Management J. Volume 2 No.

1 (January 1989)

,'

CAPITAL BUDGETING PRACTICES OF INDIAN COMPANIES

I. M. PANDEY

'

Objective

"

The objectives of this study are: (a) to document the capital bud geting policies and practices of companies in India, a developing country, and contrast them with those of USA and UK, the developed countries, and (b) to ascertain how business executives look upon the linkage between corporate strategy and investment decision-making. Capital expenditure planning and control is a process of facilitating decisions covering expenditures on long-term assets. Since a company's survival and profitability hinges on capital expenditures, specially the major ones, the importance of the capital budgeting process cannot be over-emphasized.
Sample and Methodology

We have followed an intensive interview-cum-questionnaire method. Two questionnairesone dealing with investment evaluation practice and second with other phaseswere sent to companies which had agreed to participate in the study. In all, 14 companies were studied. The responding companies belonged to different businesses. In terms of size (sales and number of employees), capital intensity (net tangible fixed assets), volume of spending (capital expenditure incurred), and level of technology, they represent a variety (Table 1). The study relates to 1984.
-,

Capital Expenditure: How Defined Strictly speaking, capital expenditure includes all those expenditures which are expected to produce benefits to the firm over more than one year, and encompasses both tangible and intangible assets. In practice, most sample companies followed the traditional definition, covering only expenditure on tangible fixed assets. *

Capital Budgeting Practices of Indian Companies

'

The Indian practice is also influenced considerably by accounting conventions and tax regulations. Large expenditures on items such as. research and development, advertisement, or employees training, which tend to create valuable intangible assets, are generally not included in the definition since most of them are allowed to be expensed for tax purposes in the year in which they are incurred. As many as ten sample companies followed the accounting convention to prepare assetwise classification of capital expenditures which is hardly of any use in decision-making Three companies classified capital expenditures in a manner which could provide useful information for decision-making. Thefr classification was in terms of capital expenditures for: (i) replacement (ii) modernization, (iii) expansion, (iv) new projects, (v) research and development, (vi) diversification, and (vii) cost reduction. Expenditure Planning Phases We have identified five phases of capital expenditure planning and control: (1) identification or origination of investment opportunities, (2) development of forecasts of benefits and costs (3) evaluation of the net benefit, (4) authorisation for progressing and spending capital expenditures, and (5) control of capital projects. The available literature emphasises the evaluation phase. Two reasons may be attributed to this bias. First, this phase is easily amenable to a structured, quantitative analysis, Second, it is considered to be the most important phase by academicians. Practitioners, on the other hand, consider other phases to be more important.7 Past surveys of capital budgeting practices in India and abroad have not focussed adequately on all phases. Since phases other than evaluation are important, research on those phasqs of capital budgeting is also needed. Investment ideas: Who Generates Investment opportunities have to be identified or created; they do not occur automatically.8'9 In six of the 14 companies surveyed; more .than 50 per cent of the investment ideas were generated at the plant level. The contribution of the board in idea generation was relatively insignificant. However, eight of the companies depended on the board upto 20 per cent of the investment ideas. Two companies depended on research centres for about 10-20 per cent of the investment ideas. These findings give an impression that the investment idea generation is primarily a bottom-up process in India. In UK, both bottom-up as well as top-down processes exist.16 Tine Indian practice, is more like

MDU Management J.

that in USA. Petty and Scott's study (1981) showed that project initiation was a bottom-up process in USA, with about'82 per cent of investment proposals coming from divisional management and plant personnel.13 However, it is to be noted that the small number of ideas generated at the top may represent a high percentage in terms of investment value, so that what looks to be an entirely bottom-up process may not be really so. Indian companies use a variety of methods to encourage idea generation. Of the 14 companies in our study, 10 depended on management sponsored studies for project identification. Formal suggestion scheme (7 companies) and consulting advice (6 companies) were also used. Most companies used a combination of methods. The offer of financial incentives for generating investments ideas, was not a popular practice. We came across only one such case in our sample. Other efforts employed by companies in searching investment ideas were: (a) review of researches done in the country or abroad, (b) conducting market surveys, and (c) deputing executives to international trade fairs for identifying new products/technology. Once the investment proposals have been identified, they could be submitted for scrutiny any time except in case of four companies, which specified submission time.
Cash Flow Estimation

We found that executives did not always have clarity about estimating cash flows. Half of our sample companies did not include additional working capital while estimating the investment project cash flows. A number of companies~also mixed up financial flows with operating flows. Although the sample companies claimed to estimate cash flows on incremental basis, half of them made no adjustment for sale proceeds of existing assets while computing the project initial cost. The prevalence of such conceptual confusion has been observed even in the developed countries. In UK, Rockley (1973) found half of the companies treating depreciation as cash flow.16 Most Indian companies in our survey chose an arbitrary period of 5 or 10 years for forecasting cash flows. This was because companies in India largely depend on governmentowned financial institutions for financing their projects, and these institutions require 5 to 10 years forecasts of the project cash flows. Evaluation of Proposals A formal financial evaluation of proposed capital expenditures has become a common practice arnong companies in India. Six companies

Capital Budgeting Practices of Indian Companies 5 in our survey had a formal financial evaluation of more than threefourths of their investment projects. About three-fourths of the companies subjected more than 50 per cent of the projects to some kind of formal financial evaluation. As many as eleven companies stated that projects, such as replacement of wornout equipment, welfare and statutorily required projects below certain limit, small value items like office equipment or furniture, replacement of assets of immediate requirements, etc., were not formally evaluated.
Methods of Evaluation

As regards the use of evaluation methods, all our sample companies, with one exception, were found to use payback criterion. In addition to payback and/or other methods, nine companies also* used internal rate of return (IRR) and six companies net present value (NPV) methods. One-third of the companies were also found using accounting rate of return (ARR) method. Thus, IRR was found to be the second most popular technique. It was found that one-third of companies insisted on computation of payback for all projects, one-third for majority of projects, and onethird for some of projects. In the case of slightly more than half of companies, standard payback period ranged between three and five years. The major reason for DCF techniques not being as popular as payback was the lack of familiarity with DCF on the part of executives. Other factors were lack of technical people and sometimes unwillingness of top management to use DCF techniques. One large manufacturing and marketing organization mentioned that conditions of its business were such that DCF techniques were not needed. By business conditions the company perhaps meant its dominantly marketing nature, and its products Being in seller's markets. Yet another company stated that replacement projects were very frequent in the company, and therefore, it was not necessary to use DCF techniques for such projects. The practice of companies in India regarding the use of evaluation criteria is similar to that in USA. A study by Schall, Sundem and Geijsbeak (1978) for USA showed that whereas 86 per cent of the firms used either the internal rate of return or net present value models, only 16 per cent used such discounting techniques without also using the payback period or average rate of return methods.17 The tendency of US firms to use naive techniques as supplementary tools has also been reported in other studies.13'14 However, firms in USA have com& to depend increasingly on DCF techniques, particularly IRR. According to Rockley's study (1973), the British companies use both DCF techni-

MDtf Management J.

ques and return on capital, sometimes in combination and sometimes solely, in their investment evaluation; the use of payback is widespread.16 One significant difference between practices in India and USA is that payback is used in India as a "primary" method and IRR/NPV as a "secondary" method, while it is just the reverse in USA. Indian managers felt that payback was a convenient method! of communicating an investment's desirabi/ity, and it best protected the recovery of capital scarce commodity in the developing countries.
Cut-off Rate:

In the implementation of a sophisticated evaluation system, the use of a minimum required rate of return is necessary. Nine of our sample companies specified the minimum acceptable rate of return. Four of them computed the weighted average cost of capital (WACC) as the discount rate. WACC was defined either as: (i) after-tax cost of debt X weight -f- after-tax cost of equity X weight (cost of equity is taken as 25 per cent (a judgemental number) and weights are in proportion to the sources of capital used by specific project); or (ii) (after tax cost of borrowing X borrowings -f- Dividend rate X equity) divided by total capital. Business executives in India are becoming increasingly aware of the importance of the cost of capital, but we did not find much clarity among them about its computation. Arbitrary judgement of management also' seems to play a role in the assessment of cost of capital. The fallacious tendency of equating borrowing rate with minimum rate of return also persisted in the case of some companies. Our results corroborate the findings of an earlier Indian study by Porwal (1976).11 fn USA, a little more than 50 per cent companies have been found using WACC as cut-off rate13. In UK, only 14 per cent firms were found to attempt any calculation of the cost of capital16. As in USA and UK, companies m India have a tendency to equate the minimum rate with interest rate or cost of specific source of finance. The phenomenon of depending on management judgement for the assessment of the cost of capital is prevalent as much in USA and UK as in India.
Recognition of Risk

The assessment of risk is an important aspect of an investment evaluation. Eleven of our sample companies considered risk and uncertainty while evaluating their investment proposals. The four most important contributors of investment risk stated by the Indian companies

Capital Budgeting Practices of Indian Companies

are: selling price, product demand, technological changes and government policies. India is fast changing from sellers market to buyers market as competition is intensifying in a large number of products; hence uncertainty of selling price and product demand are being realised as important risk factors. Uncertain government policies (in areas such as custom and excise duty and import policy), of course, are a continuous source of investment risk in developing countries such as India. Sensitivity analysis and conservative forecasts are two equally important and widely used methods of handlingi investment risk in India. Each of these techniques was used by ten of the sample companies with other methods while eleven companies used either sensitivity analysis or conservative forecasts with other methods. Four companies also used shorter payback and three companies used "inflated" discount rates (risk-adjusted discount rates). In USA, risk-adjusted discount rate is used by 90 per cent companies while only 10 per cent use payback and sensitivity analysis 17. This is also confirmed by another US study by Petty and Scott (1981 )13. In Rockley's survey of the British companies only one firm out of 69, used sensitivity analysis 16 . The contrasts in risk evaluation practices in India, on the one hand, and USA and UK on the other, are sharp and significant. G.iven the complex nature of risk factors in developing countries, risk evaluation cannot be handled through a single number such as NPV calculation based on conservative forecasts or risk-adjusted discount rate. Managers must know the impact on project profitability of the full range of critical variables. Hastie, an American businessman, strongly advocates the use of sensitivity analysis for risk handling, and casts doubt on the survey results in USA7. Capital Rationing A significant finding of our survey is that Indian companies, by and large, do not have to reject profitable investment opportunities for lack of funds, despite the capital markets not being so well developed. This may be due to the existence of the government-owned financial system which is always ready to finance profitable projects. Indian companies do not use any mathematical technique to allocate resources under capital shortage which may sometimes arise on account of internally imposed restrictions or management's reluctance to raise capita! from outside. Priorities for allocating resources are determined by management, based on strategic need for and profitability of projects.

MDII Management J.

Authorisation In India, as in UK16 the power to commit a company to specific capital exenditure and to examine proposals is limited to a few top corporate officials. However, the duties of progressing the examination and evaluation of a proposal was somewhat spread throughout the corporate management staff in case of a few of the sample companies. Thus, senior management tightly controls capital spending. Budgetary controls are also exercised rigidly. The expected capital expenditure proposals invariably become a part of the annual capital budget in all companies. Ten companies also had formal long-range plans covering a period of 3 to 5 years. Six of those companies stated that longrange plans had a significant influence on the evaluation and fund-ding of capital expenditure proposals.
Control

Indian companies practise control of capital expenditure through the use of regular project reports. In our survey, six companies required quarterly reporting, four companies monthly, one company half-yearly and yet another company required a continuous reporting. In most of the companies, the evaluation reports included information on expenditure to date, stage of physical completion, and approved and revised total cost. Most of the companies reported that in reappraising investment proposals, they considered comparison between actual arfd forecast capital costs, savings and rate of return. They pointed out the following advantages of reappraisal: (i) improvement in profitability by positioning the project as per the original plan; (ii) ascertainment of errors in investment planning which can be avoided in future; (iii) guidance for future evaluation of projects; and (iv) generation of cost consciousness among the project team. Nine companies admitted that they might take any of the following kinds of actions after the reappraisal of projects: (a) revision of the aims and size of the project, (by redesigning and resheduling of project, and (c) financial revision of the project to provide for cost escalation. A few companies also opined that they would abandon the project if it became uneconomical. The power of review is generally vested with the top executives of the companies.
Qualitative Factors and Judgement

In theory, the use of sophisticated techniques is emphasized since they maximize value to shareholders. In practice, however, companies, although tending to shift to the formal methods of evaluation, give

Capital Budgeting Practices oj Indian Companies 9

considerable importance to qualitative factors. Our survey indicated that almost all companies were guided, one time or other, by three qualitative factors: urgency, strategy, and environment. All companies stated that urgency is the most important consideration while more than three-fourths of the companies thought that strategy played a significant role. One third of the companies also found intuition, security and social considerations as important qualitative factors. Qualitative factors like employees' morals and safety, investor and customer image, or legal matters are considered important in investment analysis by companies in USA.15 Because of the significance of qualitative factors, judgement seems to play an important role. To empirically verify the significance attached to judgement, the sample companies were required to indicate its role in investment decisions. Except one company which1 did not give any response, all companies felt judgement to be important. Some typical responses are: * Vision of judgement of future plays important role. Factors like market potential, possibility of technology change, trend of gov ernment policies etc., which are judgemental, play important role. " The opportunities and constraints of selecting a project, its evaluation of qualitative and quantitative factors, and the weightage on every bit of pros and cons, cost-benefit analysis, etc., are essential elements of judgement. Thus, it is inevitable for any management decision. * Judgement and intuition should definitely be used when a deci sion of choice has to be made between two or more closely beneficial projects, or when it involves changing long-term stra tegy of the company. For routine matters, liquidity and profits should be preferred over judgement. * It (judgement) plays a very important role in determining the reliability of figures with the help of qualitative methods as well as other known financial matters affecting the projects. We feel that what businessmen call intuition or (simply) judgement Ts in fact informed judgement based on experience. A firm growing in a favourable economic environment will be able to identify profitable opportunities without making NPV or IRR computation. Businessmen often act intelligently than they talk.

10

MDf Management J.

Strategic Aspects of Investment Decision Recently, a lot of emphasis has been placed, on the view that a business firm facing a complex and changing environment will benefit immensely in terms of improved quality of decision-making if capital budgeting decisions are taken in the context of its overall strategy.3'12 This approach provides the decision-maker with a central theme or a big picture to keep in mind at all times as a guideline for effectively allocating corporate financial resources. As argued by a chief financial officer:6 Allocating resources to investments without a sound concept of divisional and corporate strategy is a lot like throwing darts in a dark room. Hastie argues.7 We have erred toot long by exaggerating the "improvement in decision-making" that might result from the adoption of DCF or other refined evaluation techniques. What is needed are approximate answers to the precise problems rather than precise answers to the approximate problems. There is little value in refining an analysis that does not consider the most appropriate alternative and does not utilise sound assumptions. Management should spend its time improving the quality of assumptions and assuring that all the strategic questions have been asked, rather than implementing and using more refined evaluation techniques. (Emphasis added)". In fact a close linkage between capital expenditure, at least major ones, and strategic positioning exists which has led some researchers to conclude that the set of problems companies refer to as capital budgeting is a task for general management rather than financial analyst.2 Some recent empirical works amply support the practitioners concern for strategic consideration in capital expenditure planning and control.4 It is therefore a myopic point of view to ignore strategic dimensions or to assume that they are separable from the problem of efficient resource allocations addressed by capital budgeting theory14. Three-fourths of our sample companies considered strategy as an important factor in investment evaluation. To ascertain the seriousness attached to strategy, companies were asked to state their corporate strategy and cite instances where projects were accepted or rejected for strategic considerations. Examples of six sample companies showing how they defined their corporate strategy are given below:

Capital Budgeting Practices of Indian Companies

11

(i) To remain market leader by highest quality and remunerative prices. This company undertook the production of a new range of product (which was marginally profitable) for competitive reasons. (ii) To have moderate growth for saving taxes and to set up plants for forward and backward integration. (iii) Our strategy is to grow, diversify and expand in related;fields of technology only. Any project which is within the strategy and satisfied profitability yardsticks is accepted. This company found a low-profit chemical production acceptable since it came within its technological capabilities. (iv) Strategy involves analysis of company's present position, nature of its relationship with the environmental forces, company's business philosophy and evaluation of company's strong and weak points. (v) To take up new projects for expansion in the fields which are closer to present projects/technology. This company rejected a profitable project (of deep sea fishing and ship building) while it accepted a marginally profitable project (of paint systems) since it was very close to its current heat transfer technology. (vi) To stay in industrial Intermediate and capital goods line, and in the process to achieve three-fold profits in real terms over 5-year period. This company rejected a highly profitable pro ject (of manufacturing! mopeds) since it was a consumer durable and accepted a marginal project (of cold formed structured purlins). i One more example is that of an Indian subsidiary of a giant multinational which stated that it looked for projects in high technology, priority sector, and that explained the undertaking of a number of projects by it in tne past. This company even sold one of its profitable nonpriority sector division to a sister concern to maintain its high-tech, priority sector profile.
',

Strategic management has emerged as a systematic approach in properly positioning companies in the .complex environment by balancing multiple objectives. In practice, therefore, a comprehensive capital expenditure planning and control system will not simply focus on profitability, as assumed by modern finance theory, but also on growth, com-

12

MV Management J.

petition, balance of products, total risk diversification, and managerial capability. There are umpteen examples in the developing countries like India where unprofitable ventures are not divested even by the private sector companies because of their desirability from the point of view of consumers and employees in particular and society in general. Such considerations are not at all less important than profitability since the ultimate legitimation and survival of companies (and certainly that of management) hinges on them. One must appreciate the dynamics of complex forces influencing resource allocation in practice; it is not simply the use of the most refined DCF techniques. Certain other considerations mentioned by respondent companies in our survey were: * Apart from profitability of the project, other features like its (project's) critical utility in the production of the main product strategic importance of capturing the new product first, adapt ing to the changing market environments, have a definite bearing on investment decisions. * Technological developments play critical role in guiding invest ment decisions. Government policies and concessions also have a bearing on these. * Investments in production equipment is given top priority among the existing products and the new project. Capital investment for expansion in existing lines where market potential is proved is given first priority. Capital investment in new projects is given the next priority. Capital investment for buildings, furniture, cars, office equipments, etc., is done on the basis of availability of funds and immediate needs. These statements reinforce the need for a strategic framework for problem-solving under complexities and the relevance of strategic considerations in investment planning. It also implies that resource allocation is not simply a matter of choosing most profitable new projects. What is being stressed is that the strategic framework provides a higher level screening and an integrating perspective to the whole system of capital expenditure planning and control. Once strategic questions have been answered, investment proposals may be subjected to DCF evaluation.
Decision-making Levels

For planning and control purposes, three levels of decision-making have been identified:

Capital Budgeting Practices of Indian Companies (i) operating (ii) administrative, and (iii) strategic.5

13

Capital budgeting could be categorized into those three levels. Operating capital budgeting may include routine minor expenditures, such as on office equipment, and it can be easily handled by lower level management. On the other extreme, strategic capital budgeting involves large investments such as acquisition of a new business or expansion in a new line of business. Strategic investments are unique and unstructured, and they cast a significant influence on the direction of the business. Such investments are, therefore, generally handled by top management. Administrative capital budgeting falls in-between these two levels. It involves medium-size investments such as expenditure on expansion of existing line of business. Administrative capital budgeting decisions are semi-structured in nature, and can be handled by middle management. Keeping in view the different decision-making levels, capital expenditures could be classified in a way which would reflect the appropriate managerial efforts to be placed in planning and controlling them. 1 One useful classification could be: (i) strategic projects, (ii) expansion in the new line of business, (iii) general replacement projects, (iv) expansion in the existing line of business, and (v) statutorily required and welfare projects. Further, each of these categories could be sub-classified according to funds required by projects. The model for a comprehensive capital expenditure planning and control (see figure 1) which emerges from our study, may be summarized as follows: Corporate strategy provides the focal point for the firm's long-run strategic planning. The capital budgeting system, particularly for large strategic projects, is determined in the context of strategic planning and, thus, it is a top-down process. Corporate strategy and strategic planning play the most crucial role at the identification and evaluation phases. Operating and administrative capital budgeting decisions can be decided at lower./middle level of management within the overall strategic framework and guidelines from top management. The capital budgeting system at lower/middle level will largely be a bottomup process. It may be noted that external and internal environment provides a context to the company to establish and review its missions, concerns, and multiple objectives which, in turn, shape its corporate strategy.

14

MDH Management J.

FIGURE 1 : Capital Expenditure Planning and Control Model.

Capital Budgeting Practices of Indian Companies REFERENCES

15

1. Ackerman R W (1970): Influence of Integration and Diversity on the Investment Process, Administrative Science Quarterly 341-351, September. 2. Bower J I (1972): Managing the Resource Allocation Process, Homewood, 111, Richard D Irwin. 3. Derkindern F G J and Crum Roy L (1981): Capital Budgeting as an Open System. In: Derkindern and Crum Ed. Readings in strategy for Corporate Investment, MA, pitman. 4. Donaldson G (1984): Managing Corporate Wealth; The Operation of a Com prehensive Financial Goal System. New York, Praeger. 5. Gordon L A, Miller D and Mintzberg M H (1985): Normative Models in Managerial Decision-Making. New York, National Association of Accoun tants . 6. Hall W K (1979): Changing Perspectives on the Capital Investment Pro cess. Long-range Planning 12, 37-40, February. 7 Hastie K L (1974): One Businessman's View of Capital Budgeting. Financial Management 3, 36-44, Winter. 8. Haynes W "W and Solomon M B (1964): A Misplaced Emphasis in Capital Budgeting. Quarterly Review of Economics and Business 95-106. JanuaryFebruary. 9.- King P (1975): Is the Emphasis of Capital Budgeting Theory Misplaced?. Journal of Business Finance and Accounting 69-82, Spring. 10. Myers S C (1984): Finance Theory and Financial Strategy. Interfaces 14 (1), 126-137, January-February. 11. Pandey I M (1984): Financing Decisions: A Survey of Management Under standing. Economic and Political Weekly, 19(8), 27-31, February. 12. -----------------(1985): Financial Policy and Strategic Management. (Working Paper 85-1). Kansas, U.S.A., Kansas State University. 13. Petty J W. and Scott D F (1981): Capital Budgeting Practices in Large U.S. Firms: A Retrospective Analysis and Update. In: Derkindern and Crum Ed. Readings in Strategy for Corporate Investment, MA, Pitman. 14. Petty J W, Scott D F and Bird M M (1975): Capital Expenditure DecisionMaking Process of Large Corporations, Engineering Economist 159-72, Spring. 15. Porwal L S (1976): Capital Budgeting in India. New Delhi, Sultan Chand & Sons. 16. Rockley L E (1973): Investment for Profitability. London, Business Books. 17. Schall L D, Sundem G L and Geijsbeek W R (1978): Survey and Analysis of Capital Budgeting Methods. Journal of Finance, 281-87, March.