CORPORATE FINANCE

CAPITAL BUDGETING PRACTISES IN INDIA

 INTRODUCTION
 India’s rapid and growing integration into the world economy has made
Indian companies subject to the volatility of global financial markets.

 Amidst a weak Indian economy, where companies are struggling with

sales slowdown, sound financial management practices and effective
investment decision making are the only keys to the survival and long-
term success of these companies.

 The study investigates the extent to which the relatively superior

nascent techniques of net present value (NPV) adjusted with real
options analysis, modified internal rate of return (MIRR), earnings
multiple approach (EMA), economic value added (EVA) and
sophisticated risk techniques like Monte Carlo simulation analysis,
discounted cash flow (DCF) breakeven analysis, decision tree analysis,
and probability theory are being applied by Indian companies in
practice.
 The prime aim of this research is to present evidence on the current Indian investment
practices and to determine how far these practices reflect the latest financial theories.

 Some companies which use their DCF techniques because of time value of money as well as
cash inflow throughout the life of the project. Other reasons favouring their usage appeared to
be less influential.

Research findings and conclusion:

Formal capital budgeting Decision

• Decision at higher/top level of management

• Conducted even for projects of smaller capital outlays.

Capital budgeting techniques most preferred

• DCF methods of NPV and IRR

• NDCF technique of payback as a supplement.
• Usage of multiple techniques preferred

NPV-IRR contradiction

• Equally divided on the issue.

• Both preferred equally in contradiction.
Reasons for preference Of DCF techniques
• Consider time value of money
• Considers entire stream of cash flows

Reasons for no preference of DCF

• Non-suitability as per business condition

• Complexity in usage
• Non-supportive top management

Reasons for preference of NDCF like payback

• Emphasis on liquidity
• Risk consideration

Simplicity and ease in calculation

Usage of latest advanced Techniques

• Sluggish adoption and less use of EVA, MIRR, APV and NPV with real options

Discount rate Preferred

• Use of WACC most prevalent
• Multiple risk adjusted discount rates favoured.
Cost of capital practices
• WACC most preferred for cost capital calculation
• CAPM model (the beta approach) and dividend yield model most popular for cost of equity capital

Risk measurement
• Increased trend of risk measurement
• Standard deviation/coefficient of variation most preferred measures.

Risk factors
• Inflation, interest rates and foreign exchange risks most important risks
• GDP/business cycle, commodity price and term structure risks also high in priority.
• Lesser importance to risks of distress, company size or momentum risk.

Risk adjustment
• Usage of risk-adjusted cash flows overrides risk-adjusted discount rates.
• For interest rate, term structure, company size and momentum risk, preference to adjust
discount rates
• For risk of unexpected inflation, GDP, commodity price, foreign exchange, market to book
value risks preference to adjust cash flows.
 Capital budgeting techniques incorporating risk

• Sensitivity analysis most popular followed by shorter payback period, scenario analysis
and conservative estimates of cash flows.

• Limited use of risk adjusted discount rates and judgment evaluations.

• Hiller model, calculated bail out factor, utility theory and certainty equivalent
approach rarely used.

Latest sophisticated risk incorporation techniques

• Strong reluctance to adopt newer sound techniques of probability theory, decision

tree analysis, and Monte Carlo simulation