Capital Budgeting Indian Oil Corporation

Advanced Corporate Finance Assignment

Fadhal Abdulla A V
215112084

CAPITAL BUDGETING
Capital budgeting involves determining the most advantageous investment options for your small business's liquid assets. Accountants use several complex calculations to analyze possible investment returns, but many small businesses lack personnel with awareness of the complexity of capital budgeting. Simply estimating yearly returns in cash flow doesn't offer your small business an accurate representation of an investment's real return value. Capital budgeting is the process of determining whether or not an investment is worthwhile. Often companies will have several opportunities and must measure each one's potential in order to make a comparison and choose just one or a few. For example, a company might be trying to determine whether to buy new equipment to expand production capacity on an existing product, or to invest in research and development for a new product. The three main methods of taking this measurement are Net Present Value (NPV), Internal Rate of Return (IRR) and Payback Period. Most companies use multiple techniques for all of their capital budgeting decisions. There are a number of minor methods, such as profitability index and sensitivity analysis, which can also be employed in making decisions. Since each method looks at the investment from a different perspective, it is best to employ multiple analyses and take the opportunities with the best return according to all techniques.

CAPITAL BUDGETING IN INDIAN OIL CORPORATION LTD.

Capital Projects in IOC are broadly divided into: a) Core-sector projects e.g. Refining, Marketing, Pipelines and R&D. b) Diversification projects e.g. Exploration & Production (E&P), Liquefied Natural Gas (LNG), Petrochemicals and Power etc. c) Globalization Projects Core/ non-core sector projects overseas. d) Merger / Acquisitions As per revised DOA effective from April 9, 2001, all capital investment proposals above Rs.100 crore require Boards approval as under: Above Rs.100 crore Above Rs.50 crore to Rs. 100 crore Above Rs.10 crore to Rs. 50 crore Up to Rs.10 crore : Board : Planning & Project Committee of Board : Chairman : Functional Director

Project costing Rs. 250 crore and above require also approval of Project Evaluation Committee.

Dynamism of a corporation in the new business environment is often dependent on diversification of investment as well as modernization and expansion of existing projects. Capital investment analysis involves estimating and comparing the benefits of these schemes. It is an exercise that helps the Corporation to take a decision on the investment proposal under review. Five steps are basic in investment analysis. They are: 1. Need and Justification 2. Market and Commercial Assessment 3. Technical Feasibility Study 4. Financial Analysis 5. Sensitivity and Risk Analysis The foremost issue that needs to be described in the Capital Investment Proposal pertains to identification of basic objective or need which is sought to be fulfilled by implementation of the proposed project. The Proposal shall present the complete perspective, rationale and background of need for the project. Market assessment helps strengthen the case for the project under review. The scope of market assessment is vast. As a tool for assessing the commercial dimensions of the project, it helps identify the critical market and economic factors such as demand for the product under review, scope for inter-product substitution, feasible pricing schemes that impinge on the profitability projections of the proposal etc. Technical feasibility study helps assemble the different components of production as land and site development, technology and equipment, material inputs, labor inputs, implementation schedule in to the relevant categories of investment (project) cost and operating (production) costs spread over the life of the project. From market assessment the revenue stream is set out against the expenditure stream from the technical studies. These two sets of inflows and outflows form the basis for developing the statements required for financial and economic analysis. On the building blocks of the market and commercial assessment along with technical feasibility studies, financial and economic analysis of the proposal are undertaken. Once the size of the investment is known assessment of project financing is made simultaneously. Financial analysis of a proposal helps in answering the questions: Is the proposal profitable? Are the expected returns commensurate with the costs involved including borrowing costs? Is the proposal profitable in terms of other investment opportunities? Is it worthwhile investing in the project in terms of certainty of returns?

The final decision on a proposal is taken only after sensitivity and risk analysis. As the name suggests sensitivity analysis test the proposals viability or profitability to modifications in few critical variables. The sensitivity of the project to the critical variables is thereby established.
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Risk analysis is a more comprehensive extension of sensitivity analysis as it seeks to examine the profitability of the capital invested subject to differing combinations of movements of the critical variables. Sensitivity analysis is the first step towards risk analysis. Both sensitivity and risk analysis enables the management to comprehend the sources of risk that a project is exposed to cover its projected life period. More important, it enables the corporation to undertake measures that help to mitigate risk either through risk sharing procedures or through hedging options. FINANCIAL ANALYSIS The Financial analysis of a project is vital for assessing the viability of the project and hence provides valuable information to the decision-maker. Financial analysis produces an estimate of the financial gains, which will accrue, to the Corporation after implementation of the project. The financial analysis entails determination of year-wise cash flow of the project, computation of key decision criterion like internal rate of return (ROI & ROE), net present value (NPV) of cash flows, debt service coverage ratio (DSCR) and break even (BE) analysis etc. Financial analysis of capital investment proposals shall be carried out based on realistic set of assumptions duly considering present prices of input / output, market forces etc. DETERMINATION OF CASH FLOWS Determination of year-wise cash flows is the most crucial step of the financial analysis. The Cash flows shall be determined for three components namely: Initial Investment Operating Cash Flows Terminal Cash Flows

INITIAL INVESTMENT This component of cash flow mainly represents net cash outlay in the period in which the asset is purchased or constructed. In other words, initial investment shall comprise of the total project cost as indicated in the capital investment proposal and shall also include incremental value of working capital, wherever required. While computing initial investment a care needs to be exercised in respect of following: In respect of proposals where financing through borrowings is envisaged, receipt / repayment of loans and payment of interest shall not be considered while calculating ROI. However, these are to be considered while calculating ROE. OPERATING CASH FLOWS This component of cash flow presents year-wise cash flow generated from operations after the project has been commissioned. The capacity utilization shall not be more than 60% in the first year and at 90% from second year onwards till project life cycle. The determination of operating cash flows shall, therefore, entail estimating year-wise operating income, input/ raw material cost and operating expenses during the project life.
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OPERATING INCOME: (a) Operating income of a project represents total realization or savings from the operations, after implementation of the project. (b) While computing the Gross operating income, following issues are to be kept in view: For Refinery projects, Refinery Gate Price (3 Years average excluding abnormal fluctuation such as war situation etc.) based on import parity (80% of import parity and 20% of export parity) considering applicable ocean freight, ocean loss, ocean insurance, present duties, inland freight etc. as included in the price build up is to be reckoned. Sale prices of free trade products in target market and basis of adoption for it. For petroleum products, 3 years average import parity (80% of import parity and 20% of export parity) prices on landed cost basis/ as per pricing policy of corporations are to be assumed. However, in case competitors prices are lower than import parity t hen the same shall be used. Product-wise marketing margins shall be based on 8% mark-up or actual margin whichever is less are to be considered. The prices should take into account the impact of discounts including cost for extended credit, freight under recovery etc. Further, in case any price cap by Govt. / Regulatory authority is applicable then it is to be considered. Sale price of regulated products (if any) is to be considered as per policy of Govt. in this regard. Subsidy component of any to be borne by Corporation is to be duly factored in. For Pipeline projects, alternate mode of transportation is to be considered as benchmark. Freight is to be compared with alternate transportation mode for return on investments (cost of capital). In the base case, 70% of Notional Railway Freight (NRF) shall be considered as revenue generation. In case there is a tariff cap by regulating authority then it is to be considered. For diversification products, prices are to be considered based on competitors prices or Govt. policy in this regard. For new products, prices are to be based on landed cost of substituted products (based on import parity). In case of Export Parity Price, selling price to be considered based on aver age 3 years FOB price at nearest market having demand for similar or near similar product (excluding abnormal period) minus 5% to take care of the impact of extra supply in the market plus freight charges (ocean and inland)/ other charges. However, export incentives if available to be considered. (c) Here it is pertinent to mention that future pricing should factor in likely supply/demand situation and impact of likely substitution, if any. (d) For such projects where investment shall result in savings in costs, there shall be detailed calculations for cost in both cases i.e. cost without investments vs. cost with investment. INPUT/ RAW MATERIAL COST: a) Landed cost of inputs / raw material shall include all the incidental costs involved including present rate of custom duties.
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b) For refineries, crude cost may be considered based on 3-year average import parity prices of identified crude (excluding abnormal fluctuation such as war situation etc.). c) For Marketing projects, cost of procurement of products, including freight up to market / storage point is to be considered. OPERATING EXPENSES: (a) The operating expenditure of the project shall include the cost of chemicals and consumables, utilities (like power, water, and fuel) repairs and maintenance, wages and salaries, rent and insurance, depreciation, other administrative expenses etc. (b) The expenses under these various heads shall be estimated on a realistic set of assumptions and past experience, wherever applicable. The basis for estimating the expenditure shall be clearly indicated in the proposal. (c) A comparative analysis of the estimated operating cost with the similar existing operations shall also be indicated along with reasons for variations, wherever applicable. TERMINAL CASH FLOW The cash flow in the terminal year of the project mainly represents the salvage value of the project plus release of incremental working capital. Salvage value shall be considered as under: Land to be valued at original cost. Other items to be valued at 30% of the original cost without financing cost. Tax on capital gain should be considered. Capital gains shall be taken as terminal value minus written down value as per income tax act. Terminal cash flow to be taken in 16th year. PROJECT LIFE For cash flow determination and financial analysis, the life of project shall be assumed as 15 years from the date of completion, unless the project life is shorter. CASH FLOWS BASED ON CONSTANT PRICES While preparing Cash Flow estimates, an issue, which is raised quite frequently, is whether such estimates shall be based on current prices or constant prices. Forecasts in current prices, which include the effects of inflation do not give a realistic picture of the true financial profitability of a project, since, inflation can artificially improve apparent profitability by increasing future revenue as compared with todays capital costs. Further, no forward cost escalation is being considered while estimating the project cost. Therefore, future income, expenses and net revenues may be stated in constant prices or values based on todays investment price levels. However, the project cost shall also be prepared based on completion project cost. FINANCIAL EVALUATION

After determination of cash flow as per methodology enumerated above, the next logical step is to financially evaluate the proposal. The evaluation shall be carried out through following two methods: Internal Rate of Return (ROI/ROE) Net Present Value (NPV) Both the above methods fully recognize the timing of cash flows through the process of discounted cash flows. INTERNAL RATE OF RETURN (IRR) Internal Rate of Return (IRR) is the discounting rate at which present value of cash inflow is equal to the present value of cash outflow. In other words, the discount rate that yields a ZERO Net Present Value is called Internal Rate of Return. IRR shall be computed for all capital investment proposals and indicated in the Capital Investment Proposals. The computed IRR shall be compared with Benchmark IRR (hurdle rates). Hurdle rates shall be calculated based on Weighted Average Long Term Cost of Capital ( WACC) along with project specific risk premium. Hurdle rates shall be revised annually after approval of competent authority. Methodology of Computation of Post-Tax Hurdle rates Hurdle rates (benchmark IRR) are proposed to be linked to long term WACC of IOCL. Major assumptions are: CAPM model has been used. Last 3-years average risk rate of return on 10-year Govt. securities has been considered. Last 3-years average Beta of IOC has been considered. Average cost of Long-term debt based on cost financing for future projects instead of historic actual. Long term debt: equity ratio is considered as 1:1. For global projects, hurdle rates are linked to cost of long term foreign Currency loan including forward premium. Margin over WACC (risk premium) is fixed on nature of projects.

Calculation of WACC for the Year 2007 is shown below: Risk free rate of return (Rf) Expected Market Return on equity (Rm) Average Beta of IOC Cost of equity, Ke=Rf+B*(Rm-Rf) Cost of Long term Debt Corporate Tax Tax Adjusted cost of Debt (Kd)
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6.35% 16% 0.96 15.61 8.93% 33.66% 5.92

Debt:Equity ratio WACC= (Ke+Kd)/2

1:1 10.77%

Based on WACC of 10.77% (say 11%) post tax hurdle rates for Different Projects are Combined projects having linkage with one or more divisions Refinery & pipelines project Marketing division Projects Petrochemical, Gas, Power and R&D projects -Through JVs -In IOC B/S E&P projects Global Projects 14% 16% 19% 14% 13% 13% 13%

NET PRESENT VALUE (NPV) The present value of a future sum of money can be found by discounting it to the present point in time or Year O at the required rate of return/ discount rate. Required rate of return shall not be less than cost of capital. Under this method, the present value of each years net cash flow is calculated, starting from the year 0 till complete project life i.e. 15 years. This discounting rate adopted shall be the Hurdle Rate. If the project has a positive Net Present Value, the project is considered to be commercially viable. Divisions shall indicate Net Present Value of all the projects at a discount rate of Hurdle Rate duly enclosing workings with the capital investment proposal. OTHER INTANGIBLE BENEFITS Apart from carrying out the financial analysis of the proposal, it is equally important that the proposal shall also indicate other intangible benefits of the project. Normally, these are the benefits related to socio and strategic needs of the country. This includes projects for pollution control, safety needs, staff welfare etc. A care needs to be taken while listing the intangible benefits of the project. The benefits, which can be quantified and measured, shall not be treated as intangible benefits. For example, a project for modernization of equipment may have a number of intangible benefits like lesser pollution, better safety etc. but it may also lead to higher productivity. PRE-REQUISITES FOR BUDGETING

Once the items or facilities in which the investments are needed are identified the next step is the initiation of the proposals. Any proposal that is initiated for inclusion in the budget shall be supported with the concept and the administrative approval, which inter-alia includes: (a) (b) (c) (d) (e) Brief description of the project. Cost of the Project Justification of project Economics of the project Benefits.

AN ENERGY CONSERVATION PROJECT AT IOCL DIGBOI REFINERY

Digboi Refinery with an installed capacity of 1.0 MMTPA has Motor Spirit (MS), Superior Kerosene Oil (SKO), Aviation Turbine Fuel (ATF) and High Speed Diesel (HSD) as white oil products. These products are stored in various storage tanks at Oil Movement & Storage (OM&S). High capacity majority of SKO & HSD tanks at Digboi refinery are of fixed roof type contributing to fugitive emission loss resulting in high fuel & loss of the refinery. Opportunity exists for reduction of loss by converting high capacity tanks of OM&S from fixed roof to floating roof. The Floating roof facilitates the reduction of evaporative loss that occurred the vapor space of fuels that were stored in fixed roof tanks. It has not only proved effective for reducing emissions from the storage of volatile organic compounds when compared to fixed roof tanks, but also helped to reduce the potential for vapor space explosions that regularly occur in fixed roof tanks. The floating roof also virtually eliminates the possibility of a boil over phenomenon that occurs in fixed roof tank farms where crude oils are stored. Because of these advantages the floating roof is now used extensively throughout the industry to store petroleum and petrochemical substances in large quantities. As per Benchmarking report of Shell Global Solutions International, Storage and handling Index of Digboi Refinery for the year 2003-04 & 2004-05 are 429.4 and 458.8 respectively against Shell benchmark of 86.2 and these accounts to a gap of US$ 0.6 millions. COST ESTIMATE For cost estimation engineering services were asked to provide with basic cost estimation for various jobs of roof conversion from Fixed to Floating for tank-13. Based on cost estimation of engineering services detail cost estimation was prepared for the total job and material with 10 % escalation. As per total cost estimation Tank roof conversion of T-13 & 14 will cost Rs. 116.71 Lakhs.
DESCRIPTION Equipment & Machinery Erection charges Civil works VALUE ( in lakhs) 66.9 47.1 23.8

Total Add: 10% contingency Total expenditure

137.8 13.8 151.6

JUSTIFICATION OF THE PROJECT: Fugitive emission loss from Tank 13 has been estimated to be 59.9 MT of SKO per Annum respectively. By conversion of Roof from fixed to floating roof of Tank 13 Digboi Refinery can save 60.0 MT of high valued petroleum products and earn extra revenue of Rs. 17.54 Lakhs/Annum with average 2005-06, 2006-07 & 2007-08 AOR prices of SKO @ Rs. 29281/MT. Digboi Refinerys Fuel & Loss is second highest among Indian refining sector and this proposal is towards improvement in this area. Loss on crude processing of Digboi is averaged to 0.5% in last Four Years. Payback period of investment is 8.6 (Without CDM) & 8.2 (With CDM) Years and IRR on investment is 5.8% (Without CDM) & 6.5 %( With CDM) %. Tank 13 is higher capacity which accounts to high fugitive emission. The project will attract additional recurring benefit of Rs. 0.85 Lakhs/Yr under Clean Development Mechanism (CDM). GR inspection recommended for replacement of tank roof in 2006. Being refinery located in heart of the city, the proposed facility will contribute towards corporations social commitment for cleaner environment. ECONOMICS OF THE PROJECT: NET SAVING : Rs. 17.54 Lakhs (Without CDM) Rs. 18.39 Lakhs (With CDM)
Value 66.0 MT/year 6.1 MT/year 59.9 MT/year

S. No 1. 2. 3.

Parameter Total loss from T-13 with fixed roof Total loss from T-13 with Floating roof Saving by conversion of roof from Fixed to Floating for T-13

4. 5.

Average SKO price

Rs. 29281/Mt

Monetary saving by conversion of roof from fixed to floating for T- Rs. 17.54/Mt 13

Estimation of CDM Benefit for Roof Conversion of Tank-13 Parameters Projected fuel saving from Roof Conversion Average density of Saved Oil Calculated C:H ration of saved oil Carbon content of saved oil

Value 59.9 MT/yr 0.84 MT/m3 6.47 51.88 MT/annum

Reduction in CO2 emission due to saved oil(Considering 12 MT of 190 MT of CO2 C generates 44 MT of CO2) Equivalent Carbon credit (CER) Prevailing price of CER (Based on inputs from M/S Ernst&Young) Prevailing conversion rate of Euro to INR CDM benefit based on E&Y projection 190 CER 8 Euro/CER 56.18 Rs/euro 0.85 Rs/Lakhs/annum

FINANCIAL EVALUATION Case-I :Without considering CDM benefit Case-II: With CDM benefit Projected Annual Benefit (Benefit due to Loss reduction) Total investment cost for Roof conversion of Tank-13 & 14 Annual maintenance /operating cost Cash outflow in 2009 (100% of investment cost) Cash inflow in 2009 (considering 0% benefit in1st year) Cash inflow in 2010 (considering 75% benefit in 2nd year) Yearly Cash inflow throughout 2011-2023
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17.54 151.58 0.00 -151.58 0.00 13.15 17.54

18.39 151.58 0.00 -151.58 0.00 13.80 18.39

Internal rate of return NPV (WACC=10.77%) Discounted Pay back period

*All in Rs. Lakhs

5.85% (43.25) 28.82

6.5% (37.99) 22.72

The project is accepted if the internal rate of return is higher or equal to the benchmark IRR is also known as Hurdle rate. A project shall be rejected if its IRR is lower than the Hurdle rate. Hurdle rate for Refinery & Pipelines Divisions Projects is 13%. As the IRR is found to be lower than the Hurdle rate the project should be rejected. As far as NPV is concerned, the project is having a negative NPV at WACC=10.77%. This also proposes to reject the project.

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