Capital Budgeting in Corporate Sector A Case Study

M. Kannadhasan1 - Dr. R. Nandagopal2

Abstract

In todays ever changing world, the only thing that does not change is change itself.

Change can trigger any corporate growth which can be measured in terms of increase in

investments or sales. A progressive business firm continually needs to expand its fixed assets

and other resources to be competitive in the race. Investment in fixed assets is an important

indicator of corporate growth. The success of the corporate growth in the long run depends

upon the effectiveness with which the management makes capital expenditure decisions. In

the dynamic business environment, making capital budgeting decisions are among the most

important and multifaceted of all management decisions as it represents major commitments

of companys resources and have serious consequences on the profitability and financial

stability. How far the corporate attains financial stability and profitability over a period of

time, while making capital budgeting needs evaluation and is a million dollar issue. In view

of this, this study has made an attempt to analyse the efficiency of the corporate sectors

capital budgeting through their financial statements.

Introduction

In todays ever changing world, the

only thing that does not change is change

itself. Successful companies are always

looking at ways in which they can change

and develop. Change can trigger corporate

growth and Growth is essential for

sustaining the viability, dynamism and

value enhancing capability of a company,

which lead to higher profits and better the

shareholders value. To achieve the desired

growth, the firm has to be competitive in

all functional areas especially in financial

management which is the back bone of any

business. Primarily growth can be

measured in terms of change in

investments or sales.

A progressive business firm

continually needs to expand its fixed assets

and other resources to be competitive in

the race. Investment in fixed assets is an

important indicator of corporate growth.

The success of the corporate in the long

run depends upon the effectiveness with

which the management makes capital

expenditure decisions. The finance

manager should ensure that he has

explored and identified potentially lucrative

investment opportunities and proposals and

select the best one based on the

opportunities identified.

Journal of Contemporary Research in Management, January - March 2008 17

18 Journal of Contemporary Research in Management, January - March 2008

In the dynamic business environ

ment, making capital budgeting decisions

are among the most important and

multifaceted of all management decisions

as it represents major commitments of

companys resources and have serious

consequences on the profitability and

financial stability. Evaluation need to be

done for the extent of financial stability

achieved by the firms capital budgeting

decisions over a period of time. In view of

this, this study has made an attempt to

know the efficiency of the corporate sectors

capital budgeting decisions.

Rationale of The Study

The success of any business depends

on the adjustments and adaptations it

makes in its operations to match the

external competitive environment. Swift

reaction to the changing business

environment is ensured only when the

organization is effective in decisionmaking

in all its operational areas. This

is a good sign for the growth-oriented

companies. Growth oriented companies

need to invest sizable proportion of its

capital in the fixed assets constantly. Rate

of investments in the corporate sector

depends on the internal growth decisions

relating to various decisions viz.

replacement, expansion, modernization,

introduction of new product lines and also

capability of raising resources for financing

growth. Thus, Capital budgeting decision

is a major corporate decision because it

typically affects the firms business

performance for a long period of time. While

making capital budgeting decisions, the

company needs to foresee the impact on

its future performance. In view of this, this

research provides comprehensive analysis

of the efficiency of the corporate sectors

capital budgeting decisions which got

reflected in their financial statements.

Review of Literature

Over the years, Research on Capital

budgeting is well documented in many

countries. Some examples of these are in

USA (Klammer, 1972, Gitman and

Forrester, 1977, Cooper et. Al, 1990,

Graham and Harvey 2001& 02, Ryan &

Ryan, 2002 Stanley Block, 2005), the UK

(Jog & Srivastava, 1995), Asia-Pacific

Region (Wong, Farragher, and Leung, 1987,

Kester & Chong, 1998, Kester et.al, 1999,)

China & Dutch (Niels Hermes et. Al, 2005,),

South Africa (Hall, 2000,), Cyprus (Lazariids

, 2004), and India (Prasanna Chandra,

1975, Porwal, 1976, Pandey, 1989, Rao

Cherukuri, 1996, Manoj Anand, 2002,

Sarkar 2004, Lokanandha Reddy Irala,

2006, Tamilmani, 2004 & 2007).

The research studies so far are mostly

concerned with the capital budgeting

practices in corporate sector with specific

focus on appraisal methods, income

measurement, determination of discount

rate and risk analysis. Almost all the

studies used primary data as the basis and

the analysis was sketchy. Though there

have been many studies published in

journals relating to capital budgeting

decision in the corporate world, but no study

has been specifically done on capital

budgeting based on secondary data which

could be dealt in this study.

Journal of Contemporary Research in Management, January - March 2008 19

Scope of The Study

This study is confined to one limited

company with eight years study period from

1998-99 to 2005-06 with special reference

to commercial vehicle industry. The study

is based on financial data obtained from the

published annual reports. The technique

used for the analysis is historical funds flow

analysis which has also its own limitations.

Objectives of The Study

This study has the following objectives:

1. To know the fixed investment and

financing trend of the company

2. To assess the growth rate in the fixed

investment pattern of the company

3. To trace out the influencing factors on

fixed investment and financing trend

of the company

Hypotheses of The Study

Having identified the objectives of this

study, the following hypotheses have been

formulated and tested during the period of

study: 1. Correlation between fixed

investments and the selected internal

factors (sales, profits, depreciation) is not

significant. 2. Correlation between

internal factors (sales, profits, depreciation)

of this company is not significant

Research Methodology

The research design of this study is

descriptive in nature. This study is based

on secondary data which was obtained from

financial statements published by this

company from 1998-99 to 2005-06 through

their website and this study was also used

the directors reports pertaining to fixed

investment decisions made during the

study period. The data collected are

analysed with the help of different

accounting and statistical tools. The

analysed data are presented in the form of

funds flow statement, fixed investment

analysis statement, fixed investment

growth statement, and statement of

correlation.

Results & Discussions

The sample company is the leader of

the commercial vehicle industry over the

past five decades. As regards to its size, the

company belongs to the large size category

with a net tangible fixed assets valuing is

10599.75 million (2005-06). The subscribed

capital of the company remained

unchanged till 2004-05, at Rs. 1189

millions and with a Rs. 33 million increase

in 2005-06. But investments in fixed

assets have undergone several changes

during this period. The manner in which

the fixed investments have changed and

the sources of financing are discussed in

this part.

1. Fixed investment Analysis Statement:

During the study period, the purpose of

investments of this company is for capacity

expansion/up-gradation and R&D. We

observe that out of 8 years, investments

have been financed by internal sources for

5 years. Besides the internal sources, this

company have also raised funds from

external sources to finance their additional

fixed investments during 1998-99, 2000-

20 Journal of Contemporary Research in Management, January - March 2008

01, and 2004-05. The second major source

of finance is long-term debts from term

lending institution and banks.

2. Trends in Fixed Investment: In order

to discover the fixed investment trend of

this company, the rate of increase in fixed

assets during the year has been computed.

In the process of classification, these rates

are classified into two categories by taking

normal business practices into

consideration and the findings of empirical

analysis.

A.Regular/routine Investments:

Company invests less than 15 per cent of

investments as regular/routine invest ments

for maintenance and replacements and

B.Growth / expansion oriented

Investments: Company invests more than

15 percent consider as growth and

expansion.

Table 1

Fixed Investment Classification Statements

(Figures in Millions)

Financial Year Net Fixed Fixed Assets Percent of Classification

Assets at increased Increase

the beginning during the year

of the year

1998-99 8935.22 1665.49 18.64 G

1999-00 9150.34 1076.98 11.77 R

2000-01 8915.41 1050.12 11.78 R

2001-02 9560.99 1613.16 16.87 G

2002-03 9025.19 1326.53 15.00 G

2003-04 8748.29 792.08 09.05 R

2004-05 8938.46 1796.95 20.10 G

2005-06 9432.71 2426.32 25.72 G

As we can see form the table 2, the

annual rate of growth in fixed statements

and their classification. In the year 1999-

00, 2000-01 and 2003-04, the investments

represents routine investments category

for normal maintenance and replacements

whereas the rest of the years reliable to

growth and expansion.

The amount of incremental

investments increased its height in 2005-

06 with Rs. 2426.32 millions. The highest

rate of growth is found in the same year

with 25.72 per cent. Overall trend of fixed

investments during the study period is found

to be increasing with an annual average

investment of Rs. 1468.45 millions and

standard deviations of Rs. 519.76. However

there are deviations for some years.

Accountable Factors for Fixed

Investment: The purpose of Investments

Journal of Contemporary Research in Management, January - March 2008 21

Table 2

Statement of Descriptive Statistics & Selected variables

(Figures in Millions)

Financial Year Incremental Fixed Sales Profit Depreciation

Investments

1998-99 1665.49 20450.71 -120.62 690.40

1999-00 1076.98 25987.18 805.86 641.42

2000-01 1050.12 26066.63 913.77 784.41

2001-02 1613.16 26304.48 1172.31 765.02

2002-03 1326.53 30739.95 1634.78 1752.18

2003-04 792.08 39272.73 2773.59 912.63

2004-05 1796.95 48112.82 3108.38 1075.91

2005-06 2426.32 60531.08 3976.11 868.24

Mean 1468.45 34683.20 1783.02 936.28

SD 519.76 13668.07 1377.19 356.61

CV 282.52 253.75 129.47 262.55

differs one to another firm. For example,

the purpose of expansion is to meet the

growing demand for products; the purpose

of modernisation helps to reduce the cost

through new production processes; and

diversification helps to additions to existing

product line. All these forms help to

increase the sales, in turn to increase

profits of the companies in the long run.

In this study, we have tried to correlate

each internal factors such as sales, profit

and depreciation charges with fixed

investments.

a. Fixed Investments and sales:

Trends of fixed investments and the sales

show the same trend but the per cent of

changes are vary during the study period.

The coefficient of correlation between sales

and fixed investments is found to be 0.60

(see table 3) which is statistically

significant at 5 per cent level of

significance, suggesting that the

relationship between the variables is

moderate. Capital budgeting decisions may

increase the sales through increased

production, and promotion programmes

provides the demand for the product goes

up in the market. This has been proved by

this company as it occupies the good

position in the market. From the analysis,

it is clear that the fixed investments and

sales have the close and direct relationship

between each other.

b. Fixed investments and profit: As

we mentioned above, increase in fixed

investment is to enhance the earning

capacity of the company. It is clear from

the table 3 where we can find a shift from

loss into profit. There are number of

fluctuations with substantially high and

low levels of the fixed investments and

profits during the study period. The

coefficient of correlation between profits

and fixed investments is found to be 0.43

(see table 3) which is statistically

significant at 5 per cent level of

significance, indicating poor association

between the variables. This is mainly due

to inefficient utilisation of fixed

investments. Hence the management has

to improve its utilisation of fixed assets.

22 Journal of Contemporary Research in Management, January - March 2008

c. Fixed investments and depreciation

charges: This is another important

internal factor considered to be associated

with fixed investments. In our study, we

found that very poor relationship between

the variables (-0.01) and this coefficient is

statistically insignificant at 5 per cent level

of significance.

Normally, more the investments in

fixed assets, the higher will be the

depreciation charges which help the

company for additional investments in

fixed assets. An appropriate method of

depreciation on fixed assets not only helps

the company to retain the profits and also

for a proper tax planning. But this

companys utilisation is very poor.

Table 3

Simple Correlation Analysis

Variables Correlation (r) t Value for r Table Value @ 5 D.F Results

Between per cent level

FI & Sales 0.60 4.5 1.895 6 Ho Rejected

FI & Profits 0.43 2.86 1.895 6 Ho Rejected

FI & -0.01 -0.06 1.895 6 Ho Accepted

Depreciation

Sales & 0.97 23.94 1.895 6 Ho Rejected

Profits

Sales & 0.16 0.97 1.895 6 Ho Accepted

Depreciation

Profits & 0.26 1.62 1.895 6 Ho Accepted

Depreciation

d. Sales, profits and depreciation

charges: We have analysed the

relationship between the variables

themselves, we observe a difference

picture. The coefficient of correlation

between sales and profits is found to be 0.97

which shows a high degree of positive

relationship. The same has tested

statistically, and the result is insignificant

at 5 per cent level of significance. The

degree of correlation between the sales and

depreciation (0.16) and between the profits

and deprecation (0.26) show the low degree

of positive correlation which is significant

at 5 per cent level.

Journal of Contemporary Research in Management, January - March 2008 23

Conclusions

The incremental investments in fixed

investments show an increasing trend

during the study period with an average of

Rs. 1468.45 millions and standard

deviations of Rs. 519.76. However the

investments are not uniform through out

the study period. In this study, we found

that the coefficient of correlation between

incremental fixed assets and sales to be

positive and significant. Similarly, the

coefficient of correlation between fixed

investments and profit have the moderate

relationship and statistically significant.

However, the relationship between the

fixed investments and depreciation have

the poor relationship and statistically

insignificant. As regards, the sources of

funds towards the fixed investments for this

company are internal sources.

In order to maintain the market

position with its products, every company

must produce product as good as, or better

than its competitors. This leads to fixed

investments decisions which can be

classified into two: routine and expansion.

Every company has to make routine

investments continuously whereas growth

investments are made intermittently.

The basic challenging task of fixed

investment decisions lies in the search for

lucrative opportunities and to derive the

benefits in the uncertainty environment

in quantitative terms. From the empirical

analysis, this companys fixed investments

decisions are wise and shows better fund

management

THINGS TO DO:

BASED ON THE RESULTS AND DISCUSSIONS OF THE CASE, MAKE AN ALTERNATIVE COURSES OF ACTIONS (STATEMENT OF STRATEGIES).

(AT LEAST 3 PARAGRAPHS)