Chapter 1

OVER VIEW

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

Objectives of capital budgeting

Common weaknesses in capital budgeting

Outline

Capital Investments : Importance and Difficulties

Importance

Long – term effects

Irreversibility

Substantial outlays

Difficulties

Measurement problems

Uncertainty

Temporal spread

Types of Investments

Mandatory Investments

Replacement investments

Expansion investments

Diversification investments

R & D investments

Miscellaneous investments

Capital Budgeting Process

Financing

Implementation

Selection

Analysis

Review

Planning

Levels of Decision Making

Operating Administrative Strategic

decisions decisions decisions

Where is the decision taken Lower level Middle level Top level

management management management

How structured is the decision Routine Semi – structured Unstructured

What is the level of resource Minor resource Moderate resource Major resource

commitment commitment commitment commitment

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

Key Issues in Project Analysis

Market Analysis

Technical Analysis

Potential Market

Market ShareTechnical Viability

Sensible Choices

Financial AnalysisRisk

Return

Economic AnalysisBenefits and Costs in Shadow PricesOther 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

NoYes

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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.”

Basic Considerations : Risk and Return

Investment decisions

Financing decisions

Return

Risk

Market value of the firm

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 maximise the present wealth of the firm’s equity

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

conflict with the goal of maximising 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.