UNIVERSITY OF DHAKA

CAPITAL BUDGETING IN A CAPITAL INTENSIVE INDUSTRY

Submitted To:

Nusrat Jahan Lecturer Department of Accounting & Information Systems University of Dhaka
Submitted by: Group-1.
Name Md. Azizur Rahman(GL) Md. Delwar Hossain Fahmida Munmun Asma Arifa Mousumi Sakib Hasan Hosni Jahan Tunisha Chakma Md. Tamij Ahammed Md. Tanvir Ahmed Kalince Tahasin Reza Khan SK. Rashed Ahmed Roll No. 16131 16149 16160 16164 16165 16174 16180 16252 16254 16256 16257

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

Date of Submission: 3rd May, 2012.

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Table of contents
Contents Abstract Literature review Objectives Methodology Introduction Capital budgeting Key motives for capital budgeting Process of capital budgeting Characteristics of capital budgeting Capital budgeting techniques Capital budgeting in practice Capital budgeting in a capital intensive industry Capital budgeting in forest industry Robust portfolio modeling Reference 4 4 4 4 4 5 5 6 6 6 12 12 13 14 17 Page

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Abstract
In this paper, we tried to show how companies do capital budgeting. We have discussed about different types of capital budgeting techniques. We have focused mainly on the capital budgeting techniques of capital intensive industry, their driving principles and their challenges in choosing suitable technique. We have discussed details about Robust Portfolio Modelling which is very much helpful for capital budgeting of capital intensive industry.

Literature Review
A search on capital budget in the periodical databases retrieved some of the following articles, which are downloadable in full text form from the database. Gyorgy Andor Capital Budgeting Practices: A Survey of Central and Eastern European Firms; Duan Guide to Resources: Capital Budgeting; E Gilbert Capital budgeting: A case study analysis of the role of formal evaluation techniques in the decision making process; John Graham How do CFOs make capital budgeting and capital structure decisions; Davina F. Jacobs A Review of Capital Budgeting Practices; Xin Wang Implementing capital budgeting for multinational corporations.

Objectives
The overall objective is to choose the best capital budgeting projects. This has been broken into the following sub-objectives: 1. To understand the risk in the analysis of capital budgeting projects. 2. To understand what capital intensive industry is. 3. To understand how capital intensive industry does capital budgeting. 4. To understand the challenges of capital intensive industry. 5. To understand the Robust Portfolio Modelling.

Methodology
We have tried to derive sum and substance of capital budgeting by observing text books and different real world situations. We have collected some articles about capital budgeting. We have overviewed those articles in the light of our knowledge. We have used some capital budgeting techniques to reach a decision. We have used some statistical tools to derive it.

Introduction
Capital budgeting is the process of allocating capital within a firm. This is done to determine the long-term investments that secure the continuity and profitability of the company. The process of capital budgeting is sometimes referred to as investment appraisal 1. By nature, capital budgeting is a process of planning, and the implementation and monitoring activities
1

In this study, the terms of 'capital budgeting' and 'investment appraisal' are used interchangeably, as in most cases in the literature.
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are omitted from this analysis. This planning process typically includes the use of a variety of investment appraisal methods, which can be both quantitative and qualitative. These methods may be divided into five; net present value, rate of return, ratio, payback and accounting methods. Capital-intensive industries, such as forest industry, hold some special characteristics in their capital budgeting procedures. In Bashundhara Paper Mills Ltd., the currently dominant production philosophy called multiproduct integrate', emphasizes the economies of scale achieved by an integrated paper mill. High amount of capital embedded in the organizational structures and industrial infrastructure leads to capital intensiveness, and further to long payback periods and high gross capital expenditure levels. This factor accentuates the importance of using proper investment appraisal techniques, as the competitiveness of the company greatly depends on the efficiencies thus achieved. The purpose of this study is to explore literature on capital budgeting in large corporations in capital-intensive industries. Subsequently, analysis of methods that are widely incorporated in multinationals, how they are used and what should possibly be taken into account in the future is conducted. After this introductory part, the fundamental methods, as well as practical aspects of capital budgeting are presented and discussed in more detail. Next, capital budgeting in forest industry is presented. The final section introduces a heuristic model that seeks to capture the relevant issues in the industry.

Capital budgeting
Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firms goal. We should carefully sort out the long-term and short-term asset because capital budgeting is related with long-term asset and working capital management deals with short-term assets and day to day activities.

Key motives for capital budgeting

Key motives for capital budgeting are: 1) To expand the level of operation; 2) To increase firms efficiency by replacing asset; 3) To involve a long-term commitment for future return. Example: 1) Advertising 2) Research and development etc.

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Process of capital budgeting

Characteristics of Capital Budgeting

The most important characteristics of capital budgeting are: 1. 2. 3. 4. Most of the projects are related to infrastructural asset. There are typically no efficient market for these assets. All of the projects have positive NPV. There are budget constrain.

Capital budgeting techniques

Commonly used capital budgeting techniques are: 1) Non discounted Approach: a) Accounting rate of return (ARR) b) Payback period (PB) 2) Discounted Approach: a) Net present value Approach (NPV) b) Probability index (PI) c) Internal Rate of Return (IRR) Discounted approaches are most scientific approaches and widely used.

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Capital budgeting techniques (details): Accounting Rate of Return (ARR):

Average profit after tax is determined by adding up the after tax profits expected for each year of the project life and dividing by the number of year. Steps: 1. 2. 3. 4. Compute average income; Compute average investment; Compute ARR by using formula; Take decision.

Decision: ARR is compared with a predetermined or a minimum rate. If (accept) (reject) Advantages: 1. It is easy to calculate. 2. Less time consuming and cost saving. Limitations: 1. It is a nondiscounted approach. 2. It is not widely used.

Payback period (PB): The length of time it takes for the original cost of an investment to be recovered from its expected cash flow. Steps: 1. Cosider the payback period; 2. Evaluate the projetcs; 3. Select the best suitable option. Decision: A project is acceptable if has determined is appropriate). Advantages: 1. Easy to calculate. 2. Time and cost saving. (n= recovery period that the firm

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Limitations: 1. It doesnot consider time value.

Net present value (NPV) approach: The present value of an assets future cash flow minus its purchase price (initial investment) is called Net Present Value (NPV). Formula for computing: ( Here, ) ( ) ( )

Steps: 1. 2. 3. 4. Calculate the cash outflow; Calculate the cash inflow; Discount these cashflows; Take decision.

Decision: If the net benefit computed on a present value basis, that is, NPV is positive, then the asset (Project) is considered an acceptable investment that is, if NPV>0, then accept.

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Advantages: 1. It considers time value. 2. This is one of the most common approach. Internal rate of return (IRR): The discount rate that forces the present value of a projected expected cash flow to equal its initial cost. That is IRR is the rate of return that firm expects to earn if a project is purchased. Formula:
( ) ( ) ( )

Decision: A project is acceptable if

Profitability Index (PI): We can get PI by using the formula,

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Decision: If If , Then accept the decision. Then reject the decision.

Which one we should prefer over others: If there is any contradiction then we may prefer,

But this decision could vary person to person.

Value management tools: Economic value added (EVA) gives an estimate of 'true' economic profit after making corrections to accounting, including deducting the opportunity cost of equity capital. According to Wikipedia, EVA's current theory is formulated by Bennett Stewart and Joel Stern. EVA tells the additional value created for the shareholders of the firm after the required return. The calculation is straightforward: ( | ) In Equation, ( ) ( )

Critics note, however that EVA is incapable of measuring the shareholder value creation in a company. Real options: In some cases, the word option is associated with investment opportunities in the sense of investment appraisal, rather than financial securities. For instance, the opportunity of investing in industrial infrastructure may be seen as a possibility, but not an obligation to the management. The word real comes into discussion because the fact that in this context, the potential investments concern real activities or real commodities (nonfinancial), as opposed to the case of financial instruments. As in the case of capital budgeting problems in general, real options are not tradable.

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Application for real option: 1. When there is a contingent investment decision. 2. When uncertainty is large enough that it is sensible to wait for more information, 3. When the value seems to be captured in possibilities for future growth options rather than current cash flow. 4. When uncertainty is large enough to make flexibility a consideration. 5. When there will be project updates and mid-course strategy corrections. Real options approach could prove to be beneficial in considering shut-downs and other forms of disinvesting. In fact, these actions are also forms of investment; money-losing operations have a cost, and assessing these problems with real options approach might prove to be fruitful. Rather than focusing on the costs, identifying the trade-offs and alternative costs might pave the way for the wider understanding of the financial consequences of shutdowns. Drawbacks of real options: 1. It is complex. 2. It demands significant computational work and additional data. 3. Communicating real options approach and its findings in a real-life situation within a company might prove to be challenging.

Capital budgeting under uncertainty

Up to this we discussed some techniques which are applicable in normal situation. Here are some more techniques related with uncertainty. Stand alone risk: Stand alone risk is the risk an asset would have if it were a firms only asset. Corporate (within firm) risk: Corporate risk is the risk that does not take into consideration the effects of stockholders diversification; it is measured by a projects effect on the firms earnings variability. Beta (market) risk: Beta risk is that part of a projects risk that cannot be eliminated by diversification; it is measured by the projects beta coefficient. Sensitivity analysis: Sensitivity risk a risk analysis technique in which key variables are changed and the resulting changes in the NPV and the IRR are observed. Scenario analysis: Scenario analysis is a risk analysis technique in which bad and good sets of financial circumstances are compared with a most likely or base cases situation. Monte Carlo simulation: Monte Carlo simulation is a risk analysis technique in which probable future events are simulated in a computer, generating a probability distribution that indicates the most likely outcomes. Capital rationing: Capital rationing is a situation in which a constraint is placed on the total size of the firms capital investment.

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Capital budgeting in practice

The most widely used methods in capital budgeting and project selection are net present value, internal and external rate of return, return on investment, benefit/cost ratio method and payback period methods. As previously noted, a shift from IRR to NPV methods has taken place during the last decades. Evidence from 10 large British and Dutch companies shows that high performing companies use market-based methods, frequent assessment & monitoring, as well as value-based management and modified DCF methods. Especially in the case of so called 'soft projects', such as R&D and ICT projects, qualitative methods are widely used. Respectively, low performing companies use accounting-based methods, infrequent assessment and monitoring, accounting and basic DCF-based models, as well as mostly qualitative methods. This study strongly suggests adding more complexity to the models currently in use. One step into this direction would possibly be the adoption of simulation, real options and portfolio techniques. Multinational capital budgeting1. Repatriation of earnings-the process of sending cash flows from a foreign subsidiary back to the parent company. 2. Exchange rate risk-the uncertainty associated with the price at which the currency from one country can be converted into currency of another country. 3. Political risk-the risk of expropriation (seizure) of a foreign subsidiaries assets by the host country or of unanticipated restrictions of cash flows to the parent company.

Capital budgeting in a capital intensive industry

Capital budgeting concept revisited: Capital allocation problem typically consists of allocating a budget among a set of competing investment possibilities. here investments are selected after evaluting. Portfolio approaches come into question especially in the case of interdependent projects in which significant synergies can be achieved by choosing a particular combination of projects. Capital intensive industry: Capital intensive refers to the degree that a company must invest money in physical or financial assets in order to produce a profit. Characteristics of a capital intensive industry: 1. 2. 3. 4. Multy product integrate. High amount of capital is needed. Mainly focused on organizational structures and industrial infrastructure. Payback period is long.

Examples: Papermaking, Airlines, auto manufacturers, and drilling operations are often considered capital-intensive businesses because they require large amounts of expensive equipment and raw materials to make their products Although there is no mathematical threshold that definitively determines whether an industry is capital intensive, most analysts look to a companys capital expenses in relation to its labor expense. The higher the ratio between capital and labor expenses, the more capital intensive a
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business is. For example, if Company XYZ spent TK. 10,000,000 on equipment in one year but only TK. 3,000,000 on labor, Company XYZ is probably in a capital-intensive industry.

Capital budgeting in forest industry

Forest industry and more precisely, papermaking, can be seen as an example of capitalintensiveness. For decades, the capacity of new paper machines has been growing. The reasons for this are intricate; dominant production philosophy searching efficiencies of scale, cluster-effects, and so on. Regardless of the reason(s), forest industry companies, especially in the Western economies are in a situation in which their profitability and therefore whole existence is threatened due to serious overcapacity and erosion of profitability. In forest industry (as in other industries as well), the bulk of capital budgeting methods are based on conventional DCF techniques. IRR-based methods are also notably popular in the industry, increasing their popularity since the 1970s, despite the pressure in the relevant literature against them. In addition, some larger companies use more sophisticated evaluation methods, such as economic value analysis. The use of mathematically more sophisticated methods, such as covariance analysis, simulation studies or decision-tree analysis is found to be at most marginal. As the business environment in forest products industry can be considered very competitive, assessing capital allocation problems using the most elegant techniques would be justifiable.

Driving principles
Forest industry consists of sub-industries that hold different characteristics. It may be considered to represent a set of relatively mature, large-scale industries that have globalised quite recently. It can be argued that in the past, the main driver of investment was not the effective management of capital, but rather the need to create capacity in order to fulfill the market demand for the end-products, that is, paper. Nevertheless, the former set of incentives that were mainly motivated by unsatisfied, growing markets, has to be replaced with a new one, in order for the industry to survive. This applies especially to Western forest industry companies, as they face increasing competition from new players, many of which are from the 'new Asia'. When capital budgeting methods in the forest industry are considered, IRR is among the most popular methods in use. Sometimes choosing this method is explained through referring to the difficulty of determining a 'risk-adjusted' discount rate in using NPV. One question still remains unanswered: why is MARR suitable for comparing the internal rates of the project proposals with the market return, but not in the case of net present value calculation? On the other hand, choosing projects according to their IRR-order, until the budget constraint is met, is not optimal. It increases the risk of leaving a part of the budget intact.

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Challenges in choosing suitable capital budgeting technique

Some challenges are: 1. Hardness of budget constraint. 2. Poor choice of method. 3. Poor choice of combination of methods leads to the selection of a weak project with greater probability than in the case of choosing a good one.

Robust Portfolio Modelling

Robust Portfolio Modelling (RPM) could prove to be helpful when applied to capital allocation problems. RPM 'is a decision support methodology for analyzing large-scale multiple criteria project portfolio problems'. The RPM methodology extends the use of preference programming into portfolio problems where a subset of available project candidates is to be financed considering multiple criteria. Additive scoring model is used to model the overall value of each project in a setting of incomplete information. That is, weight coefficients are not be fixed as precise values, but rather as intervals. Ultimately, RPM builds on the computation of efficient portfolios. A portfolio is efficient (non-dominated), if it is not possible (using existing assets) to compose another portfolio, the overall value of which is higher considering the allowed weights and values. The process of RPM is shown in Figure 1.

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Figure 1 Robust Portfolio Modelling (source: http://www.rpm.tkk.fi/) The definition of a 'core project' is the following: 'If the core index of a project is 1, the project is included in all non-dominated portfolios; it is consequently called a core project. At the other extreme, if its core index is 0, the project is not included in any non-dominated portfolio; it is therefore referred to as an exterior project. Finally, projects whose core index is strictly greater than zero but less than one are called borderline projects'. Mathematically, core, borderline and exterior projects are defined as follows: ( ) ( ) ( ) { { { | | | ( ( ) ( ) } ) } }

The core projects would be chosen in the portfolio that maximizes the overall portfolio value in a situation of additional information concerning the point estimates of weights and score parameters.

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Real options in papermaking: 'Real options in papermaking' could be the topic of a research paper, thesis, or a dissertation in exploring the possibilities that option pricing approach offers. Especially considering the non-linearities, the cost of waiting and hedging, real options could provide valuable information in terms of capital budgeting. Contemplating either new investments or shut-downs (disinvestments) in the new market situation, the need of applying novel approaches in the forest industry setting is imminent. Increased market volatility, the grown probability of technological discontinuity and/or industry shakedown, as well as the role of strategic investments in this context, suggest that a significant source of advantage could reside in 'new investment appraisal methods'. One possibility could be combining RPM and real options approaches. This would take place in the following manner. First, RPM would be used to identify the core and exterior project candidates. Core projects form the basis of the portfolio, as they are included in all efficient (non-dominated) portfolios. Instead of using RPM methodology in identifying the core projects, other ways could be considered as well. Considering the historical practices in investment appraisal that are being used in firms, it might prove beneficial to use the traditional capital budgeting methods in conjunction with RPM. Hence, NPV and IRR could be used to identify the core project proposals, thereby paving the way for novel approaches, yet adhering to accustomed practices. Consequently, the decision maker(s) would have three sets of projects: core, borderline and exterior. Core projects would be executed in any case, but the novelty of this approach lies in the handling of the borderline. The figure should be interpreted so that interdependent investment proposals can be modelled mathematically. For instance, investment A could represent the procurement of land from the Southern hemisphere'. Consequently, investment B could be 'the start of planting activities', and C 'waiting'. In this case, the investor(s) would have the possibility to allocate uncertainties to the respective investment possibilities. Additionally, what is notable here is that investments such as 'waiting', 'shut-down' etc. are considered as investments, as the 'building' investments. In mathematical terms the setting is the following:

This is interpreted so that B and C are only executable in case of the realization of the project A. In addition, both of the two options B and C can be either done or not (using the option or not). Considering the 'real-life' example of land procurement in the Southern hemisphere, starting planting activities or waiting, is an example of real-world options. Identifying investment possibilities using real options is presented here to develop the option-based thinking in capital budgeting. In this model, there is still plenty of room for traditional thinking, in terms of choosing the core set of projects. Nevertheless, a novel approach for assessing investment candidates with higher uncertainty levels is presented here.
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Reference
Literature: 1. Gitman L. J. Principles of Managerial Finance-12th edition. 2. Akalu M. (2003), 'The process of investment appraisal: the experience of 10 large British and Dutch companies', International Journal of Project Management, 21: 355362. 3. Gilbert E. (2004), 'Investment Basics XLIX. An introduction to real options', Investment Analysis Journal, 60: 49-52. 4. Modigliani F. and M. Miller (1958), 'The cost of capital, corporation finance and the theory of investment', The American Economic Review, 48: 261-297. Internet Links: http://en.wikipedia.org/wiki/Economic_value_added http://www.rpm.tkk.fi/

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