Professional Documents
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Introduction
SAIL wants to modernise all its existing plants, and TATA wants to divest its old businesses to enter into new
economy ventures. Such situations require a sound capital expenditure (budgeting) decision. The basic
feature of capital expenditure is that it involves a current outlay of funds in the expectation of a stream of
future benefits. This section provides a broad overview of capital budgeting.
Analysis
If the preliminary screening suggests that the project is worth investing, a detailed analysis of the marketing,
technical, financial, economic, and ecological aspects is conducted.
Selection
The selection process addresses the question—is the project worth investing? A wide range of appraisal
criteria has been suggested to judge the worth of a project. There are two broad categories. Non-Discounting
criteria and Discounting criteria. Some selection rules for both methods are listed below: -
Review
Once the project is commissioned, a review phase has to be set in motion. Performance review should be
done periodically to compare the actual performance with the projected performance. In this stage, feedback
is useful in several ways:
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Project appraisals
Market & demand analysis
The first step in project appraisal is to estimate the potential size of the market for the product
proposed to be manufactured, and get an idea about the market that is likely to be captured. Market
and demand analysis is concerned with two issues:
• What is the likely aggregate demand for the product / service?
• What share of the market will the proposed project enjoy?
The analysis should be conducted systematically. Two broad categories in market and demand
analysis include: collection of secondary information and conducting market survey i.e. collection
of primary information.
Technical analysis
• Selection of technology
• Acquisition of technology
• Purchase of materials and equipments
• Selection of sites and layout of facilities on the site
• Discussion on pollution and effluent disposal
Financial analysis
Once the commercial (technical, market & demand) analysis is completed, the project has to be
assessed in terms of financial feasibility. It will be measured in terms of costs and benefits of the
project. Of the many steps involved, we will discuss the most important topics like cost of project,
working capital requirements. These areas are to be considered before finalising any project.
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Project Planning
Project planning is directly proportional to one’s determination to achieve a specific task. It relates
two aspects of a project:
(1) What one wants
(2) How best one can achieve it
A project involves activities, resources, constraints and inter-relationships that a human being can
analyse and plan informally. Once a project goes beyond a certain level of size, formal planning has
to replace informal planning. Lack of effective planning may lead to chaos. Planning puts forward a
course of action to achieve a predetermined task in a forecasted environment. To install a good
project plan in an organisation, the objectives, the process and other related matters should be stated
clearly.
Objectives of Project planning
The primary objectives of project planning would be to:
(1) Avoid working in a haphazard manner.
(2) Plan for the best execution of projects and apprehend problems
(3) Keep up with the deadlines & budgets specified.
(4) Help in proper communication and coordination
Once the objectives are well defined, they serve as the framework for decisions to be made by the
project manager. A clear set of objectives will enable the project manager to take expeditious
actions, by following a specific process.
Process
All departments, involved in a project, should take part in the planning process of the project.
Participation in the planning process will increase commitment to the objectives and goals. A
planning process can be divided into five phases:
(1) Defining objectives
(2) Delineating tasks
(3) Identifying departments which are involved
(4) Identifying resources
(5) Installing the MIS
The plan prepared should be systematic and flexible enough to include other activities later.
Basically, project plans can be of two types: strategic plans and general plans. A strategic plan scans
the environment from different angles; identifying emerging markets and preparing an action plan
accordingly. Once the strategic plan ends, the general plan is prepared to achieve strategic
objectives.
Project Life cycle
To facilitate the study of various activities of a project, the project life is divided into phases. . In
planning these stages, one has to focus on two points: the rolling wave concept i.e. detailed
planning done for the project development & preliminary engineering; and the integration concept
i.e. planning for all the stages must be integrated. To maintain a consistency in planning, the general
phases/ stages in the project life cycle are:
(1) Project development & Project Engineering.
(2) Bidding and contract negotiation.
(3) Purchase and procurement.
(4) Construction
(5) Commissioning
According to David Cleland the phases of project life cycle are:
(1) The conceptual phase
(2) The validation phase
(3) The full scale development phase
(4) The production phase
(5) The development phase
Phases should enable preparation of a good plan and promote periodic review.
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Project selection
Components of cash flow streams
Analysing a project from the financial perspective, using market and technical analysis. The three
dimensions of financial analysis are:
1. Costs of projects
2. Means of finance
3. Projected income and cash flows
Project from different perspectives
The next step after identifying cash flows is to consider them, in the light of:
• The long-term perspective
• The equity perspective
• The total fund perspective
There are certain principles to be followed in estimating the income from project which will be
applicable for all the three different perspective to cash flows. These are:
• All costs and benefits are to be measured only in terms of cash flows.
• Net cash flows for the firm are those, which accrue after paying tax.
• Cash flows must be measured in incremental terms.
Various appraisal criteria
After analysing the costs and benefits of a project in terms of cash flows, the focus now shifts to the
assessment of the project’s worth. But before we do so, certain assumptions are made:
• The risk of project proposals should be in line with existing investment projects of the firm.
• The firm has certain benchmarks to evaluate projects.
Appraisal methods can be classified into two broad categories:
• Discounted cash-flow criterion
• Non-discounted cash flow criterion
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0 -15,00,000
1 1,00,000
2 3,00,000
3 5,00,000
4 6,00,000
5 7,00,000
Now, if the cost of capital (k) is 10%, then the net present value of the project is:
NPV = (-)15,00,000 + 1,00,000 + 3,00,000 + 5,00,000 + 6,00,000 + 7,00,000
0 1 2 3 4 5
(1.10) (1.10) (1.10) (1.10) (1.10) (1.10)
= Rs.58,953.40
Accept-reject rule
ü The proposal for investment will be accepted if the NPV is positive, and rejected if the NPV is
negative.
ü If the NPV is zero then the project is in an indifferent position.
ü If a choice has to be made between two projects, the project with higher NPV will be accepted for
investment.
Like other appraisal criteria, NPV also has some benefits and drawbacks. The pros and cons are as follows:
Pros
The most significant benefit of NPV is that it considers the time value of money in calculations.
It considers the total benefit of an investment proposal over its lifetime.
Changes in the discount rate are easily reflected in the evaluation process.
NPV allows easy comparisons of returns from different projects, which enables rational resource
allocation decisions to be made
Cons
Ø NPV cannot differentiate between a project with higher cash flows and a project with lesser cash
flows in the early years
Ø It does not provide the same base for comparison between two projects, with different lives of
cash outflow
Ø It is an absolute measure, and does not consider initial cash outlays. Hence, it may not provide
dependable results.
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1 200 40 100 20 80 25 55
2 160 40 95 20 75 20 55
3 120 40 80 20 60 20 40
4 80 40 80 20 60 15 45
5 40 40 85 20 65 20 55
Sum 600 200 440 100 340 100 250
Avg. 120 40 88 20 68 20 50
Accept—Reject Rule
According to the Accept—Reject Rule for ARR, we have to compare the actual or calculated ARR with the
pre-determined minimum ARR or the minimum required return, to accept any project. A project with a higher
ARR than the minimum ARR qualifies for acceptance.
We can also use a rating method when more than one project is available for selection with every project
having ARR more than the minimum ARR. In such a scenario, we can arrange the projects in descending
order of ARR and then make a final decision.
Like all other project appraisal models, ARR also has its pros and cons.
Pros
• Accounting information is always readily available and easy to calculate
• Benefits accruing during the entire life of the project
Con
• Accounting profits are focused on only accounting cash flows ignoring actual cash flows in a specific
period
• The time value of money is not considered.
• Investment size and risk involved in the projects, are overlooked
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Multiple Projects and Constraints
In the existing environment, an organisation cannot consider a capital investment project
individually as certain pre-conditions require to be fulfilled.
Constraints: Project dependence, capital rationing and project indivisibility are factors that restrict
isolated project selection. If the acceptance and rejection of one influences the cash flow stream of
the other or affects the acceptance and rejection of others, then the two projects are said to be
economically dependent. The three types of economic dependency are as follows:
1. Mutual exclusiveness
2. Negative dependency
3. Positive dependency (complementariness).
Capital rationing occurs when funds available are not adequate to undertake all the projects that are
acceptable otherwise. It also arises because of internal limitation or an external constraint.
A project cannot be accepted or rejected partially, it is indivisible, and has to be accepted or rejected
in totality.
Methods for comparison: Factors like economic dependency, capital rationing or project
indivisibility emphasise the need for comparison of projects. The methods used for comparing
projects are:
1. Method of ranking: Joel Dean originally proposes a method of ranking. It consists of two steps:
(i) Ranking all the projects in decreasing order of the NPV’s, IRR’s, or BCR’s. Assumptions in
these 4 methods are:
NPV method: The intermediate cash flow is re-invested at a rate of return equal to the cost of capital
of the firm.
IRR method: Cash flow is re-invested at a rate of return equal to or greater than the Fisherian rate of
return.
BCR criterion: The intermediate funds are reinvested at a rate of return greater than the Fisherian
rate of return.
Accepting all projects in that order until the capital budget is exhausted.
(ii) All combination of feasible projects should be defined, given the capital rationing constraint and
project dependencies. Then choosing a combination having the highest NPV is known as the
feasible combination procedure.
Problems: There are two major problems related to this method (i) because of the discounted cash
flow criteria, conflict arises in the ranking. (ii) Indivisibility of the project.
2. Mathematical programming approach: Two broad categories of equations are considered for
formulations in the mathematical programming approach:
(a) The objective function and (b) The constraint equations
The following three models are commonly used:
(i) Linear programming model: Assumes that the objective function and the constraint equation are
linear while the decision variables are continuous.
(ii) Integer linear programming model: It is presupposed that decision variables assume a value of 0
or 1.
Advantages of the method: (a) It overcomes the problem of partial projects which besets the linear
programming model and. (b) It is capable of handling virtually any kind of project interdependency
like mutual exclusiveness, contingency and complementary.
(iii) Goal programming model: It solves the programming problem of minimising the
absolute deviation from specific goals in order of the established priority structure.
(iv)
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Technical Analysis
Technical analysis is mainly concerned with:
1. Material inputs and utilities
2. Manufacturing processes
3. Product mixes
4. Plant capacities
5. Locations and sites
6. Machinery and equipments
7. Structures and civil work
8. Project charts
9. Lay outs & work schedules
When a project is undertaken, the analysis of technical and engineering aspects becomes a
continuous process. Technical analysis defines the materials and inputs required, their properties
and the supply programme. It classifies material inputs into four categories: (a) raw materials (b)
processed industrial materials (c) auxiliaries materials and factory supplies (d) utilities.
Evaluation of Technological Options
The evaluation of technological options provided by suppliers should be based on the following
considerations. The technology should be:
1. Proven and tested; preference could be given to the technology used by the market leader.
2. Up- to –date; otherwise, the risk of obsolescence is high.
3. Cost effective and par excellence.
Choice of technology
The choice of technology is influenced by many factors such as:
• Plant capacity
• Principal Inputs
• Investment outlay and production cost
• Use by other units
• Product Mix
• Latest Developments
• Ease of integration
Elements of technology transfer
The process of technology transfer consists of three elements:
(1) Transfer of Documentation: All the information essential for the execution of all phases of the
project should be passed to concerned functions during the technology transfer.
(2) Assistance in Implementation: During implementation, skills required for the modification of
technology should be provided for the transition to be smooth.
Upgrading of Technology: As technology is updated on a timely basis, it is necessary for the buyer
to check that the seller is providing the latest version of the technology.
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The second stage of SRI is shareholder activism where they exercise their rights as corporate
owners to advocate their issues of concern like deforestation or employee wages. They can express
themselves through dialogues with management, shareholders resolutions, or divestment.
Community investing is the third option, which includes providing low interest rate loans to
people in low-income communities. It includes organising community development banks and non-
profit cooperative societies, which finance housing, small business loans and other local projects.
Community investing provides an effective way for socially oriented investors to put money into
grass root development projects and provide direct route to gain social returns. The emerging
benefits at the community level in many cases outweigh diminished financial returns, making
community investing one of the most satisfying and promising venues for SRI in future.
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