CHAPTER 1

OVERVIEW

Capital investments: Importance and difficulties

Types of capital investments

Phases of capital budgeting

Levels of decision making

Facets of project analysis

Feasibility study: A schematic diagram

Key issues in major investment decisions

Objectives of capital budgeting

Common weaknesses in capital budgeting

OUTLINE

Capital Investment

Or

Capital Expenditure

Or

Project

Current outlay (or current and future outlay) of funds in the expectation of streams of benefits far into the future.

Capital Investments Decisions : Importance and Difficulties

Importance

Long – term effects (firm future activities depend on current decisions)

Irreversibility (hard to change investment decision)

Substantial outlays (involves huge cost)

Difficulties

Measurement problems (identify & measure cost & benefits of project)

Uncertainty (very hard to predict future)

Temporal spread (hard to predict long term interest rates)

Types of Capital Investments

Types of Capital Investments (planning & control)

Capital Budgeting Process

Financing

Implementation

Selection

Analysis

Review

Planning

Capital Budgeting Process

Planning

Preliminary screening of various available projects

Identify project proposal

Conduct preliminary project analysis

Whether project on prima facie is worthwhile for full feasibility report

What areas require in-depth analysis

Capital Budgeting Process

Analysis

If Preliminary screening suggest that project on prima facie is worthwhile then detailed analysis is conducted

Marketing

Technical

Financial

Economic

Ecological

The focus this phase is to gather, prepare, and summarize relevant information about various projects

Capital Budgeting Process

Selection

It often overlap analysis Phase.

Addresses the question……Is the project worthwhile?

there are two techniques for project selection

1. Non-Discounting Criteria

Pay Back Period Accounting Rate of Return

2. Discounting Criteria

NPV IRR Internal Rate of return

• There should be suitable cut off value or rate (hurdle rate, target rate, and cost of capital)

Capital Budgeting Process

Financing

Equity or Debt

Risk, income, control, and taxes influence the choice

there are two techniques for project selection

Implementation

Translating an investment proposal into concrete project is a complex, time consuming, and risky.

Improper implementation will lead to cost over run

To avoid cost overrun:

1. Be flexible and adapt to shock and surprises, as every thing cannot be planned

Capital Budgeting Process

Implementation

2. Assign responsibility to project manager for timely completion with adequate cost control

3. Use of network techniques

• PERT (Program Evaluation Review Technique)

• CPM (Critical Path Method)

Review

It should be done periodically to compare actual and projected performance.

feedback

Levels of Decision Making

Operating decisions

Administrative

decisions

Strategic decisions

Where is the decision taken Lower level management

Middle level management

Top level management

How structured is the decision Routine Semi-structured Unstructured

What is the level of resource

commitment

Minor resource commitment

Moderate resource

commitment

Major resource

commitment

What is the time horizon Short-term Medium-term Long-term

Key Issues in Project Analysis

Market Analysis

Technical Analysis

Potential Market (demand of project)

Market Share

Technical Viability

Sensible Choices

Financial AnalysisRisk

Return

Economic AnalysisBenefits and Costs in Shadow Prices

Other Impacts

Ecological AnalysisEnvironmental Damage

Restoration Measures

Feasibility Study : A Schematic Diagram

Generation of Ideas

Initial Screening

Is the Idea Prima Facie Promising

Plan Feasibility Analysis

Conduct Market Analysis Conduct Technical Analysis

Conduct Financial Analysis

Conduct Economic and Ecological Analysis

Is the Project Worthwhile ?

Prepare Funding Proposal Terminate

Terminate

Yes No

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Objective of Capital Budgeting

Finance theory rests on the premise that managers should manage their firm’s resources with the objective of enhancing the firm’s market value. This goal has been eloquently defended by distinguished finance scholars, economists, and practitioners. Wit the following :

“ The quest for value drives scarce resources to their most productive uses and their most efficient users. The more effectively resources are deployed, the more robust will be the economic growth and the rate of improvement in our standard of living.”

Key Issues in Major Investment Decisions

• Investment story

• Risks and return trade off

• Impact on firm value

Common Weaknesses in Capital Budgeting

Poor alignment between strategy and capital budgeting

Deficiencies in analytical techniques

Poor identification of base case

Inadequate treatment of risk

Improper evaluation of options

Lack of uniformity in assumptions

Neglect of side effects

No linkage between compensation and financial measures

Reverse financial engineering

Weak integration between capital budgeting and expense budgeting

Inadequate post - audits

SUMMING UP

Essentially a capital project represents a scheme for investing resources that

can be analysed and appraised reasonably independently.

The basic characteristic of a capital project is that it typically involves a

current outlay (or current and future outlays) of funds in the expectation of a

stream of benefits extending far into the future.

Capital expenditure decisions often represent the most important decisions

taken by a firm. Their importance stems from three inter-related reasons:

long-term effects, irreversibility, and substantial outlays.

While capital expenditure decisions are extremely important, they pose

difficulties which stem from three principal sources: measurement problems,

uncertainty, and temporal spread.

Capital budgeting is a complex process which may be divided into six broad

phases: planning, analysis, selection, financing, implementation and review.

One can look at capital budgeting decisions at three levels: operating,

administrative, and strategic.

The important facets of project analysis are: market analysis, technical

analysis, financial analysis, economic analysis, and ecological analysis.

Financial theory, in general, rests on the premise that the goal of financial

management should be to maximize the present wealth of the firm’s equity

shareholders. Business firms may pursue other goals. When these other goals

conflict with the goal of maximizing the wealth of equity shareholders, the

trade-off has to be understood.

The common weaknesses found in capital budgeting systems in practice are:

poor alignment between strategy and capital budgeting; deficiencies in

analytical techniques; no linkage between compensation and financial

measures; reverse financial engineering; weak integration between capital

budgeting and expense budgeting; inadequate post-audits.