Chapter 1 INTRODUCTION

1.1

Background Capital expenditure is the list of planned investment expenditure on fixed assets outlays

for different projects. It is a process of selecting viable investment project. We can simply define capital expenditure as investments to acquire fixed or long lived assets from which a stream of benefits is expected. It represents an organization's commitment to produce and sell future products and engage in other activities. Thus capital expenditure decision forms a foundation for the future profitability of a company. Capital expenditure activities are made up of two distinct processes: (a) making the decision and (b) implementing it, which may include performing a post-appraisal. This Practice deals only with the first process. The capital expenditure decision is derived from and is closely associated with strategic planning which is an effort by an organization to define its mission and goals and the policies and strategies it will follow to attain them.

Capital Budgeting Tools Payback Period Accounting Rate of Return Net Present Value Internal Rate of Return Profitability Index Modified Internal Rate of Return

Payback Period

Payback period is the time duration required to recoup the investment committed to a project. Business enterprises following payback period use "stipulated payback period", which acts as a standard for screening the project. Computation of Payback Period When the cash inflows are uniform the formula for payback period is cash outflow divided by annual cash inflow Indian Institute of Technology Madras Accounting Rate of Return Accounting rate of return is the rate arrived at by expressing the average annual net profit (after tax) as given in the income statement as a percentage of the total investment or average investment. The accounting rate of return is based on accounting profits. Accounting profits are different from the cash flows from a project and hence, in many instances, accounting rate of return might not be used as a project evaluation decision. Accounting rate of return does find a place in business decision making when the returns expected are accounting profits and not merely the cash flows. Computation of Accounting Rate of Return The accounting rate of return using total investment. or Sometimes average rate of return is calculated by using the following formula: Net Profit after Tax Average Investment Where average investment = total investment divided by 2 Net Present Value (NPV) Net present value of an investment/project is the difference between present value of cash inflows and cash outflows. The present values of cash flows are obtained at a discount rate equivalent to the cost of capital.

Internal Rate of Return (IRR)

The internal rate of return method is also known as the yield method. The IRR of a project/investment is defined as the rate of discount at which the present value of cash inflows and present value of cash outflows are equal. IRR can be restated as the rate of discount, at which the present value of cash flow (inflows and outflows) associated with a project equal zero. Profitability Index (PI) Profitability ratio is otherwise referred to as Benefit/Cost ratio. This is an extention of the Net Present Value Method. This is a relative valuation index and hence is comparable across different types of projects requiring different quantum of initial investments. Profitability index (PI) is the ratio of present values of cash inflows to the present value of cash outflows. The present values of cash flows are obtained at a discount rate equivalent to the cost of capital. Modified Internal Rate of Return (MIRR): Shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used. Is basically the same as the IRR, except it assumes that the revenue (cash flows) from the project are reinvested back into the company, and are compounded by the company's cost of capital, but are not directly invested back into the project from which they came.

1.2

Report Objective The main objective of the study is

 To understand about how the financial institutions make capital expenditure decision. To understand practically the capital budgeting techniques.

1.3

Limitations

Time constraints Lack of accurate information from the respondents Lack of knowledge about capital expenditure to respondents Lack of reliability

Chapter 2 RESEARCH METHODOLOGY

2.1

Introduction Information was collected from five financial institutions of Pokhara. The five financial

institutions that were surveyed are NIC Bank Limited, Muktinath Bikas Bank, Garima Bikas Bank, Kist Bank and Lumbini Finance Company.

2.2

Research Design A research design is the specification of methods and procedures for acquiring the

information needed to structure to solve problems. The present study is exploratory in nature. The main aim of this study is to understand the capital expenditure practices in different institutions of Pokhara. The survey research design has been adopted for this study. The information were collected from the survey are analyzed according to the need of the study for the attaining the stated objectives. Also, the analyzed data are presented in graphs using SPSS package. 2.3 Sources of Data The data were collected in the form of i. ii. Primary Data Secondary Data

i. Primary Data was collected in the form of Questionnaire and personal interview. ii. Secondary Data was collected from

Internet Books

Chapter 3 DATA ANALYSIS 3.1 DATA INTERPRETATION

Data Interpretation can be defined as "the application of statistical procedures to analyze specific observed or assumed facts from a particular study". The collected data from each financial institution was compared with each other and then observed.

Views on capital expenditure 1. Garima Bikas Bank- it covers decisions to acquire other firms, either through the purchase
of their common stock or group of assets that can be used to conduct an ongoing business. It involves the entire process of planning expenditure with returns that are expected to extend beyond one year. 2. Muktinath Bikas Bank- Money spent to acquire and upgrade physical assets. 3. Kist Bank- Long term planning for making financial proposed capital outlay. 4. NIC Bank- Expenditure for acquiring physical assets at the time of establishment and expansion of bank, 5. LFLC- long term decision for investment in assets. For example: Tallo Modi Hydropower Project, Parbat It is a hydropower project. If project wants to take lone from bank to operating its activities, Project have to make capital structure and projected financial statement which shows future cash inflow and outflow from this project. After that, calculate the NPV, IRR, Discounted payback period of projected financial statement and have to submit banks credit analysis committee. Banks credit analysis committee also makes project financials statement and calculates the NPV, IRR, discounted payback period. Credit analysis committee have to tally both calculated figure, if any deviation found once times they can evaluate project and make a decision but companys calculated figure should greater than or equal to banks calculated figure and finally they make decision to invest on this project. Bank used the most appropriate tools to take final decision which is NPV and IRR because discounted payback period ignores cash flow after the expiration of the payback period. NPV and IRR may give contradictory result, but NPV shown to lead to the correct project selection because banks are expected to add greatest increment in value of the firm. Initial stage, bank doesnt provide loan fully they provides installment basis according to debt equity ratio to complete fixed period of task. If debt equity ratio have 80%, bank provides 48% loan and project should invest 52% equity to complete the fixed task during the fixed period. This cycle will be continuing up to end the project.

Taking about the capital expenditure fixed assets are included furniture fixture, office equipment, computer software, leasing, machinery items and vehicles. They are using deprecation method straight-line and diminishing balance method to depreciation and amortization according to nature. The table below indicates the same. Items Furniture Leasehold property Computer software Fixture(leasehold development) Computer accessories Office Equipment Machinery Vehicles Computer parts Depreciation charge 25% 5 years written off 25% 10% 25% 25% 15% 20% 15% SLM Diminishing rate Diminishing rate Diminishing rate Zero at the end of five year SLM Method SLM

Comparative study of five financial institutions in making capital expenditure decision

3.1.1 Origin
Official of similar salary or

Completion of proposal

Name

Type of project

Originator of proposal

rank status

Proposal origination Mgmt sponsored productivity scheme Formal suggestion scheme Mgmt sponsored productivity scheme Formal suggestion scheme Formal suggestion scheme

Use of proposal origination

origination decided by

GBL

Investment in loan

Board of directors

none

Memorandum

Financial Interaction committee

MBBL

Investment in loan

Board of directors

none

Memorandum

Financial manager

Kist

Investment in hydro project

Loan Approved Committee

some

Memorandum

Operation managers

NIC

Investment in loan

Board of directors

none

Memorandum

Loan head Financial Manager

LFLC

Investment in loan

Executive members

none Table 1

Specific form

From the table 1, it is clear that among the five financial institutions, Kist invests in Hydro project whereas rest of the financial institutions invests in loan and other development programs like construction of Blacktopped roads and infrastructure which were mentioned during the interview. It is also seen that Board of Directors are originators of proposals whereas in LFLC, executive members does. Similarly, LFLC uses specific form for proposal origination whereas other financial institutions use Memorandum for the same. It is also found that there are various governing body as seen in the table which decides the completion of proposal origination. Graph of the above table is also shown.

Fig 1 shows the type of project that financial institutions invest in. Among the five institutions surveyed, four has responded in favor of investments in loan and one institution in hydro project.

Fig 1 Fig 2 indicates the form used for proposal origination. Here, as stated in the table above four financial institutions uses Memorandum whereas one of the surveyed institutions uses a specific form for proposal origination.

Fig 2

3.1.2 Progression
Responsible Authorization of Name proposal Duty undertaken Preliminary investigation No production of CEO GBL CEO MBBL CEO Kist CEO NIC CEO LFLC Financial Manager Not any Loan Manager Loan manager Not any Loan Manager Loan manager Not any Loan Manager Financial Interaction Committee Loan manager prototype machine and products Not any Loan Manager Loan manager person for proposal study

Table 2 From the above table, it is found that CEO authorizes the proposal and Loan Managers are responsible for proposal study in the surveyed financial institutions. Financial Interaction Committee undertakes the duty at GBL whereas Loan Managers undertakes at MBBL, Kist & NIC and Financial Manager at LFLC. Fig 3 indicates the same.

Fig 3

3.1.3 Evaluation
Formal Name Financial Evaluation Evaluation of capital expenditure proposal Prices GBL subjected demanded by customers Working MBBL subjected capital requirement Prices quoted Kist subjected by suppliers 2 Debt coverage ratio Return on Equity NPV and IRR Cash inflowscash outflows NPV, IRR, Payback period and ARR NPV No. of years project assessed Assessment of cost to the firm of financing

Method of evaluation

Working NIC subjected capital requirement Working LFLC subjected capital requirement Table 3 From the table 3 it is found that all types of capital expenditure proposals are subjected to formal financial evaluation at the surveyed financial institutions. Increase working capital requirements is included for the evaluation of capital expenditure proposal at MBBL, NIC and LFLC whereas at GBL and Kist, evaluation is included in the form of prices demanded by customers and prices as quoted by suppliers respectively. There was no response when asked number of years a project is assessed but in Kist, estimation of 2 years would require. Inorder for evaluation method, NPV, IRR and payback period are normally followed. Cash inflowscash outflows NPV and IRR Debt/Equity ratio NPV and IRR

Fig 4 reflects the way in which the assessment of cost of the firm to the financing the capital invested.

Fi g4

Fig 5 reflects the method of evaluation used by institutions

Fig 5

3.1.4 Decision Appraisal

Changes in approach to capital expenditure management

Name

Practice to appraise profitability

Review the information

Benefits from decision appraisal

GBL

Project size

Financial committee

Profitable return

No changes

MBBL

Cost of project

Financial committee

Long term sustainability

No use of ARR Changes in the use of NPV, IRR and Payback period

Kist

Cost of project

Financial committee Financial committee Financial committee Table 4

Profitable return

NIC

Cost of project

Profitable return

No changes

LFLC

Project size

Profitable return

No ARR

Table 4 indicates the information about Decision Appraisal. It is found that size of the project is the practice followed to appraise the profitability of investments when they become operational at GBL and LFLC whereas cost of project determines the practice to appraise profitability among the rest. It is also found common in all the financial institutions surveyed that financial committee is the one who reviews the information on decision appraisal. Long term sustainability is the benefit resulted from decision appraisal at MBBL whereas Profitable return is the benefit resulted in rest of the financial institutions surveyed. Figures indicating the practice to appraise the profitability of investments and the benefits that have resulted from the decision appraisal are shown on the following page.

Fig 6 indicates the practice to appraise the profitability of investments when they become operational.

Fig 6 Fig 7 indicates the benefits that have resulted from decision appraisal.

Fig 7

3.2

MAJOR FINDINGS OF THE STUDY

Capital expenditure covers decisions to acquire other firms, either through the purchase

of their common stock or group of assets that can be used to conduct an ongoing business. It involves the entire process of planning expenditure with returns that are expected to extend beyond one year.
If the present value of project's future cash flow is greater than cost of project, than such

project is accepted. The institutions are using NPV for maximizing the wealth which measures the incremental wealth from undertaking the project. Such project is undertaken whose NPV is greater than zero.
Under capital budgeting techniques we found that, the institutions are using NPV,

payback period, IRR and even ARR. For making decision, NPV is mostly used as it shows present value of expected future cash flows.NPV is most preferred as it considers risk factor. In most of the institution we found that IRR is preferred after NPV criterion as it is affected by size of cash flows and consider reinvestment rate. It was found that profitability index was used by institutions to assess the amount of profit from investment in assets. It is the ratio of present value of cash inflows and cash outflows. It also assists in relative comparison of project as it is also a modified NPV.

Chapter 5 RECOMMENDATION
For the organizations: The institution should use capital budgeting techniques for making major investment decision and to implement it as it influence profitability. As founded that capital budgeting techniques is the lifeblood for undertaking major decision, financial institutions should pertain all the information require for capital budgeting expenditure. There should be discussions of quantitative estimates to represent decision model for administration of the capital expenditure decision process in these institutions. For the researcher:
Researcher need to prepare on the questionnaire part more so that the same could be

enquired with the interviewee with ease. It would have been better if various organizations are surveyed instead of only financial institutions.

REFERENCE
Brigham, E.F (June 2001, 10th edition). Financial Management Theory and Practice.

Florida: Thomson South Western Publication.

http://en.wikipedia.org/wiki/Capital_expenditure http://EzineArticles.com/3452410

Appendix