1.

1 INTRODUCTION
CAPITAL BUDGETING Capital Budgeting is the process of making investment decisions in capital expenditures. A capital expenditure may be defined as an expenditure the benefits of which are expenditure the benefits of which are expected to be received over period of time exceeding one year. The main characteristic of a capital expenditure is that the expenditure is incurred at one point of time whereas benefits of the expenditure are realized at different points of time in future. 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 firms 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 firms 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 firms 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.,

1.2 NEED FOR THE STUDY

Analyze the proposal for expansion or creating additional capacities.

Whether or not funds should be invested in long term projects such as setting of an industry, purchase of plant and machinery etc.

To decide replacement of permanent asset such as building and equipments.

To make financial analysis of various proposals regarding capital investments so as to choose the best out of many alternative proposals.

To know how the company gets funds from various resources.

1.3 OBJECTIVES OF THE STUDY

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

To understand the practical usage of capital budgeting techniques

To study the relevance of capital budgeting in evaluating the project for project finance in HDFC.

To measure the present value of rupee invested.

To understand the nature of risk and uncertainty

To understand an item wise study of the company financial performance of HDFC.

To make suggestion if any for improving the financial position if the company.

1.4 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 with the accountants and other persons in the financial department. A part from these some information is collected through the seminars, which were held by HDFC

Secondary sources Secondary data has been collected from various sources such as: Publications of the company Business magazines Journals, text books Websites Annual reports

In order to gain information on current practices and problems, the area chosen for study are the emerging and competitive companies in and around Hyderabad City.

1.5. COMPLEXITIES INVOLVED IN CAPITAL BUDGETING DECISIONS:

Capital expenditure decision involves forecasting of future operating cash flows. Such forecasting suffers from uncertainty because the future is highly uncertain. Forecasting the future cash flows demands the necessity to make certain assumptions about the behavior of costs and revenues in future. Fast changing environment makes the technology considered for implementation many times obsolete. For example, the arrival of mobile revolution totally made the pager technology obsolete. The firms which invested in pagers faced the problem of pagers losing its relevance as a means of communication. The firms with the ability to adapt the new knowhow in mobile technology could survive the effect of this phase of technological obsolescence. Others who could not manage the effect of change in technology had a natural death and so most Capital expenditure decisions are irreversible. Estimation of future cash flows of Capital budgeting decisions is really complex and difficult commitment of funds on long term basis along with the associated problem of irreversibility of decisions and difficulty in estimating cash flows makes Capital expenditure decisions complex in nature.

2.1. INTRODUCTION: An efficient allocation of capital is the most important finance function in the modern times. It involves decisions to commit the firms funds to the long term assets. Such decisions are of considerable importance to the firm since they tend to determine its size by influencing its growth, profitability and risk.

MEANING: Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting. capital budgeting is also known as Investment Decision Making, Capital Expenditure Decision, Planning Capital Expenditure and Analysis of Capital Expenditure.

DEFINITION: According to Charles T.Horngreen, Capital budgeting is long term planning for making and financing proposed capital outlays. According to Lynch, Capital budgeting consists in planning development of available capital for the purpose of maximizing the long term profitability of the concern.

NATURE OF INVESTMENTS:

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. A capital budgeting decision may be defined as the firms decisions to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of years. The long term assets are those which affect the firms operations beyond the one year period

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 firms 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 firms 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 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 decisions 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 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

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

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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 PROCESS:

Capital budgeting is a complex process as it involves decisions relating to the investment of current funds for the benefit to the achieved in future and the future is

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always uncertain. However, the following procedure may be adopted in the process of capital budgeting:

1 Identify Investment Proposals

2 Screen Proposals

7 Review Performance

CAPITAL BUDGETING PROCESS

3 Evaluate Various Proposals

6 Implement The Proposals 5 Final Approval

4 Fix Priorities

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1. IDENTI FICATION OF INVESTMENT PROPOSALS: The capital budgeting process begins with the identification of investment proposals. Investment opportunities have to be identified or created; they do not occur automatically. Investment proposal of various types may originate at different levels within a firm. Most proposals, in the nature of cost reduction or replacement or process or product improvement takes place at plant level. The contribution of top management in generating investment ideas is generally confined to expansion or diversification projects. The proposal may originate systematically in a firm. In view of the fact that enough investment proposals should be generated to employ the firms funds fully well and efficiently, a systematic procedure for generating proposal may be evolved by a firm. In a number of Indian companies, more than 50% of the investment ideas are generated at the plant level. Indian companies uses a variety of methods to encourage idea generation.

2. SCREENING THE PROPOSALS: The expenditure planning committee screens the various proposals received from different departments. The committee views these proposals from various angles to ensure that these are in accordance with the corporate strategies, selection criterion of the firm and also do not lead to departmental imbalances. 3. EVALUATION OF VARIOUS PROPOSALS: The evaluation of projects should be performed by group of experts who have no axe to grind. For example, the production people may generally interested in having the most modern type of equipment and increased production even of productivity is expected to be low and

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goods cannot be sold this attitude can bias their estimates of cash flows of the proposed projects. Similarly, marketing executives may be too optimistic about the sales prospects of goods manufactured, and overestimate the benefits of a proposed new product. It is therefore, necessary to ensure that projects are scrutinized by an impartial group and that objectivity is maintained in the evaluation process.

A company in practice should take all care in selecting a method or methods of investment evaluation. The criterion or criteria selected should be a true measure of evaluating if the investment is profitable(in terms of cash flows), and it should lead the net increase in the companys wealth(that is, its benefits should exceeds its costs adjusted for time value and risk).

4. FIXING PRIORITIES: After evaluating various proposals, the unprofitable or uneconomic proposals may be rejected straight away. But it may not be possible for the firm to invest immediately in all the acceptable proposals due to limitation of funds. Hence, it is very essential to rank the various proposals and to establish priorities after considering urgency, risk and profitability involved therein.

5. FINAL APPROVAL AND PREPARATION OF CAPITAL EXPENDITURE BUDGET: Proposals meeting the evaluation and criteria are finally approved to be included in the capital expenditure budget. However, proposals involving smaller investment may be decided at the lower for expenditure action. The capital expenditure budget lays down the amount of estimated expenditure to be incurred on fixed assets during the budget period.

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6. IMPLEMENTING PROPOSAL: Preparation of a capital expenditure budgeting and incorporation of a particular proposal in the budget does not itself authorize to go ahead with the implementation of the project a request for authority to spend the amount should further be made to the capital expenditure committee which may like to review the profitability of the project, in the changed circumstances. Further, while implementing the project, it is better to assign responsibilities for completing the project within the given time frame and cost limit so as to avoid unnecessary delays and cost over runs. Network techniques used in the project management such as PRRT and CPM can also be applied to control and monitor the implementing of the projects.

7. PERFORMANCE REVIEW: A capital projects reporting system is required to review and monitor the performance of investment projects after the completion and during their life. The follow up comparison of the actual performance with original estimate not only ensure better forecasting. Based on the follow up feedback, the company may reappraise its projects and take remedial action. Indian companys practices control of capital expenditure through the use of regular project reports. Some companies required quarterly reporting, monthly, half yearly and yet a few companies require continuous reporting. In most of the companies the evaluation reports include information on expenditure to date stage of physical completion, and revised total cost.

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3.1. 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

Traditional or non-discounting

Time- adjusted or discounted cash flows

Pay back period Accounting rate of return

Net present value Profitability index Internal rate of return

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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 payback period can be computed by dividing cash outlay by the annual cash inflows.

Payback period = Initial investment Annual cash flow

Accept reject rule: Many firms use the payback period as accept/reject criterion as well as a method of ranking projects. If the payback 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.

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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 payback 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: It does not take into account the cash inflows earned after the payback 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.

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 It is difficult to determine the minimum acceptable payback 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 depreciated constantly. Alternatively, it can be found out dividing the total of the investments 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:

ARR=Average annual income (after tax & depreciation) Average investment 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 projects 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.

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 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 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.

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:

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:

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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: Net present value is used as an accept or reject criteria. In case NPV is positive (NPV0) 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 firms 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.

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 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.

INTERNAL RATE OF RETURN METHOD: 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.

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CALCULATION OF INTERNAL RATE OF RETURN: Calculate cash flow after tax Calculate fake payback period or factor by dividing the initial investment by average cash flows. Look for the factor in the present value annuity table in the years column until you arrive at a figure which is closest to the fake payback 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.

IRR

Present value _ Cash at lower rate out flow X diff. in the rates Present value _ present value 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.

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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 holders 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. 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:

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 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.

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: PI= PRESENT VALUE OF CASH INFLOWS INITIAL CASH OUTLAY ACCEPT OR REJECT CRITERION: The following are the PI acceptance rules: Accept if PI>1 Reject if PI<1 May accept if PI=1 When PI is greater than one, then the project will have net present value.

EVALUATION OF PI METHOD: It recognizes the time value of money

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It is a variation of the NPV method, and requires the same computation as the NPV method. 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

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as a 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 uncertainty 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

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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 projects 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.

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. Certainty 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 assumes 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

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considered in combination with other proposals to the maximum utilization of available funds.

TYPES OF CAPITAL BUDGETING DECISIONS FROM THE POINT OF VIEW OF FIRMS EXISTENCE:

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. 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 decisions may

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 firms revenue may remain unchanged. Assets become outdated and obsolete with

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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.

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.

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 be classified from the point of view of the decision situation as follows:

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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 proposal 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.

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. 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

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firm may straight accept or reject a proposal on the basis of a maximum return on investment required. 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) proposals 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 overall objectives are to maximize the profits and thus optimizing the return on investment. Thus capital expenditure can be of two types:

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:

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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.

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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 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 shareholders 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.

36

 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 shareholders 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. DATA ANALYSIS Various methods are used for ascertainment of profitability of capital expenditure. The practical usages of these methods are discussed here under:

PAY BACK METHOD: This method tells us the number of years required to recover the initial investment of that asset. It is calculated Payback period = Initial Investment Annual cash flow The shorter the payback period, lesser the risk of investment and greater its liquidity.

TO ILLUSTRATE: YEAR 1 2 3 4 5 PROJECT X 10000 20000 40000 50000 80000 PROJECT Y 20000 40000 60000 80000 These cash flows are earned from investment of Rs.200000 for each project.

37

The annual cash inflows are not constant so we calculate cumulative cash inflows in order to compute the payback period.

Project-X: Year 1 2 3 4 5 Cash inflows 20000 30000 40000 50000 80000 Initial investment = 200000 Cumulative cash inflows 20000 (20000+30000) (50000+40000) (90000+50000) (140000+80000)

Amount received up to the 4th year = 140000 Amount to be received in 5th year = 60000 (200000-140000) Cash flows after taxes in 5th year = 80000 PBP = 4Yrs + 60000 80000 = 4 + 0.75 years = 4 years and 9 months Project-Y Year 1 2 3 4 5 Cash inflows 20000 40000 50000 70000 40000 Initial investment = 200000 Amount received up to the 4th year = 180000 Amount to be received in 5th year = 20000 (200000-180000) Cash flows after taxes in 5th year = 40000 PBP = 4Yrs + 20000 40000 Cumulative cash inflows 20000 (20000+40000) (60000+50000) (110000+70000) (180000+40000)

38

= 4 + 0.50 years = 4 years and 6 months Hence, from the above given projects, project-Y has to be selected. As it payback period is less than project-X. 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 ARR= Average Annual Profit after taxes X100 Annual Average investment TO ILLUSTRATE: A project requires an investment of Rs.1200000 and has a scrap value of Rs.200000 after five years. It is expected to yield profits after depreciation and taxes during the five years amounting to Rs.250000, Rs.300000, Rs.350000, Rs.400000 and Rs.200000. Calculate the average rate of return on the investment. SOLUTION: Total profit = Rs. 250000+300000+350000+400000+200000 = Rs. 1500000 Average profit = 1500000 5 = Rs. 300000 New investment in the project = Rs. 1500000 200000 (Scrap value) = Rs. 1300000 Average rate of return = Average Annual profit Net Investment in the Project X 100

= 300000 X100 1300000 = 23.076%

39

This method is based on accounting information rather upon cash flows. This method is simple and makes use of readily available accounting information. Once 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. 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 payback period.

TO ILLUSTRATE: The Alpha Company Ltd. is considering the purchase of a new machine. Two alternative machines (A and B) have been suggested each costing Rs.400000. Earning after taxation is expected to be as follows:

YEAR 1 2 3 4 5

CASH FLOW OF MACHINE-A 40000 120000 160000 240000 160000

CASH FLOW OF MACHINE-B 120000 160000 200000 120000 80000

The company has a target of return on capital of 10% and on this basis. You are required to compare the probability of the machines and state which alternative you consider financially preferable.

40

SOLUTION: The profitability of the machine can be compared on the basis of net present value of cash inflows as follows:

Year 1 2 3 4 5

PRESENT VALUE OF CASH FLOWS Discount Cash inflow Present Cash value inflows 0.91 40000 36400 120000 0.83 0.75 0.68 0.62 120000 160000 240000 160000 99600 120000 163200 99200 518400 Machine-A 160000 200000 120000 80000

Present value 109200 132000 150000 81600 49600 523200 Machine-B

Net present value (-) Initial Investment

518400 (400000) 118400

523200 (400000) 123200

P.I=Present Value of Cash Inflows Initial Investments

= 518400 400000 = 1.29

= 523200 400000 = 1.30

The net present values as well as the profitability index are higher in case of Machine B and hence Machine B will be preferred.

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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 techniques 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 company is considering investment in a project that costs Rs.200000. The project has an expected life of 5 years and zero salvage value. The company uses straight line method of depreciation. The companys tax rate is 40%. The estimated earnings before depreciation and before tax from the project are as follows:

Year CFBT PVCF

1 70000 0.909

2 80000 0.826

3 120000 0.751

4 90000 0.683

5 60000 0.621

You are required to calculate the present value at 10% and advise the company

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SOLUTION:

Years

Earnings before dep.& tax 70000 80000 120000 90000 60000

Calculation of Cash Flows Depreciation EBT Tax EAT

1 2 3 4 5

40000 40000 40000 40000 40000

30000 40000 80000 50000 20000

12000 16000 32000 20000 8000

18000 24000 48000 30000 12000

Cash Flows (EAT+ Dep.) 58000 64000 88000 70000 52000

PV @ 10% 0.909 0.826 0.751 0.683 0.621

PV of Cash Flow 52722 52864 66088 47810 32292

Total present value of cash inflows Less: present of Initial cost

= 251776 = (200000) = 51776

The net present value of the project is 51776.

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

Profitability index =

PV of cash inflows PV of cash outflows

TO ILLUSTRATE:

43

The initial cash outlay of a project is Rs.50000 and it generates cash inflows of Rs.20000, Rs.15000, Rs.25000 and Rs.10000 in four years. Using present value index method, appraise profitability of the proposed investment assuming 10% rate of discount.

SOLUTION: Calculations of present values and profitability index: Year 1 2 3 4 Cash Inflows 20000 15000 25000 10000 Present Value Factor @10% 0.909 0.826 0.751 0.683 Present Value 18180 12390 18775 6830 56175 Profitability Index = Present value of Cash Inflows Initial Cash Outlay = 56175 50000 Profitability Index = 1.1235

As the P.I is higher than 1, the proposal can be accepted.

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

44

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:

Initial Investment Life of the Asset Estimated Net Annual Cash Flows: 1st Year 2nd Year 3rd Year 4th Year Calculate Internal Rate of Return.

Rs.60000 4 years

15000 20000 30000 20000

SOLUTION: Cash Flow Table at various Assumed Discount Rates of 10%, 12%, 14% & 15%

Year 1 2 3 4

Annual Dis rate 10% Cash P.V.F P.V Flow Rs. 15000 0.909 13635 20000 30000 20000 0.826 0.751 0.683 16520 22530 13660 66345

Dis rate 12% P.V.F P.V Rs. 0.892 13380 0.797 0.711 0.635 15940 21330 12700 63350

Dis rate 14% P.V.F P.V Rs. 0.877 13155 0.769 0.674 0.592 15380 20220 11840 60595

Dis rate 15% P.V.F P.V Rs. 0.869 13035 0.756 0.657 0.571 15120 19710 11420 59285

The present value of net cash flows at 14% rate of discount is Rs.60595 and at 15% rate of discount it is Rs.59285. So the initial cost of investment which is Rs.60000 falls

45

in between these two discount rates. At 14% the NPV is +595 but at 15% the NPV is -715, we may say that

IRR=

Present value _ at lower rate Present value _ at lower rate

Cash out flow X diff. in the rates present value at higher rate

IRR= 14% +

595 X (15% - 14 %) 595 + 715

= 14.45%

INTRODUCTION: SLOGAN:With you right through. Helping Indians experience the joy of home ownership.

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The road to success is a tough and challenging journey in the dark where only obstacles light the path. However, success on a terrain like this is not without a solution. As HDFC found out over three decades ago, in 1977 the solution for success is customer satisfaction. All you need is the courage to innovate, the skill to understand your clients and the desire to give them your best. HDFCs objective from the beginning has been to enhance residential housing stock and promote home ownership. Now, HDFCs offerings range from hassle free home loans and deposit products, to property related services and a training facility. HDFC also offers specialized financial services to their customer base through partnerships with some of the best financial institutions worldwide. OBJECTIVES AND BACKGROUND: Against the trend of rapid urbanization and a changing socio-economic scenario, the demand for housing has grown explosively. The importance of housing sector in the economy can be illustrated by a few key statistics. According to the National Building Organization (N.B.O), the demand for housing is estimated at two million units per year and the total housing short fall of estimated to be 19.4 million units, of which 12.76 million units is from rural areas and 6.64 million units is from urban areas. The housing industry is second largest employment generator in the country. It is estimated that the budgeted two million units would lead to the creation of an additional ten million manyears of direct employment and another 15 million man-years of indirect employment BACKGROUND: HDFC was incorporates in the year 1977, with the primary objective of meeting a social need that of promoting home ownership by providing long-term finance to house holds for their housing needs. HDFC was promoted with an initial share capital of Rs.100 millions.

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BUSINESS OBJECTIVES: The primary objective of HDFC is to enhance residential housing stock in the country through the provision of housing finance in a systematic and professional manner and to promote home ownership. Another objective is to increase the flow of resources to the housing sector by integrating housing finance sector with overall domestic financial markets.

ORGANIZATIONAL GOALS: 1. Develop close relationships with individual households. 2. Maintain its position has a premier housing finance institution in the country. 3. Transform ideas into viable and creative solutions 4. Provide consistently high returns to shareholders. 5. To grow through diversification, by leveraging off the existing client base. CONSULTANCY SERVICES: HDFC is a unique example of housing finance company that has demonstrated the viability of market oriented housing finance in a developing country. It is viewed as a market leader in the Housing finance sector in India. The World Bank considers HDFC a model private sector housing finance company in developing countries and a provider of technical assistance for new and existing institutions in India and abroad. HDFCs executives have undertaken consultancy assignments related to housing finance and urban development on behalf of multi lateral agencies allover the world. HDFC has also served as consultant to international agencies such as World Bank, United States Agency for International Development (USAID), Asian Development

48

Bank, United Nations Centre for Human Settlements, Common wealth Development Corporation (CDC) and United Nations Development Programme (UNDP). At the national level, HDFCs executives have played a key role in formulating national housing policies and strategies. Recognizing HDFCs executives to join a number of comities and task force related to housing finance, urban development and capital markets.

SUBSIDARY & ASSOCIATE COMPANIES: HDFC Bank. HDFC Mutual Fund. HDFC Standard Life Insurance Company. HDFC Securities. HDFC Reality. HDFC Chubb General Insurance Company ltd. Intel net Global services. Credit Information Bureau (India) Ltd. Other Companies Co-Promoted by HDFC.

HOUSING DEVELOPMENT FINANCE CORPORATION HDFC Bank was incorporated in August 1994 in the name of HDFC Bank Limited, with its registered office in Mumbai, India. The Bank commenced operations as a Scheduled Commercial Bank in January 1995. The Housing Development Finance

49

Corporation Limited (HDFC) was amongst the first to receive an in principle approval from the Reserve Bank of India (RBI) to set up a bank in the private sector, as part of the RBIs liberalization of the Indian Banking Industry in 1994. Headquartered in Mumbai, HDFC Bank, has a network of over 531 branches spread over 228 cities across India. All branches are linked on an online real-time basis. Customers in over 120 locations are serviced through Telephone Banking. The Bank also has a network of about over 1054 networked ATMs across these cities. HDFC Banks ATM network can be accessed by all domestic and international Visa, MasterCard, Visa Electron, Maestro, Plus, Cirrus and American Express Credit, Charge cardholders. The Banks expansion plans take into account the need to have a presence in all major industrial and commercial centers where its corporate customers are located as well as the to build a strong retail customer base for both deposits and loan products. Being a clearing settlement bank to various leading stock exchanges, the Bank has branches in the centers where the NSE/BSE has a strong and active member base. HDFC Bank also has Private Banking Group which offers investment advisory and portfolio management services to its clients. HDFC Bank has won many awards for its excellent service. Major among them are Best Bank in India by Hong Kong-based Finance Asia magazine in 2006 and Company of the Year Award for Corporate Excellence 2005-05. Business Today has declared HDFC Bank the Best Bank for the year 2007. Net Profit for the nine months ended 31st December 2007 up by 31.3%. PROMOTERS 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

50

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, a strong market reputation, large shareholder base and unique consumer franchise, HDFC was ideally positioned to promote a bank in the Indian environment BUSINESS FOCUS HDFC Bank's mission is to be a World-Class Indian Bank. The objective is to build sound customer franchises across distinct businesses so as to be the preferred provider of banking services for target retail and wholesale customer segments, and to achieve healthy growth in profitability, consistent with the bank's risk appetite. The bank is committed to maintain the highest level of ethical standards, professional integrity, corporate governance and regulatory compliance. HDFC Bank's business philosophy is based on four core values - Operational Excellence, Customer Focus, Product Leadership and People. BUSINESS STRUCTURE The authorized capital of HDFC Bank is Rs.450 crore (Rs.4.5 billion). The paid-up capital is Rs.311.9 crore (Rs.3.1 billion). The HDFC Group holds 22.1% of the bank's equity and about 19.4% of the equity is held by the ADS Depository (in respect of the bank's American Depository Shares (ADS) Issue). Roughly 31.3% of the equity is held by Foreign Institutional Investors (FIIs) and the bank has about 190,000 shareholders. The shares are listed on the Stock Exchange, Mumbai and the National Stock Exchange. Shares are listed on the New York Stock Exchange (NYSE) under the symbol "HDB".

51

MANAGEMENT Mr. Jadish Capoor took over as the bank's Chairman in July 2002. Prior to this, Mr. Capoor was a Deputy Governor of the Reserve Bank of India.

The Managing Director, Mr. Aditya Puri, has been a professional banker for over 25 years and before joining HDFC Bank in 1994 was heading Citibank's operations in Malaysia. The Bank's Board of Directors is composed of eminent individuals with a wealth of experience in public policy, administration, industry and commercial banking. Senior executives representing HDFC are also on the Board. Senior banking professionals with substantial experience in India and abroad head various businesses and functions and report to the Managing Director. Given the professional expertise of the management team and the overall focus on recruiting and retaining the best talent in the industry, the bank believes that its people are a significant competitive strength. TECHNOLOGY HDFC Bank operates in a highly automated environment in terms of information technology and communication systems. All the bank's branches have online connectivity, which enables the bank to offer speedy funds transfer facilities to its customers. Multi-branch access is also provided to retail customers through the branch network and Automated Teller Machines.(ATMs).

BUSINESSES WHOLESALEBANKING: The Bank's target market ranges from large, blue-chip manufacturing companies in the Indian corporate to small & mid-sized corporate and agri-based businesses. For these customers, the Bank provides a wide range of commercial and transactional banking

52

services, including working capital finance, trade services, transactional services, cash management, etc. The bank is also a leading provider of structured solutions, which combine cash management services with vendor and distributor finance for facilitating superior supply chain management for its corporate customers. Based on its superior product delivery / service levels and strong customer orientation, the Bank has made significant inroads into the banking consortia of a number of leading Indian corporate including multinationals, companies from the domestic business houses and prime public sector companies. It is recognized as a leading provider of cash management and transactional banking solutions to corporate customers, mutual funds, stock exchange members and banks. Retail banking services The objective of the Retail Bank is to provide its target market customers a full range of financial products and banking services, giving the customer a one-stop window for all his/her banking requirements. The products are backed by world-class service and delivered to the customers through the growing branch network, as well as through alternative delivery channels like ATMs, Phone Banking, and Net Banking and Mobile Banking.

The HDFC Bank Preferred program for high net worth individuals, the HDFC Bank Plus and the Investment Advisory Services programs have been designed keeping in mind needs of customers who seek distinct financial solutions, information and advice on various investment avenues. The Bank also has a wide array of retail loan products including Auto Loans, Loans against marketable securities, Personal Loans and Loans for Two-wheelers. It is also a leading provider of Depository Participant (DP) services

53

for retail customers, providing customers the facility to hold their investments in electronic form.

HDFC Bank was the first bank in India to launch an International Debit Card in association with VISA (VISA Electron) and issues the MasterCard Maestro debit card as well. The Bank launched its credit card business in late 2002. By September 30, 2006, the bank had a total card base (debit and credit cards) of 5.2 million cards. The Bank is also one of the leading players in the "merchant acquiring" business with over 50,000 Point-of-sale (POS) terminals for debit / credit cards acceptance at merchant establishments. Treasury Within this business, the bank has three main product areas - Foreign Exchange and Derivatives, Local Currency Money Market & Debt Securities, and Equities. With the liberalization of the financial markets in India, corporate need more sophisticated risk management information, advice and product structures. These and fine pricing on various treasury products are provided through the bank's Treasury team. To comply with statutory reserve requirements, the bank is required to hold 25% of its deposits in government securities. The Treasury business is responsible for managing the returns and market risk on this investment portfolio CREDIT RATING HDFC Bank has its deposit programmers rated by two rating agencies - Credit Analysis & Research Limited. (CARE) and Fitch Ratings India Private Limited. The Bank's Fixed Deposit programme has been rated 'CARE AAA (FD)' [Triple A] by CARE, which represents instruments considered to be "of the best quality, carrying negligible

54

investment risk". CARE has also rated the Bank's Certificate of Deposit (CD) programme "PR 1+" which represents "superior capacity for repayment of short term promissory obligations". Fitch Ratings India Pvt. Ltd. (100% subsidiary of Fitch Inc.) has assigned the "tAAA (ind)" rating to the Bank's deposit programme, with the outlook on the rating as "stable". This rating indicates "highest credit quality" where "protection factors are very high". HDFC Bank also has its long term unsecured, subordinated (Tier II) Bonds of Rs.4 billion rated by CARE and Fitch Ratings India Private Limited. CARE has assigned the rating of "CARE AAA" for the Tier II Bonds while Fitch Ratings India Pvt. Ltd. has assigned the rating "AAA (Ind)" with the outlook on the rating as "stable". In each of the cases referred to above, the ratings awarded were the highest assigned by the rating agency for those instruments. Corporate Governance Rating The bank was one of the first four companies, which subjected itself to a Corporate Governance and Value Creation (GVC) rating by the rating agency, The Credit Rating Information Services of India Limited (CRISIL). The rating provides an independent assessment of an entity's current performance and an expectation on its "balanced value creation and corporate governance practices" in future. The bank has been assigned a 'CRISIL GVC Level 1' rating which indicates that the bank's capability with respect to wealth creation for all its stakeholders while adopting sound corporate governance practices is the highest.

HDFC was incorporated in 1977 as the first specialized Mortgage Company in India. HDFC provides financial assistance individuals, corporate and developers for the purchase or construction of residential housing. It also provides property services (e.g. property identification, sales services and valuation), training and consultancy. Of

55

these activities, housing finance remains the dominant activity. HDFC has a client base of around 10, 00,000 borrowers, around 8, 50,000 depositors, over 92,000 shareholders and 50,000 deposit agents, as at December 31, 2010. HDFC has raised funds from international agencies such as the World Bank, IFC (Washington), USAID, DEG, ADB and KfW, international syndicated loans, domestic term loans from banks and insurance companies, bonds and deposits. HDFC Standard Life Insurance Company Limited, promoted by HDFC was the first life insurance company in the private sector to be granted Certificate of Registration (on October 23, 2001) by the Insurance Regulatory and Development Authority to transact life insurance business in India.

AWARDS AND ACCOLADES: HDFC ranked no.3-Indias Best managed Companies by Finance Asia Clean Sweep by HDFC at the 43rd ABCI Awards. National Award for Excellence in Corporate Governance by the Institute Of Companies Secretaries of India. 2nd best company for Corporate Governance in India by The Asset Magazine. The Economic Times Lifetime achievement Award 2009 (Mr. Deepak Parekh, Chairman, HDFC ltd.). One of the top ten- Most Admired Companies in India 2004 by Business barons. One of the top ten Most Admired CEOs in India 2004 by Business Barons (Mr. Deepak Parekh). Indias second Best Managed Company-2009 by Financial Asia. Indias biggest wealth creator in the banking and financial services by the fourth Business Today-Stern Steward Survey.

56

 Highest rating for Governance and Value Creation by CRISIL> Best Managed Financial Institutions in India by Fox Pitt Survey. HDFC Bank began operations in 1995 with a simple mission: to be a "Worldclass Indian Bank". As part of the Asian Banker Awards 2004. In 2010, HDFC Bank was selected by Business World as "One of India's Most Respected Companies" as part of The Business World Most Respected Company Awards 2010. In 2010, HDFC Bank won the award for "Operational Excellence in Retail Financial Services" India.

INTRODUCTION: 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

57

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 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 concerns required rate of return is the concerns 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 concerns cost of capital or required rate of return is 14%. This required rate is compared at the concerns 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.

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USE OF IRR TECHNIQUE IS EXPLAINED WITH THE HELP OF THE FOLLOWING EXAMPLE M/S ventech private limited 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 overall project cost is worked at RS.3003 lakhs as given below: (RS in lakhs) Project cost Land Buildings Plant & machinery Factory equipment Electrical Computers & furniture Vehicles Deposits Working capital margin Existing 70.00 233.00 518.00 4.00 20.00 7.00 21.00 30.00 40.00 943.00 --280.00 2060.00 Proposed --200.00 1580.00 --------30.00 320.00 3003.00 Total 70.00 433.00 2098.00 4.00 20.00 7.00 21.00

The project has been appraised by HDFC and worked out the following economics for the project: Capacity utilisation = 90% Sales = RS.3314 lakhs

MANUFACTURING EXPENSES (A) (RS. In lakhs) Raw materials 1553.00

59

Con Power & fuel Wages Repairs & maintenance Taxes Other inputs

31.00 303.00 50.00 54.00 42.00 42.00 2076.00

ADMINISTRATIVE EXPENSES (B) (RS. In lakhs)

Management remunerating Salaries Other expenses

12.00 22.00 42.00 76.00

Total cost of production (A+B) Gross profit

2151.00 1163.00

FINANCIAL EXPENSES Interest on term loans Interest on bank borrowing 230.00 65.00 295.00 868.00 Depreciation Operating profit Provision for taxation 355.00 513.00 173.00

60

Profit after tax

340.00

Net profit before taxes Interest added back, but after depreciation

808.00

The project cost is met as under: (RS. In lakhs) Existing Equity share capital Reserves & surplus Term loan fromNTPC Unsecured loans 175.00 76.00 494.00 198.00 943.00 proposed 407.00 153.00 1500.00 --2060.00 Total 582.00 229.00 1994.00 198.00 3003.00

The cash flows are generated for 8years at follows: CASH INFLOW E.B.I.T DEPRECIATION TOTAL 1ST YR 808 355 1163 2ND YR 914 311 1225. 3RD YR 937 267 1204 4TH YR 963 229 1191 5TH YR 981.01 196.35 1177.37 6TH YR 995 169 1163 (RS. In lakhs) 7TH 8TH YR YR 1003 1008 145 124 1148 1132

The procedure adopted for calculating IRR is as given:

61

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.

The following assumptions are made:

The life of the project is assumed at 15 years The residual value of fixed assets at the end of 15 years is taken as NIL excluding cost at land. The realizable value of current assets is at 100% The interest rate changed for the term loan being sanctioned is assumed at 12%. The term loan being sanctioned is expected to be repaid in a period of 8 years.

The outlay is expected to be spent in a period of 3 years as Follows:

(RS. In lakhs) O year 1st year 3rd year 2683 920

52 3655 IRR can be calculated manually or by using computers. The IRR is calculated by using computer as follows is as under:

Year construction 1st

Capital out lay 2683.25 920.00

benefits 0.00 1162.57

Net benefits -2683.25 242.57

Discounted benefits -2683.25 180.34

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2nd 3rd 4th 5th 6th 7th 8th 9th 10th 11th 12th 13th 14th 15th

51.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

1225.45 1203.76 1190.87 1177.37 1163.16 1148.28 1132.62 1132.62 1132.62 1132.62 1132.62 1132.62 1132.62 2333.21

1174.34 1203.76 1190.87 1177.37 1163.16 1148.28 1132.62 1132.62 1132.62 1132.62 1132.62 1132.62 1132.62 2333.21

649.05 494.62 363.78 267.38 196.38 144.13 105.69 78.57 58.41 43.43 32.39 24.00 17.84 27.33

Re projects IRR is worked at 34.5%

OBSERVATIONS:

The IRR for the instant project proposal is worked out at 34.5% The cost of capital or cut off rate is interest rate charged by HDFC that is 12% 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 values of inflows are equal to present value of out flows.

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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 projects 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.

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 employment. The corporation has completed 25 years of service and to mark this occasion Golden Jubilee Celebration was conducted during 2006-2007 HDFC has achieved tremendous results during 2006-2007 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 5th year

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The evaluation techniques are broadly classified into two types i.e traditional technique and discounted cash flow technique. The traditional technique includes net pay back period, average rate of return The discounted cash flow 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 works out Internal Rate Of Return in appraisal of the project among the capital budgeting technique.

An accept-reject criterion has been applied for all the capital budgeting methods. The result in this case study suggests 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.

CONCLUSIONS

All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not practically be true in some particular circumstances. The techniques of capital budgeting require estimation of future cash inflows and outflows. The future is always uncertain and the data collected for future may not be exact. Obviously the results based upon wrong data may not be good. There are certain factors like morale of the employees, goodwill of the firm, etc., which cannot be correctly quantified but which otherwise substantially influence the capital decision.

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 Urgency is another limitation in the evaluation of capital investment decisions. Uncertainty and risk pose the biggest limitation to the techniques of capital budgeting.

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.

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 All the techniques of capital budgeting are not used in HDFC. Therefore it was possible to explain only few methods of capital budgeting.

BIBLOGRAPHY:

Financial Management Management Accountancy Financial Management Advanced Accountancy Financial Management Management Accountancy

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I.M. Pandey Khan & Jain S.N. Maheshwari S.P. Jain & K.V. Narayana Prasanna Chandra Sharma & Shashi K. Gupta

HDFC Annual reports

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WWW.hdfc.com WWW.HDFCINDIA.COM

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