Professional Documents
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DECLARATION
I here by declare that this project report entitled A Study on Capital Budgeting Decisions at, The Godavari Biorefineries Ltd, Sameerwadi is submitted to Karnataka University Dharwad in partial fulfillment for the award of the degree of Masters of Business Administration. It has not been submitted previously in part or full to any Universities or institutes for the award of any degree or diplomas. It has been done under the guidance and supervision of Prof. SUSHMA PATIL faculty and internal guide of KLSs Institute of Management Education & Research, Belgaum. To the best of my knowledge and belief, this report is original and bona fide work prepared by me.
ACKNOWLEDGEMENT
I sincerely thank the management of Godavari Biorefineries Ltd, Sameerwadi, for giving me an opportunity to undergo my summer In Plant Project. I thank to Mr.A.M.ASTAGI (Asst, manager Personal) and Mr. Mitesh, for helping me to carry out my training under them and providing me with their valuable time and information. I thank all the staff, employees of Godavari Biorefineries Ltd, Sameerwadi for their cooperation and help during my every visit. I take this opportunity to express my humble and deep sense of gratitude to our esteemed Director and respected professors for their constant rendered support, for successful completion of this project report. I am very grateful to all the staff members of different departments, who have been very helpful in furnishing information and completing this project.
EXECUTIVE SUMMARY
The Godavari Biorefineries Ltd, Sameerwadi is the biggest sugar industry (12000 TCD) in India which is located in the Karnataka state Bagalkot district Mudhol taluka at the perfect place where the large number of business opportunities are there. Here the sugar cultivation is very high. This Industry is not only concentrating on core product i.e. Sugar but it also invested much more money in by products of the sugar industry. It has by products plants of POWER DIVISION, CHEMICAL DIVISION, BIO GAS, ETHYLE LACTATE, SPIRIT AND ALCHOHOL, FERTILIZER many more. It is the first sugar plant to implement SAP in INDIA. The study gives an idea about the Capital Budgeting. Capital Budgeting refers to the process which companies allocate funds to various investment projects designed to ensure profitability and growth. Evaluation of such project involves estimation their future benefits to the company and comparing these with their costs. Effective capital bugeting begins with an understanding of two elements : 1. The capital requirements of the organization, both now and in the future (capital expansion),and 2. An understanding of the requirements to maintain present capital assets in a useful state (maintenance). There are methods upon which the decisions relating to capital budgeting and criterias for investment proposals are evaluated. If any project or investment proposal is feasible then that is selected for implementation. From the analysis, it can be interpreted that the Companys capital budgeting decisions are favorable.
TABLE OF CONTENTS
PARTICULARS
SL.NO 1 2 3 4 5 6 7 8 9 10 11
PAGE NO 5 6 7 8 12 34 54 61 62 63 64
Over view of sugar industry Scope of the study Methodology of the study Industry profile Company Profile Introduction to Capital Budgeting Analysis and Interpretation Findings Suggestion Conclusion Bibliography
India has been known as the original home of sugar and sugarcane. Indian mythology supports the above fact as it contains legends showing the origin of sugarcane. India is the second largest producer of sugarcane next to Brazil. Presently, about 51,51,000 hectares of land is under sugarcane cultivation with an average yield of 69.02 tons per hectare. There were a total number of 621 sugar factories in India as on March 31, 2009 compared to 138 during 1950-51. These 621 sugar mills produce a total quantity of 24.2 million tons (MT) of sugar. Department of Agriculture and Co-operation, sugarcane production is estimated at 232.3 MT.
India is the largest single producer of sugar including traditional cane sugar sweeteners, Khandsari and Gur (jaggery) equivalent to 26 million tons raw value followed by Brazil in the second place at 18.5 million tons. Even in respect of white crystal sugar, India has ranked No.1 position in 7 out of last 10 years.
At present there is great demand for alcohol (C2H5OH) all forms of alcohol whether it is technical, potable, or industrial have different usages. Since Govt is initiating use of renewable energy, ethanol is being used as bio-fuel i.e. ethanol is blended with petrol (10%) more over it has less pollutants and higher calorific value than petrol.
SCOPE OF STUDY
Main Objective: To understand the Capital Budgeting decisions at The Godavari Biorefineries Ltd, Sameerwadi Sub-objectives: To study the organisation structure of the Godavari Biorefineries To know what Capital Budgeting is and to assess the factors to be considered when making investment decisions. To outline the steps involved in Capital Budgeting & planning investment decisions. To analyze the evaluation methods for capital budgeting decisions.
Scope of the study: In this project, an attempt is made to understand the Capital Budgeting Decisions followed by The Godavari Biorefineries. The study is also made to understand the investment decisions for new plant.
Duration of the project-: The project commenced from 1st June 2010 and ended on 31st July 2010.
METHODOLOGY:
Primary source: Primary data was collected through: Discussion with chief manager (finance & accounts). Interaction with other staff of Godavari Biorefineries
Secondary source: Secondary data was collected through: Annual report Capital budgeting report
INDUSTRY PROFILE
The Historical Background of the Indian Sugar Industry: The sugar industry is proud to be an industry, which spreads the taste of sweetness to the mankind. The history of origin of this industry is as old as the history of man him self. Sugar is generally made from sugarcane and beet. In India, sugar is produced mainly from sugarcane. India had introduced sugarcane all over the worlds and is a leading country in the making sugar from sugarcane.
National Scenario of Sugar Industry: KLS, INSTITUTE OF MANAGEMENT EDUCATION & RESEARCH, BELGUM 8
The first sugar mill in the country was set up in 1903 in the United Provinces. There are 566 installed sugar mills, of which 453 were in operation in the year 2008-09 and utilized 194.4 million ton of sugarcane (69% of total cane production) to produce 20.14 million tons of sugar. About 5 lacs workmen are directly employed in the sugar industry, besides many in industries, which utilize by-products of sugar industry as raw material. India is the largest consumer and second largest producer of sugar in the world. The Indian sugar industry is the second largest agro-industry located in the rural India. Indian sugar industry has been a focal point for socio-economic development in the rural areas. About 50 million sugarcane farmers and a large number of agricultural laborers are involved in sugarcane cultivation and ancillary activities, constituting 7.5% of the rural population. Besides, the industry provides employment to about 2 million skilled/semi skilled workers and others mostly from the rural areas. The industry not only generates power for its own requirement but surplus power for export to the grid based on byproductBagasse. It also produces ethyl alcohol, which is used for industrial and potable uses, and can be used to the manufacture Ethanol, an ecology friendly and renewable fuel for blending with petrol. The sugar industry in the country uses only sugarcane as input; hence sugar companies have been established in large sugarcane growing states like Uttar Pradesh, Maharashtra, Karnataka, Tamil Nadu, and Andhra Pradesh. In sugar year 2008-09, these six states contribute more than 85%of total sugar production in the country; Uttar Pradesh, Maharashtra, and Karnataka together contribute more than 65%of total production. The government of India licensed new units with an initial capacity of 1250 TCD up to the 1980s and with the revision in minimum economic size to 2500 TCD, the Government issued licenses for setting up of 2500 TCD plants thereafter. The government de-licensed sugar sector in the year of 11.September1988. The entrepreneurs have been allowed to set up sugar factories of expand the existing sugar factories as per the technoeconomic feasibility of the project. However, they are required to maintain a radial distance of 15 km from the existing sugar factory. After de-licensing, a number of new sugar plants of varying capacities have been set up and the existing plants have substantially increased their capacity. KLS, INSTITUTE OF MANAGEMENT EDUCATION & RESEARCH, BELGUM 9
There are 596 installed sugar mills in the country as on March 31st 2009, with a production capacity of 180 lacks MT of sugar, of which only 487 are working. These mills are located in 18 states of the country.
Sugar Production: Most of the sugar in India is manufactured and sold as White Crystal Sugar which is produced by Double Sulphitation Process, while the norm in developed and emerging nations is refined sugar, which is produced by the Phosphofloation Process. Most of the mills in India are not equipped to make refined sugar. Mills which are designed to produce refined sugar can manufacture sugar not only from sugarcane but also from raw sugar which can be imported. Therefore, such mills can run their production all the year round, as opposed to single state mills, which are dependent upon the seasonal supply of sugarcane.
The sector wise break ups as follows: Table no#1 KLS, INSTITUTE OF MANAGEMENT EDUCATION & RESEARCH, BELGUM 10
COMPANY PROFILE
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Godavari Sugar Mills was a pioneer in the research-based Sugar Industry, situated in the state of Karnataka; it combines modern technology and the latest mechanization techniques and compliments it with a 6-decade experience. Alongside, the factory waste, namely molasses is used by Somaiya Organo Chemicals. Industrial alcohol/rectified spirit are manufactured with the sugar waste. The Somaiya Group Company is also looking towards Venturing into cogeneration of power at all of its sites, with excess power being sold off to the state power grids.
VISION
The Somaiya Group will continue to expand its operations by expanding production into new markets and applications. Growth will also come from value added diversification derived from the groups strengths in products and processes. The quality of the products and services delivered by the Somaiya Group will always strive to exceed customer expectations.
MISSION
The Somaiya Group always has and will continue to use renewable resources in its products. It believes that this is an important need for sustainable development. The Somaiya Group has been and always is aware of its social commitment to the community that it serves. It believes that we have a responsibility and obligation to return to society what we earn from it.
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The Somaiya Group has been always being aware of its Social commitment to the community that is serves. It believes that we have a responsibility and Obligation to return to society what we earn from it. Since the last six decades, commencing operations in the high growth field of sugar, the Group has created the perfect platform for its future success. Built upon the foundation of care, each of the following facets of the Group was response to a need.
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MANAGEMENT TEAM
DR.SHANTILAL SOMAIYA SHRI SAMEER S SOMAIYA SHRI I G PATEL SHRI P M KAVADIA SHRI N G SATYA PROF ROOSHIKUMAR PANDYA SHRI B R BARWALE SHRI KAILASH PERSHAD DR. K V RAGHAVAN SHRI VINEY KUMAR SHRI P .K. R. NAIR
BANK OF INDIA. ANDHRA BANK. BANK OF BARODA. SYNDICATE BANK. UNION BANK OF INDIA. INDUSTRIAL DEVELOPMENT BANK OF INDIA. KARNATAKA STATE INDUSTRIAL INVESTMENT AND DEVELOPMENT. CORPORATION BANK. SICOM LIMITED. KLS, INSTITUTE OF MANAGEMENT EDUCATION & RESEARCH, BELGUM 16
AUDITORS:
AMBAL THAKKA AND ASSOCIATES. CHARTERED ACCOUNTANTS.
SOLICITORS:
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PRODUCT PROFILE
The Specification of Sameerwadi Sugar is: Polarization Moisture Icumsa Ash : : : : 99.80 to 99.88 0.35 to 0.06 up to 150 units 0.08 to 0.10
Packing
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We are committed to produce and supply products to meet our costumers needs.
We shall continually strive to improve the effectiveness of our Quality Management system.
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Further taking into consideration the acute power shortage in the country, both on demand and energy terms and effort to generate power and augment the grid supply will be a laudable and worthy effort; the factory has been planning for setting up a 44MW Multifuel Co-generation power project at the factory site. This will enable the factory to play a significant role in supplying power to the public utility simply by increasing its operating efficiency in addition to meeting its need of power. KLS, INSTITUTE OF MANAGEMENT EDUCATION & RESEARCH, BELGUM 20
The main purpose of setting up this power project ,as principal fuel, supplemented by Bagasse, other bio-mass fuel and conventional fuels(as needed for maximizing utilization of proposed power project) for at least 300 days per year. The factory, for this worthy project, has obtained all statutory/non-statutory clearances such as Karnataka State Pollution Board, Airports Authority of India, Environmental clearance, In- principal clearance, Clearance for installation of 110 KV SubStation from the Karnataka Power Transmission Corp. Ltd which has already been set up now, to commence with the project. PRODUCTION AND DISTRIBUTION OF POWER Particulars Self load Sugar Unit Export to HESCOM TOTAL Capacity ( MW) 2.7 MW 5.3MW 16.0 MW 24 MW
The factory had installed its own Distillery Unit in October 1984 as a bye-product industry with its capacity of 30KL liters per day .However taking into consideration the stage wise expansion of the Sugar Mill and the excess availability of molasses, the
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installed capacity was later on increased 30 to 60KL Liters with another extra investment of 30.27 crores. The average recovery of Spirit per MT of molasses is 265 Liters. Basically in the beginning means 1986 to 1999 the plant was given on lease to Saptagiri Enterprise. And also recently its expansion work is going on by increasing the capacity 60 to 120 KL.
BAGASSE:
Bagasse is the main raw material to the co-generation. It will obtain from sugar unit as a waste material. So this will become main raw material to the co-generation department.
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IV quarter of 2010
2. Cogeneration 3. Distillery 4. Bulk & Specialty Chemicals Expansion & New Products
24 MW to 44 MW 200 KLPD
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Somaiya Organo Chemicals: will boost its Ethyl Acetate (EA) production capacity
to cater to the increasing Local & International demand. The expansion was scheduled for completion by mid 2006. On completion of the project the Company possessed a production capacity of 30000 MT per annum, widening its global export base. Our technology uses Renewable resources to manufacture EA, which is ever so important in this age of rising prices due to depleting crude oil reserves our long-term goal is to grow our markets by expanding existing product lines and by introducing new products based on sustainable technologies & renewable resources.
Specialty Chemicals With a view to augment our range of specialty chemicals, we have added one more aldehyde based product and successfully commissioned the plant recently. The product is having good export potential. One time land application for bio-methaneted distillery spent wash Besides the pollution control measures like bio-composting etc for distillery effluent, Pollution control board has for the first time allowed us to use bio-methanated spent wash to be used as liquid manure on farm lands. This is being done successfully with our tie-up with Rahuri Agricultural University for close co-ordination & effective implementation.
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ORGANIZATION CHART
KLS, INSTITUTE OF MANAGEMENT EDUCATION & RESEARCH, BELGUM 25
Account Department
Engineering Department
Cane Department
General Account
Cane Account
Manufacturing Department
Computer Section
Stores Section
Time Section
Purchase
Sales
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Sugar (Sucrose) is a Carbohydrate that occurs naturally in every fruit and vegetable. Sugar occurs in greatest quantities in sugar cane and sugar beet from which it is separated for commercial use. The natural sugar stored in the cane stalk is separated from the rest of the plant material through a process known as refining. In the first stage the sugar cane is cut into small pieces through cutter, and then the small pieces are pressed to extract the juice. The extracted juice is then sent to boiler house and heated into two stages. In primary stage it is heated up to 72 C and in the secondary stage to 102 C. hen lime sulphur dioxide and phosphoric acid is added. Lime is added to settle impurities, sulphur dioxide for bleaching a phosphoric acid to maintain phosphate content. Then again the juice is heated to 100 C to 103 C. The juice begins to thicken and sugar begins to crystallize. Then the crystals are spinned in the centrifugal pan to remove the syrup producing the raw sugar. And in the final stage, shipping the sugar to a refinery where it is washed and filtered to remove remaining nonsugar ingredients and Color and then crystallizing, drying, and packing the refined sugar. Sugarcane contains about 14% fibred and 86% juice consists of about 13% Sucrose and 73% moistures and non-sugar solids.
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SUGAR CANE
BYPRODUCTS
SUGAR
BAGASSES
MOLASSES
PRESS MUD
RECTIFIED
SPIRIT
POTABLE ALCOHOL
POWE R
JUICE HEATING
MANURE
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200,000 liters per day total 95 % Alcohol. 180,000 liters per day ethanol.
: : : :
Cane Molasses with 50 % FS Min. River water after suitable treatment. Bagasse client scope. Steam turbine for regular operation and Generator for emergency use.
Bio composting using filter mud from Sugar factory to produce manure.
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River Water
Product Alcohol
Continuous Fermentation
Vacuum Distillation
Molasses
Evaporation
Composting
Electricity
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SECTION II
The distillery project is guaranteed to achieve the following performance figures. Parameters Plant capacity Main products Description 200,000 liters / day total 95 % v/v alcohol. 180,000 liters / day of RS and 180,000 liters / day ethanol based MSDH Technology Fed batch cum continuous fermentation with special yeast strain using separators. The fermentation is trouble & maintenance free with recycle of yeast and spent wash, which ensures cleaner & longer fermentation cycle. 3 columns vacuum distillation with distillation. The distillation is designed to alcohol is produced using vacuum distillation. Efficiency & 1. EFFICIENCY alcohol yield at Fermentation efficiency90 % (91% for FS more than 45%) 45 % w/w Distillation efficiency 98.5 % Fermentable 2. YIELD sugars 265 to 267 liters 96 % v/v alcohol per Ton molasses at 45 % Fermentable Sugars. 3. FORMAULA FOR CALCULATION OF YIELD Alcohol Production in Liters / kg of Molasses = FS X 0.511 X Eff F X EffD ___________________________________ 0.795 X Alcohol Concentration in v/v Where, FS Fermentable Sugar in % w/w EffF Fermentation Efficiency in % EffD Distillation Efficiency in %
1 2 3
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For the Distillery with Sugar factory, at present the best spent wash treatment option is the Composting. We have 12000 TCD Sugar factory which is to be expanded to 15000 TCD from next Crushing season onwards. Sufficient quantity of the press mud is available for composting. Both spent wash and press mud are excellent sources of the organic matter and the essential plant nutrients. Due to tropical climatic conditions replenishing of organic matter is soil is most essential to keep the soil healthy. To make best utilization of organic matter in press mud and spent wash the Composting of both these organic residues is must. Application of organic matter is essential for improving the soil Biological and Physical properties.
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The investment decisions of a firm are generally known as the capital budgeting decisions. A capital budgeting decision may be defined as the firms decision 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. The firms investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. sale of a division or business is also analyzed as an investment decision. It is important to note that investment in the long-term assets invariably requires funds to be tied up in the current assets such as inventories and receivables. As such investment in fixed and current assets is one single activity.
The following are the features of investment decisions: The exchange of current funds for future benefits. The funds are invested in long-term assets. The future benefits will occur to the firm over a series of years. It is significant to emphasize that expenditure and benefits of an investment should be measured in cash. In the investment analysis, it is cash flow, which is important, not the accounting profit. It may also be pointed out that investment decisions affect the firms value. The firms value will increase if investments are profitable and add to the shareholders wealth. KLS, INSTITUTE OF MANAGEMENT EDUCATION & RESEARCH, BELGUM 35
Risk: A long-term commitment of funds may also change the risk complexity of the firm. If the adoption of an investment increases average gain but causes frequent fluctuations in its earnings, the firm will become more risky.
Funding: Investment decisions generally involve large amount of funds which make it imperative 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.
Complexity: Investment decisions are among the firms most difficult decisions. 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, social and technological forces.
There are many ways to classify investments. One classification is as follows: Expansion of existing business: A company may add capacity to its existing product lines to expand existing operations. For e.g. a sugar refinery may increase its plant capacity to manufacture more refined sugar. Expansion of new business: It requires investment in new products and a new kind of production activity within the firm. If a package manufacturing company invests in a new plant and machinery to produce ball bearings, which the firm has not manufactured before, this represents expansion of new business or diversification. Replacement and modernization: The main objective of replacement and modernization is to improve operating efficiency and reduce costs. Cost savings will reflect in the increased profits, but the firms revenue may remain unchanged. If a cement company changes from semi-automatic drying equipment to fully automatic drying equipment, it is an example of modernization and replacement. Yet another useful way to classify investments is as follows: Mutually exclusive investments: Mutually exclusive investments serve the same purpose and compete with each other. If one investment is undertaken, others will have to be excluded. A company may, for example, either use a more labor-intensive, semi-automatic machine, or employ a more capitalintensive, highly automatic machine for production. Independent investments: Independent investments serve different purposes and do not compete with each other. For e.g. a heavy engineering company may be considering expansion of its plant capacity to manufacture additional excavators and addition of new production facilities to manufacture a new product-light commercial vehicle. Contingent investments: Contingent investments are dependent projects; the choice of one investment necessitates undertaking one or more other investments. For e.g. if a company decides to build a factory in a remote, KLS, INSTITUTE OF MANAGEMENT EDUCATION & RESEARCH, BELGUM 37
backward area, it may have to invest in houses, roads, hospitals, schools etc. for employees to attract the work force. Thus, building of factory also requires investment in facilities for employees.
Evaluation Techniques:
The methods of appraising capital expenditure proposals can be classified into two broad categories. I) II) Traditional Time adjusted
The latter are more popularly known as discounted cash flow (DCF) techniques as they take the time factor into account. The first category includes i) ii) Average rate of return method and Pay back period method
The second category includes i) ii) iii) Net present value method Internal rate of return Net terminal value 38
iv)
Profitability index
The most commonly used evaluation techniques are I) Accounting or Average Rate of Return: Accounting rate of return considers the earnings of the project of the economic life. This method is based on conventional accounting concepts. The rate of return is expressed as percentage of the earnings of the investment in a particular project. This method has been introduced to overcome the disadvantage of pay back period. The profits under this method are calculated as profit after depreciation and tax of the entire life of the project.
Formula: Average annual income after tax and depreciation ARR = Initial investment Average annual income (after tax and depreciation) ARR = Average investment Original investment This method of ARR is not commonly accepted in assessing the profitability of capital expenditure. Because the method does to consider the heavy cash inflow during the project period as the earnings with be averaged. The cash flow advantage derived by adopting different kinds of depreciation is also not considered in this method. Accept or Reject Criterion: Under the method, all project, having Accounting Rate of Return higher than the minimum rate establishment by management will be considered and those having ARR less than the predetermined rate. This method ranks a Project as number one, if it has highest ARR, and lowest rank is assigned to the project with the lowest ARR. KLS, INSTITUTE OF MANAGEMENT EDUCATION & RESEARCH, BELGUM 39 * 100 * 100
Merits: 1. It is very simple to understand and use. 2. This method takes into account saving over the entire economic life of the project. Therefore, it provides a better means of comparison of project than the pay back period. 3. This method through the concept of net earnings ensures a compensation of expected profitability of the projects and 4. It can readily by calculated by using the accounting data.
Demerits: 1. It ignores time value of money. 2. It does not consider the length of life of the projects. 3. It is not consistent with the firms objective of maximizing the market value of shares. 4. It ignores the fact that the profits earned can be reinvested.
capital expenditure decisions. This method answers the question: How many years will it take for the cash benefits to pay the original cost of an investment, normally disregarding salvage value? Thus, the pay back method (PB) measures the number of years required for the CFAT to pay back the original outlay required in an investment proposal.
There are two ways of calculating the PB period. The first method can be applied when the cash flow stream is in the nature of annuity for each year of the projects life, that is, CFAT are uniform. In such a situation, the initial cost of the investment is divided by the constant annual cash flow:
Investment PB = Constant annual cash flow The second method is used when a projects cash flows are not uniform (mixed stream) but vary from year to year. In such a situation, PB is calculated by the process of cumulating cash flows till the time when cumulative cash flows become equal to the original investment outlay.
Year
1 2
Rs.14000 16000
3 4 5
The initial investment of Rs.56125 on machine A will be recovered between years 3 and 4. The pay back period will be fraction more than 3 years. The sum of 48000 will be recovered by the end of 3 rd year. The balance Rs.8125 is needed to be recovered in the fourth year. In the fourth year CFAT is Rs.20000. The pay back fraction is therefore 0.406 (Rs.8125/ Rs.20000). The pay back period for machine A is 3.406. Similarly, for machine B the pay back period would be 2 years and a fraction of a year. As Rs.42000 is recovered by the end of the second year, the balance of Rs.14125 needs to be recovered in the third year. In the third year CFAT is Rs.18000. The pay back fraction is 0.785 (Rs.14125/ Rs.18000). Thus, the PB period for machine B is 2.875 years.
Accept-Reject Criterion:
The pay back period can be used as a decision criterion to accept or reject investment proposals. One application of this technique is to compare the actual pay back with a predetermined pay back that is the pay back set up by the management in terms of the maximum period during which the initial investment must be recovered. If the actual pay back period is less than the predetermined pay back, the project would be accepted; if not, it would be rejected. Alternatively, the pay back can be used as a ranking method. When mutually exclusive projects are under consideration, they may be ranked according to the length of the pay back period. Thus, the project having the shortest pay back may be assigned rank one, followed in that order so that the project with the longest pay back would be ranked last. Obviously, projects with shorter pay back period will be selected.
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Evaluation:
The pay back method has certain merits. It is easy to calculate and simple to understand. Moreover, the pay back method is an improvement over the Average rate of return approach. Its superiority arises due to the fact that it is based on cash flow analysis. The pay back approach, however, suffers from serious limitations. Its major short- comings are as follows: i) It completely ignores all cash inflows after the pay back period. This can be very misleading in capital budgeting evaluations. Following is an example where in it reveals alternative projects with same pay back period.
Project X Rs.15000
Project Y Rs.15000
6 Pay back
0 3
3000 3
ii) In fact, the projects differ widely in respect of cash flows generated after the pay back period. The cash flow for project X stops at the end of the third year, while that of Y continues up to the sixth year. Obviously, the firm would prefer project Y because it makes available to the firm Cash flows of Rs.12000 in years 4 through 6, whereas project X does not yield any cash inflow after the third year. Under the pay back method, however both the projects would be given equal ranking, which is apparently incorrect. Its failure lies in the fact that it does not consider the total benefits accruing from the project.
iii) Another deficiency of the pay back method is that it does not measure correctly even the cash flows expected to be received within the pay back period as it does not differentiate between projects in terms of the timing or the magnitude of cash flows. It considers only the recovery period as a whole. This happens because it does not discount the future cash inflows but rather treats a rupee received in the second or third year as valuable as a rupee received in the first year.
iv) Another failure of the payback method is that it does not take into consideration the entire life of the project during which cash flows are generated. As a result the project with large inflows in the later part of their lives may be rejected in favor of less profitable projects which happen to generate a larger proportion of their cash inflows in the earlier part of their lives.
of capital is the minimum discount rate that must be earned on a project that are discounted to their present values only on the ground that a rupee received at a future date is worth less than a rupee received today. Merits: 1.It takes into account all the benefits and costs occurring during the earnings for profit, for an entire economic life of the project. 2. It takes into account the time factor while evaluating the profitability of a project, in the sense that they recognize the fact that the value of a rupee received at a future date is less than its present value. 3. They provide for uncertainty and risk as they recognize the time factor while evaluating the profitability of investment proposals. 4. They are more scientific and dependable.
Demerits:
1.They are complicated as they involve a good amount of calculations. 2. They do not correspond to the accounting concepts while recording costs and reserves. 3. They are not suitable for ranking projects regarding different capital outlay. Discounted cash flow method is suitable for evaluating projects when cash flows are uneven. They are quite valuable for long-term capital decisions.
compared with present value of cash outflows (cost of project) and the net present value or the excess present value of the project and the difference between total present value of cash inflow and present value of cash outflow is ascertained and on this basis, the various investments proposals are ranked. Cash inflow = earnings / profits of an investment after taxes but before depreciation The present value of cash outflows = initial cost of investment and the comment of project at various points of time
Decision rule:
After ranking various investments proposals on basis on net present value, projects with negative net present value (net present value of cash inflows less than their original costs) are rejected and projects with positive NPV are considered acceptable. In case of mutually exclusive alternative projects, projects with higher net present value are selected. Net present value method is suitable for evaluating projects where cash flows are uneven.
Merits:
1.The most significant advantage is that it explicitly recognizes the time value of money, e.g., total cash flows pertaining to two machines are equal but the net present value are different because of differences of pattern of cash streams. The need for recognizing the total value of money is thus satisfied. 2. It also fulfills the second attribute of a sound method of appraisal. In that it considers the total benefits arising out of proposal over its lifetime. 3. 4. It is particularly useful for selection of mutually exclusive projects. This method of asset selection is instrumental for achieving the objective of financial management, which is the maximization of the shareholder's wealth. In brief the present value method is a theoretically correct technique in the selection of investment proposals. KLS, INSTITUTE OF MANAGEMENT EDUCATION & RESEARCH, BELGUM 46
Demerits:
1. It is difficult to calculate as well as to understand and use, in comparison with Payback method or averages return method. 2. The second and more serious problem associated with present value method is that it involves calculations of the required rate of return to discount the cash flows. The discount rate is the most important element used in the calculation of the present value because different discount rates will give different present values. The relative desirability of a proposal will change with the change of discount rate. The importance of the discount rate is thus obvious. But the calculation of required rate of return pursuits serious problem. 3. Another shortcoming is that it is an absolute measure. This method will accept the project, which has higher present value. But it is likely that this project may also involve a larger initial outlay. 4. The present value method may also give satisfactory results in case of two projects having different effective lives. The project with a shorter economic life is preferable, other things being equal. It may be that, a project which has a higher present value may also have a larger economic life, so that the funds will remain invested for longer period while the alternative proposal may have shorter life but smaller present value. In such situations the present value method may not reflect the true worth of alternative proposals.
on. Like net present value, internal rate of return method also considers the time value of money for discounting the cash streams. The basis of the discount factor however, is different in both cases. In the net present value method, the discount rate is the required rate of return and being a predetermined rate, usually cost of capital and its determinants are external to the proposal under consideration. The internal rate of return, on the other hand, is based on facts which are internal to the proposal. In other words, while arriving at the required rate of return for finding out the present value of cash flows, inflows and outflows are not considered. But the IRR depends on the initial outlay and cash proceeds of project, which is being evaluated for acceptance or rejection. It is therefore appropriately referred to as internal rate of return. The IRR is usually, the rate of return that a project earns. It is defined as the discount rate, which equates the aggregate present value of net cash inflows (CFAT) with the aggregate present value of cash outflows of a project. In other words, it is that rate which gives the net present value zero. IRR is the rate at which the total of discounted cash inflows equals the total of discounted cash outflows (the initial cost of investment). It is used where the cost of investment and its annual cash inflows are known but the rate of return or discounted rate is not known and is required to be calculated.
Accept/Reject decision
The use of IRR as a criterion to accept capital investment decision involves a comparison of actual IRR with required rate of return, also known as cut off rate or hurdle rate. The project should qualify to be accepted if the internal rate of return exceeds the cut off rate. If the internal rate of return and the required rate of return are equal, the firm is indifferent as to accept or reject the project.
Evaluation of IRR:
1.Is a theoretically correct technique to evaluate capital expenditure decision .It possesses KLS, INSTITUTE OF MANAGEMENT EDUCATION & RESEARCH, BELGUM 48
the advantages which are offered by the NPV criterion such as, it considers the time value of money and takes into account the total cash inflows and outflows.
2. In addition, the IRR is easier to understand. Business executives and non-technical people understand the concept of IRR much more readily than they understand the concept of NPV. For instance, Business X will understand the investment proposal in a better way if it is said that the total IRR of Machine B is 21% and cost of capital is 10% instead of saying that NPV of Machine B is Rs. 15,396.
3. It itself provides a rate of return which is indicative of profitability of proposal. The cost of capital enters the calculation later on. 4. It is consistent with the overall objective of maximizing shareholders wealth. According to IRR, the acceptance / rejection of a project is based on a comparison of IRR with required rate of return. The required rate of return is the minimum rate which investors expect on their investment. In other words, if the actual IRR of an investment proposal is equal to the rate expected by the investors, the share prices will remain unchanged. Since, with IRR, only such projects are accepted which have IRR of the required rate; therefore, the share prices will tend to rise. This will naturally lead to maximization of shareholders wealth.
The IRR suffers from serious limitations: 1. It involves complicated computation problems. 2. It produces multiple rates, which can be confusing. This situation arises in the case of non-conventional projects. 3. In evaluating mutually exclusive proposals, the project with highest IRR would be picked up in exclusion of all others.
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4. Under IRR, it is assumed that all intermediate cash flows are reinvested at the IRR. It is rather ridiculous to think that the same firm has the ability to reinvest the cash flows at different rates. The reinvestment rate assumption under the IRR is therefore very unrealistic.
Evaluation:
Like the other discounted cash flow techniques, the PI satisfies almost all the requirements of a sound investment criterion. It considers all the elements of capital budgeting, such as the time value of money, totality of benefits and so on. Although based on NPV, it is a better evaluation technique than NPV in a situation of capital rationing.
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Project Background
1. GBL has decided to set up another new unit of distillery along with chemicals 200 KLPD 2. The proposed site is located in sameerwadi near to Bio-fertilizer unit. 3. The installed capacity for the proposed plant will be 200 klpd; it can distill up to 240 klpd. 4. The main equipments are evaporators of capacity 1000 HTA. 5. The total average distillation is estimated 3 corers every year.
The total project cost includes land, civil works, main plant equipment, auxiliary plant; miscellaneous works preliminary and preoperative expenses, contingencies, margin money for working capital, interest during construction, financing and other costs.
The financial analysis is based on the present RECTIFIED SPIRIT & E.N.A price.
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EBIT Interest EBT (Rs. In (Rs. In (Rs. In Lakhs) Lakhs) Lakhs) (12.5%) 3324 415.50 2908.50
3834
510
2035.95 2545.95
5380
510
4870
608.75
4261.25
6038.83
6897
510
6387
798.37
5588.62
10460.87
8619
510
8109
1013.62
7095.38
15937.64
12369
510
11859
23711.28
14378
510
13868
32715.43
Note: The EBIT, Depreciation, Interest and Tax figures are given by the Company.
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Interpretation:
Normally the pay back method is used by the companies to take decisions whether to accept or reject a particular investment proposal. For this purpose, the actual pay back is compared with the predetermined pay back, i.e. the pay back set up by the management in terms of the maximum period during which the initial investment must be recovered. In GBL, they have estimated a pay back of 3 to 3.5 years. But, as per the calculations, the pay back period is coming as 2.83 years, which is less than predetermined pay back. So the project is feasible.
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Average Annual Income after tax and depreciation Formulae = Average investment * 100
9724 Average Investment = 2 = 4862 5452.57 Annual Rate of Return = 4862 = 121.14% * 100
Interpretation: As the accounting rate of return is more than cost of capital i.e. 11%
so the project is acceptable
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Year
Cash Inflow
Discount @11%
1 2 3 4 5 6
Calculation of Net Present Value: NPV= Present value of cash inflow INITIAL INVESTMENT =21398.79 9724 = 11674.79
Interpretation:
Under NPV, the decision rule to accept the project if the NPV is positive and reject if it is negative. In GBL, as per the calculations, the NPV is positive (i.e. sum total of future cash inflows is more than initial investment) so the project is acceptable.
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Interpretation:
It is the ratio, which is obtained dividing the present value of future cash inflows by the present value of cash outlays. Under PI, a project will qualify for acceptance if its PI > 1. In GBL, the project under consideration is having PI >1. So the project can be undertaken.
(Rs. In lakhs) Year Cash Inflow Discount @11% 0.901 0.812 0.731 0.659 0.593 0.535 Discounted Cash Inflow 2293.90 2836.21 3232.51 3609.19 4609.76 4817.22 Cumulative Cash inflow 2293.90 5130.11 8362.62 11971.81 16581.57 21398.79
1 2 3 4 5 6
Calculation of Internal Rate of Return: NPV = A (n) - C (1+k) n 0 = 2545.95 + 3492.88 + 4422.04 + 5476.77+ 7773.64 + 9004.15 (1+.380)1 (1+.380)2 (1+.380)3 (1+.380)4 (1+.380)5 (1+.380)6 IRR = 38.05% - 9724
Interpretation:
The IRR considers comparison of the actual IRR with the required rate of return. The project would qualify to be accepted if the IRR (r) exceeds the cut off rate (k) (r > k) i.e. cut off rate here is the cost of capital & when r > k it means that firm is earning more than the cost of capital ,which in turn increases the value of the firm. In GBL, IRR (38.05%), this is greater than the cut off rate (10%). So the project can be accepted.
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Observations:
1. Since the capital invested in the assets are recovered within a short period of 2.83 years the proposal is viable to the company. 2. Net present value of the firm is positive as a result of that the project is favorable for implementation. 3. Internal rate of return is 38.05% which is more than the cost of capital (11%) as a result of that the project is favorable for implementation. 4. Profitability index: Ratio of the present value of future cash inflows by the present value of cash outlays is > 1 .In GBL it is 2.2. Hence the project is accepted. 5 The capital budgeting decisions taken by the Company for implementing new plant are favorable
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Suggestions:
1. The Company can use other method of capital budgeting such as IRR & PI to check the feasibility of the project. 2. The company can invest in chemical division to enhance its capacity and to bridge the gap between demand and supply of Ethanol, this will help the company to reap the benefits so as to strengthen the position in bio fuel segment. 3. The company should try to reduce its debt component which is about 60% as seen in Capital structure, because debt carries financial risk and entails a definite contractual commitment.
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CONCLUSION:
The Godavari Biorefineries Ltd, Sameerwadi is the leading sugar producer in the Indian Sugar Industry. The company is using all the resources very effectively so to produce better quality of sugar. So as per the company policy Godavari Biorefineries Ltd, Sameerwadi is not leaving any wastage. So to use it has so many by products plants.
The capital budgeting decisions taken by the Company are favorable, company Should invest in Ethanol project and in chemical division; from the analysis also I Would like conclude that the new project implementation is feasible.
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REFERENCES:
JOURNALS AND MAGZINES Annual Reports of Godavari Biorefineries Ltd, Sameerwadi. Articles on Sugar Industry
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