7 : Summary, Conclusion and Recommendations

7 : Summary, Conclusion and Recommendations

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Chapter 7: Summary, Conclusion and Recommendations

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 in chapter 5.

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.

One of the objectives of this study is to determine the types of capital investments undertaken and the methods of appraisal used. The responding firms ranked pay back period as the most important technique followed by internal rate return and net present value. Thus, pay back period method (59.3%) still continues to be the most favoured technique though it ignores time value of money and also the cash flow beyond pay back period followed by IRR. But almost all the company's are using now multiple techniques

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for evaluating their capital budgeting proposals. In this research study, the company's prefer IRR and NPV with the PBP method. The investment in the new projects being strategic decisions in nature IRR, PBP and NPV are the most preferred techniques while for expansion, replacement, modernization, etc. PBP is favoured by the respondents.

Another objective of this study is to analyze the problems faced to estimate the cash flows associated with each capital investment accurately. The cash flow estimation is considered as the most difficult task in capital budgeting decisions. This can be understood from the responses of the respondents of the present study. Many respondents have replied that items like expenses incurred on R&D, market survey, test marketing, interest on borrowings, depreciation, income taxes etc. have been included in the cash flows which requires to be excluded actually. In fact, many of them might have been intending to convey that they include it in the project cost. Even the firms are using different inflation adjustment methods for their investment appraisal.

One of the objectives of this research is to analyze how `Risk' and `Uncertainty' in the future estimates in investment projects is being taken care of. Sensitivity analysis is considered as the most important technique while scenario analysis is considered as the second important technique for assessing risk. The other more sophisticated techniques like Decision tree, Monte Carlo simulation, Certainty equivalent, Probability analysis, Beta analysis has got very low ratings that means these techniques are rarely used in practice by firms in India.

The researcher wanted to assess suitability of Discounted Cash Flow (DCF) Techniques in India and the preferences between Net Present Value (NPV) and Internal Rate of Return (IRR) methods. All the companies responded to my study are using DCF techniques either IRR or NPV or both which indicates that now these techniques are very well accepted and used by finance officials of the organizations. With reference to this Porwal (1976) in his study has mentioned, "As long term planning under the present conditions is not quite possible in India, the use of DCF methods do not seem to be efficacious. However, it needs to be mentioned that as conditions improve, it would be desirable for Indian companies to apply `theoretically correct' techniques in a larger measure." Prasanna Chandra (1975) in his study conducted on 20 companies made the

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following observations. "The most commonly used method for evaluating the investments of small size is payback period method....For investments of large size, the average rate of return is commonly used as the principle criterion and the payback period is used as a supplementary criterion. DCF techniques, though not commonly used, are gaining importance, particularly in the evaluation of large investments." It appears that now though the government restrictions are minimized on business but firms are always working under highly volatile environment. Still no respondents in my study is using only pay back period method at the same time no organizations are using single technique for evaluating capital budgeting proposals. Though Pay back period is still a popular technique, it is always used with some other DCF techniques which are in most of the cases IRR or NPV. The suitability of DCF techniques even depends on how professional the organization is. But all the respondents in my study appreciate and use the suitability of these techniques. In capital budgeting literature, two widely discussed methods for appraisal of capital investments are the NPV and IRR methods. There is good amount of controversy exist regarding the superiority of one method over the other. Many authors argue that the NPV method leads to correct decision (Bierman and Smidt S, 1980). On the other hand Merret A J and Sykes A (1966) prefer the yield method. In some situations the NPV and yield methods give contradictory results. Babu C P (1984) explains the reasons for this phenomenon-"...in capital investment appraisal using the yield like yield to maturity in bonds, or as a growth rate of an investment is misleading, and is responsible for the contradictions that exist between the NPV and yield methods." He further says that as the NPV criterion is compatible with the objective of the firm, the yields can be used in such a manner so as to give the same results as that of NPV. The respondents of my study prefer both the techniques but IRR (40.7%) seems to be given more importance by them in comparison to NPV (33.3%) as it gives some rate for comparison. When they were asked to mention frequency of the use of different capital budgeting techniques the NPV (59.3%) got more preference than IRR (55.5%). Thus, it can be concluded that both the techniques goes side by side when it comes to selecting one over the other. The respondents of my study prefer both the techniques but IRR seems to be more favoured by them as it gives some rate for comparison, however, there is a negligible difference between the preference for both the techniques i.e. NPV and IRR. The uses of DCF techniques require determining the minimum acceptable rate of return for using it as a

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discount rate. The study reveals that weighted average cost of capital (55.6%) is maximum in use for using it as a discount rate. And the preferred methods of estimating cost of equity are CAPM (capital asset pricing model) and dividend yield plus growth rate followed by cost of debt plus risk premium. The use of present market values of debtequity is more preferred (46.67%) while calculating WACC. Generally, the companies do not prefer to use different discount rates for different sizes of investment. The maximum number of companies (70.4%) do prefer to categorize projects into different risk classes and they feel that fluctuations in expected return as a major risk factor followed by changes in economic, social and political factors. Sensitivity analysis (81.4%) is considered as the important technique for assessing risk followed by scenario analysis (62.9%). There is no major switch in techniques by the companies for investment appraisal. Almost three fifth of the firms place a limit on the size of its annual capital budget. There are many reasons responsible for it but the main reason is investment decisions important for whole group and require central control (38.9%) followed by the another reason i.e. management wants to control areas of activity and mix of products. The companies do accept non-economic projects due to many reasons viz., health and safety, legislation, social and environmental reasons etc. The most of the firms prefer to go for post audits of their major capital expenditures. The CFOs and Board of Directors are involved for approving almost all capital budgeting projects in all organizations.

Further, An effort has been made to develop a relationship between the independent variables; Plant and machinery and sales to explain the variation in the dependent variable as operating income of the company. The analysis has been carried out with the help of regression analysis. The period covered in the study is last five financial years (2003-2007). The summarized results of analysis for each company are provided in the chapter 6.

It is clear from the results obtained that, in most cases the R2 for almost 90 % of the companies is around 95 %. Thus, it can be said that capital budgeting decisions leading to investment in plant and machinery and sales together influence almost 95 % variation in the operating income of a company. Thus, our findings, through the above analysis it can be stated that proper usage of capital budgeting techniques lead to accurate decision for

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