After reading this article you will learn about investment decisions taken in private and public sector.
Investment Decisions in the Private Sector:
The experience of industrial enterprises in the private sector is highlighted below:
The following four objectives are playing significant role for which capital expenditure decisions are taken in Indian industries.
(i) To maximise per cent return on investments;
(ii) To maximise aggregate earnings;
(iii) To achieve a desired growth rate in earnings; and
(iv) To maximise ordinary share prices.
Out of the above four objectives, (i) and (ii) are the most favoured objectives. There are reasons to believe that for the most part business executives favour objectives that can be translated into explicitly measurable goals in India.
In most cases, the period of planning is usually short, i.e., two to five years. But there are cases where a period of ten years is covered. The short-duration of the planning period is probably due to many uncertainties caused by peculiar business environment, viz., rise in price level, power shortage, scarcity of materials etc.
The organisation and first screening are done at the plant level where there is existing lines of product. But in case of new lines of product, it is done at the central or top level. The process is ‘top-down’ instead of ‘bottom-up’.
In other words, in 80% cases the Board of Directors take the final decision about the capital expenditure whereas in 20% cases, the Chairman takes the final decision for the capital expenditure proposals.
It has been highlighted above that the different methods are considered for evaluating investment decisions:
(1) Accounting Rate of Return (ARR);
(2) Pay-Back Period (PB);
(3) Net Present Value (NPV);
(4) Internal Rate of Return (IRR);
(5) (Net) Terminal Value (TV).
Now the question arises which of these techniques are being used in India.
The following information is available from the empirical evidence made so far:
(a) Most of the private sector companies particularly those are in new product lines, depend on more than one technique, i.e., they use a combination of different techniques stated above.
(b) There is some large corporate undertaking who are not using the DCF techniques due to: (1) too much sophistication, (ii) existence of a seller’s market.
(c) The most widely accepted method is the ARR technique for appraising capital investment decisions and PB is considered a supporting one.
The basic financial criterion which is universally accepted on financial management is the cut off rate which is also known as cost of capital.
Needless to mention that the cut-off rate can be calculated with the help of the following alternative methods:
(i) Cost of funds.;
(ii) Weighted Average Cost of Capital;
(iii) Historical rate of return;
(iv) Arbitrary cut-off rate.
In India, the method applied for determining Cost of Capital actually varies from company to company. The “weighted average cost of capital” which is a theoretically correct method, is gradually being realized. Moreover, a large number of companies use cut-off rate arbitrarily established by the management.
A group of companies, those who are high-profitability companies, use ‘cost of funds’ to finance expenditure simply because it is relatively easy for them to arrange funds to finance capital expenditure proposals as a when the need arises.
From empirical evidence it is found that in most cases, existing product lines are financed from internal sources whereas new product lines are financed from internal as well as external sources, particularly the term loan which is the cheapest one.
That is why capital rationing does not seem to be a problem in capital budgeting in Indian industry. According to the executives of those companies, to collect funds is not a constraint; the only constraint is government policy.
The risk aspect of capital management has the following dimensions:
(a) Management concept of project risk;
(b) Approaches for incorporating project risk into the decisions;
(c) Method to reduce risk.
According to the industrial enterprises, the main factors are:
(1) Uncertainty in the availability of inputs;
(2) Uncertainty in Govt. Policy;
(3) Uncertainty of pay-back period;
(4) Uncertainty about market potential;
(5) Inability to predict key factors.
(l)and (2) are most important risk factors in India.
At present, most of the Indian Companies are following one or more methods against risk incorporation:
(1) Shorter pay-back (for risky projects);
(2) Higher cut-off rate;
(3) Sensitivity Analysis.
The first two are widely used in India.
At about two-thirds of the companies use post completion audit in order to control capital expenditures in India although there is a great variation in the quality and contents of post completion audit. The remaining one-third companies control their capital expenditures with the help of periodical reports and performance appraisal.
It is interesting to note that there is wide gap between the theory of investment appraisals and the actual industry practices in the private sector enterprises in India. Professor Porwal’s work expresses that most of the large private sector undertakings need a well-founded capital expenditure planning.
During the late sixties and early seventies, application of DCF techniques (particularly the NPV and IRR methods) has become introduced. But India is always lagging behind it.
The significant reasons are:
(i) The existence of seller’s market; and
(ii) Government policy restricting expansion.
That is why, Government should provide better scope for investment opportunities in private sector/enterprises about the review of licensing, control and other restrictive policies.
Investment Decisions in the Public Sector/Public Enterprises in India:
The present study highlights the capital expenditure decisions in the public sector undertakings. Needles to mention that capital budgeting decisions of the public sector are public industrial investment decisions of the government where a number of government agencies are involved in the process of decision making.
At the same time, the decisions are governed by guidelines and directives issued by the government.
We deal with the two aspects:
a. Guidelines for investment decisions, and
b. Industry practices.
(a) Guidelines for Investment Decisions:
Till 1965, no guidelines for investment decisions by public enterprises were issued by the Government of India. As such, the ministries in charge of the different public undertakings prepared project reports for different industrial undertakings by a ‘Trial and Error Method’.
As a result, attention was drawn by various consulting agencies and individuals to the deficiencies in economic analysis, wide variation in approaches etc.
In 1965 a Manual of Feasibility Studies for Public Sector Projects was prepared jointly by an American Consulting Firm and the committee on Plan Projects of the Planning Commission, Govt. of India. The said Manual was published by the Planning Commission and issued to public sector undertakings. These guidelines are to be followed for investment decisions by public sector enterprises in India. Objectives
The significant objectives of the Manual are discussed below:
(1) To develop a systematic and comprehensive method of project planning and appraisal; and
(2) To suggest a correct and systematic procedure for making investment decisions.
The Manual is divided into two parts.
It gives an outline and definition of major approval phases leading to the commencement of the construction. It also expresses the objectives to be kept in mind in preparing a feasibility study. It claims to examine the present capital budgeting practices in public sector undertakings.
This manual is devoted to the management and elaboration of the techniques of conducting a feasibility study.
Stages in Project Formulation:
According to the Manual, the systematic development of a project, before the actual construction period, should consist of three formal stages:
(a) Preliminary Project Formulation;
(b) Feasibility Study; and
(c) Project Report.
(a) Preliminary Project Formulation:
This is nothing but the stage of initiating a project proposal.
It has two objectives:
(i) To determine the number and size of products which are needed in order to satisfy plan targets in any one industrial sector;
(ii) To indicate the feasibility of each of the projects recommended.
The task should be done by the concerned administrative ministries or some other responsible group. This report is prepared to be a discussion document for the consideration of the Planning Commission and the Administrative Ministries. A decision whether a feasibility study should be taken into consideration or not is simply taken on the basis of the preliminary analysis.
The principal elements of the preliminary estimate of feasibility are:
(a) Demand for the product and its position in the economic development;
(b) Preliminary technical feasibility;
(c) Alternative location;
(d) Preliminary technical feasibility;
(e) Total cost (capital) and commercial profitability; and
(f) National benefits from the projects.
(b) Feasibility Study:
The feasibility study, the next stage in project formulation, is the most important part of the project analysis since approval of the projects and allotment of foreign exchange for purpose depend on it. This study is prepared in order to gauge the most economic size, location, product-pattern, and processes to be chosen for the project.
At this analysis level, the technical development of the project is carried out to the extent necessary for evaluating the commercial and national economic aspects. At this level, all alternatives are properly examined and one project clearly emerges as the most economic one.
The Manual suggests a detailed and comprehensive analysis of the following aspects and recommends techniques for the said purposes:
(i) Demand analysis;
(iii) Technical development of the project;
(iv) Location of the project;
(v) Project cost estimates;
(vi) Profitability analysis; and
(vii) National economic benefits.
The impact of the above techniques is not discussed here in detail. Only no (vi) i.e., profitability analysis.
The most important aspect of the feasibility study suggested by the Manual is the analysis of its commercial profitability. The Manual has listed the following methods as indices of profitability.
1. Return on Investment Criteria:
(a) Average Return on Original Investment.
(b) Average Return on Average Investment;
(c) Return on full production on original investment.
2. Pay-Back Period
3. Discounted Cash Flow Indices:
(a) Present worth Method;
(b) Internal Rate of Return Method;
The Manual has recommended that the commercial profitability should be calculated by adopting two methods simultaneously.
(i) Average Return on Original Investment Method from the first category of indices; and
(ii) Present Worth Method from the second category indices.
The Manual also suggests that the cost of capital should be on the basis of a ‘desired rate of return’ established by the Reserve Bank of India and the planning Commission in the estimates. These indicate that 12% is a desirable rate of return for public sector industries.
But the Manual admits that there should be different rates for different industries
(c) Project Report:
The project report is drafted as prepared by the ‘project authorities’ after the approval of the feasibility study by the government although it does not require any approval from the government.
However, the need for such a report is explained in the Manual which is reproduced as under:
Although such technical development has taken place in the feasibility study, generally insufficient information has been developed for making detailed technical plan and estimates and for awarding contracts. It is this work that is carried out after the feasibility study is approved and is documented in the project report.
There are two elements in project planning:
(i) Overall project planning, and
(ii) detailed contract planning.
(i) Overall Project Planning:
It includes preparation of work schedules for construction of projects, decision about the type of equipment that are used, detailed plant layout and initial constriction drawing etc.
(ii) Detailed Contract Planning:
It reveals the scope and objectives of each contract, detailed schedule about them and inter-relation between them.
(c) The Industry Practices in the Public Sector:
The capital budgeting practices in public enterprises in India do not conform to the guidelines framed in the Manual on Feasibility Studies. This study actually is based on the study conducted by Raj and other. The feasibility report is not prepared according to the manner suggested by the Manual.
This is expressed from the following:
(1) All the elements are not incorporated in the feasibility report which is prepared by the public enterprises. For instance, NEBA (National Economic Benefit Analysis) is not included in any feasibility report. Even organisations, like the BPE (Bureau of Public Enterprises), the PC (Planning Commission), who have prepared it, have not any clear idea about it.
(2) Discounted Cash Flow (DCF) techniques are very rarely followed. Those who are actually following it are doing it at the instance of Bureau of Public Enterprises (BPE) and not at their own initiative.
(3) Demand analysis is very rarely done by the enterprises themselves or by the Administrative Ministries. They depend on, however, the projections made by external agencies (via. the Planning Commission and the Directorate-General of Technical Development (DGTD).
(4) The determination of the selling price, the effect of price on demand, location etc. and time-phasing of demand suggested in the Manual are not followed.
(5) In most of the cases, the analysis of national economic benefits’ is not included in the feasibility report.
However, the area which has received good coverage in the feasibility report states the technical aspect of the project. But at the same time, financial, commercial and economies aspects are neglected or are not given proper importance according to the guidelines prescribed by the Manual. The national cost benefit is totally ignored
The divergence between the guidelines prescribed by the Manual and current practices of capital budgeting by public enterprises are primarily due to the following factors:
(a) Many executives in the public sector enterprises are not aware of the existence of such a Manual for preparing feasibility report, i.e., they have not even been heard about its existence.
Although a large number of copies have been issued by the Planning Commission to the various public enterprises, it is interesting to note that neither the existence of the Manual nor its contents are known by the executives of the public sector enterprises. The Manual has not been put to use by the Administrative Ministries over a long period of time simple due to personality conflicts among high Government officials.
(b) While preparing the feasibility reports and detailed project reports, the engineers and the technical staffs play a most significant role, i.e., a major role is played by the financial executives. Due to the imbalance in participation, there is inadequate coverage of commercial, financial and economic aspects in the feasibility report. As such, in the absence of a good team work, desired result cannot be expected.
(c) The incongruence between the guidelines and the practice among public enterprises may be the proficiency, called for in a wide range of subjects, viz., economics, marketing, finance, engineering etc., for obtaining the feasibility study reports. At the enterprise level or at any other decision making process, such expertise hardly exists.
It is needless to mention that in the financial analysis, capital investment decisions of public sector enterprises are the public industrial investment decisions of the Government. As a result, some agencies of the Government are related with the decision making process.
We all know that most of the executives including decision makers are the government employees and they have not had adequate knowledge, training or experience about capital budgeting.
As such, the Manual which is prepared by a sophisticated group of management consultants may not be understood by those inexperienced employees. Because, they are either engineers or accountants taken from the Audit and Accounts service of the Govt. of India who are actually familiar with Govt. procedures and accounting system.
Some senior Government officials and a few politicians are appointed as Board of Directors of the public enterprises.
As a result, at the level of the Administrative Ministries, the Finance Ministry, the Industry Ministry, and the Planning Commission, the senior executives are drawn the Central Administrative Service.
The Cabinet of the Govt. of India which analyses the major investment projects and the Parliament which approves the project, do not consist of experts whose services may be effectively utilized but on the contrary, do consist of politicians. Therefore, it is difficult to get expert services which are required by the guidelines presented in the Manual for the purpose of preparing feasibility reports.
In conclusion, the present organisational set up for investment decisions suffers because of:
(a) The non-availability of an adequate-equipped organisational structure either in the enterprise or in the outside agencies;
(b) The personnel who take capital budgeting decisions have neither the training nor the requisite experience for the job which they undertake;
(c) The decision-making process consists of innumerable committees consisting of identical personnel, but having different chairmen;
(d) The organisation set-up is highly complex and involves inordinate delays in decision-making;
(e) The organisational set-up is one in which various units of the government are involved and, consequently, ideally suited for conflicts;
(f) At the level of decision-making, enormous outside pressure, particularly from State Governments and politicians, are brought to bear on decision-makers who are mainly civil servants; and
(g) The senior civil servants of the Government who are predominantly involved in decision-making, also occupy very influential positions within the organisation at the Board level as well as in the various Ministries who control these enterprises.
Moreover, since the public sector enterprises have been playing a very significant role in the economic development of our country, the role of correct capital budgeting decisions cannot be overemphasized.
The studies which were made on early seventies upon which the conclusions were drawn about the industry practice are very old. At present, a considerable improvement has been made in our country about the activities of the public sector enterprises. Until there is an improvement in the internal affairs and/or environment of the enterprise, these improvement could not be achieved.
Moreover, throughout the country, there appears to be a growing awareness among the decision-makers at all levels in order to select the right projects. Besides, modification/changes may be made in the guidelines of the Manual on the basis of past result and experience for better improvement and results.
At least, the managers in the public sector enterprises have in the meantime, acquired some knowledge and experience and they may be converted into a good team of decision-makers after some training or development programme.