods are used for ascertainment of profitability of capital expenditure. The
practical usage of these methods are 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 a 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

37
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.

38
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:

YEAR 2010-11 2011-12 2012-13 2013-14 2014-15

CFS(LAKHS) 60 80 50 40 40

Initial investment = 200000

39
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

2010-11 600000 600000
2011-12 800000 (600000+800000)
2012-13 500000 (1400000+500000)
2013-14 400000 (1900000+400000)
2014-15 400000 (2300000+400000)

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

40
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.

COMPUTATION OF DISCOUNTED PAY BACK PERIOD

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

inflow inflow
2010-11 600000 0.909 545400 54500
2011-12 800000 0.826 660800 (545400+660800)
2012-13 500000 0.751 375500 (1206200+375500)
2013-14 400000 0.683 273200 (1581700+273200)
2014-15 400000 0.621 248400 (1854900+248400)

Initial investment = 2000000

Amount to be received up to the end of 4th year = 1854900

41
 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

42
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 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.
Year 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15
CFATS 10000 12000 18000 25000 8000 4000

Cost of capital= 10%

43
NET PRESENT VALUE:
YEAR CASH INFLOW PV @ 10% PV OF CASH
INFLOW
2009-10 10000 0.909 9,090
2010-11 12000 0.826 9,912
2011-12 18000 0.751 13,518
2012-13 25000 0.683 17,075
2013-14 8000 0.621 4,968
2014-15 4000 0.564 2,256

NPV = 56,819 – 50000

= 6,819

The net present value of the project is 6,819

44
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

YEAR CASH FLOWS PVF(10%) PRESENTVALUE

RS RS
2010-11 -40000 1.000 -40,000
2011-12 20000 0.909 13,180
2012-13 40000 0.826 33,040
2013-14 -20000 0.751 -15,020
2014-15 20000 0.683 13,660

45
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

46
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

YEAR 2010-11 2011-12 2012-13 2013-14 2014-15

CF’S(RS 1000 1045 1180 1225 1675
000)

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

INITIAL INVESTMENT

47
FAKE PBP= AVERAGE CASH INFLOW

TOTAL CASH INFLOWS

AVERAGE CASH INFL OWS = NUMBER OF YEARS

= 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
2010-11 1000 0.935 935
2011-12 1045 0.873 912
2012-13 1180 0.816 963
2013-14 1125 0.763 935
2014-15 1675 0.713 1194

YEAR CASH INFLOW PV @ 6% PV OF CASH

48
 INFLOW
2010-11 1000 0.943 943
2011-12 1045 0.890 930
2012-13 1180 0.840 991
2013-14 1125 0.792 970
2014-15 1675 0.747 1251
To increase the PV of cash inflow, we decrease the rate let the new rate be 6%

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)

49
 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
= 85

Difference in discounting rate

=7–6
=1

85
IRR = 6% + ----- * 1
146

= 6 + 0.58
= 6.58%

SUMMARY

50
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:

 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
 The ARR of the project is 20%
 The NPV of the project is more than the “0” i.e. 6,819
 The PI is more than 1 i.e. 1.18
 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.

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

51
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 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.

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)

52
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

(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
53
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
Unsecured loans 198.00 --- 198.00
---------- --------- ----------
943.00 2060.00 3003.00
---------- ----------- -----------

The cash flows are generated for 8years at follows:

(RS. In lakhs)
CASH INFLOW 1ST 2ND 3RD 4TH 5TH YR 6TH 7TH 8TH
YR YR YR YR YR YR YR

54
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

55
The procedure adopted for calculating IRR is as given:
1) 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.
2) 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%
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.
3) 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
-------

56
IRR can be calculated manually or by using computers. The IRR is
calculated by using computer as follows is as under:

year Capital out benefits Net benefits Discnted bnfts

lay
constrn 2683.25 0.00 -2683.25 -2683.25
1st 920.00 1162.57 242.57 180.34
2nd 51.00 1225.45 1174.34 649.05
3rd 0.00 1203.76 1203.76 494.62
4th 0.00 1190.87 1190.87 363.78
5th 0.00 1177.37 1177.37 267.38
6th 0.00 1163.16 1163.16 196.38
7th 0.00 1148.28 1148.28 144.13
8th 0.00 1132.62 1132.62 105.69
9th 0.00 1132.62 1132.62 78.57
10th 0.00 1132.62 1132.62 58.41
11th 0.00 1132.62 1132.62 43.43
12th 0.00 1132.62 1132.62 32.39
13th 0.00 1132.62 1132.62 24.00
14th 0.00 1132.62 1132.62 17.84
15th 0.00 2333.21 2333.21 27.33

Info: 15th = 2012-2013 like going up\

Re projects IRR is worked at 34.5%

Observations:

1) The IRR for the instant project proposal is worked out at 34.5%

57
 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.

CHATPER-5

58
FINDINGS, SUGGESTIONS &
CONCLUSIONS

59
 FINDINGS
 HDFC has been instrumental in industrial development of Andhra Pradesh.

 During the 25th of its long saga, the corporation has financed above RS6000 cr
to nearly 86000 cr enterprises.

 The corporation has generated direct and indirect employement.

 The corporation has completed 25 years of service and to mark this occasion
Golden Jubilee Celebration was conducted during 2010-2011

 HDFC has achieved tremendous results during 2010-2011 in its key areas of
operation. There is a 26% growth in sanction, 21% in disbursements over the
previous year.

 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 5 th
year

 The evaluation techniques are broadly classified into two types i.e traditional
technique and discounted cashflow technique.

 The traditional technique includes net pay back period, average rate of return

 The discounted cashflow technique includes Net Present Value, Internal Rate
Of Return, Profitability Index.

 In HDFCC a project is appraised to examine the financial viability of the

project.

 HDFC worksout Internal Rate Of Return in appraisal of the project among the
capital budgeting technique.

 An accept-reject criteria has been applied for all the capital budgeting
methods.

 The result in this case study suggest that the project can be accepted.

 The corporation may consider using of other capital budgeting techniques like
Pay Back Period, Average Rate Of Return, Net Present Value, Profitability
Index in the appraisal of the project, which will enhance the quality of the
appraisal.

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 SUGGESTIONS

1. There are various developments taking in the industry to challenge so as

to the company should develop as a full fledged research and developed
department for bringing technological changes and improvements in its
design & process.

2. The management has physically verified the stock of finished goods and
work-in-progress at the end of the year.

3. Company needs to identify the potential business revenue generation

which results to profit on operations.

4. In respect of service activities, there is a reasonable system of recording

receipts, issues and consumption of materials and stores of allocation of
materials consumed to the relative job. Commensurate with its size and
nature of its business.

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 CONCLUSIONS
An empirical study of the practices of the Capital Budgeting for evaluation of
investment proposals in the corporate sector in India has been made in the preceding
chapters. Comparison, wherever possible, has been made with the practices and
procedures in the foreign countries. It has to be noted that conclusions based upon a
study of this type have to be taken as indicative of broad trends only. However, the
results of this study do indicate that majority of large scale companies in India are
aware of the need for a well formulated capital budgeting decisions. It is proposed to
review the important findings of this study and venture to outline some suggestions
and recommendations for the benefit of academicians, industry as well as for post
doctoral research. An in-depth analysis has been carried out to observe the trend and
insight into factors that influence capital budgeting decisions. The results of the
survey and its analysis have been provided. The companies in India do have specific
amount of average size of annual capital budget and all project size requires formal
quantitative analysis. However, such analysis and use of capital budgeting method
differ on the basis of nature and size of a particular project under consideration.
Surprisingly, the companies under study in India seem to be planning one year in
advance only but here also the period of planning is different for different projects.
This may be due to volatile business environment. The authority to take
final capital budgeting decision rests with the chief finance officer and top
management officials of all the organizations under study.

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BIBLIOGRAPHY

63
 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

HDFC Annual reports

 WWW.hdfc.com
 WWW.Hdfcindia.Com

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