CHAPTER 1

OVERVIEW

OUTLINE
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

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

Planning
Analysis
Selection
Financing
Implementation
Review

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 questionIs 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

Where is the decision taken

How structured is the decision

What is the level of resource

commitment

What is the time horizon

Administra
tive
decisions

Strategic
decisions

Lower level
management

Middle level
management

Top level
management

Routine

Semi-structured

Unstructured

Minor resource
commitment

Moderate
resource
commitment

Major
resource
commitment

Short-term

Medium-term

Long-term

Key Issues in Project Analysis

Potential Market (demand of project)

Market Analysis
Market Share
Technical Viability

Technical Analysis
Sensible Choices
Risk

Financial Analysis
Economic Analysis

Return
Benefits and Costs in Shadow
Prices
Other Impacts
Environmental Damage

Ecological Analysis
Restoration Measures

Feasibility Study : A Schematic Diagram

Generation of Ideas

P
r
e

Initial Screening

l
i
m

Is the Idea Prima Facie Promising

No

Yes

n
a

Plan Feasibility Analysis

Terminate

Conduct Market Analysis

Conduct Technical Analysis

o
r

Conduct Financial Analysis

k
E
A

o
n

Conduct Economic and Ecological Analysis

Is the Project Worthwhile ?
Yes
Prepare Funding Proposal

No
Terminate

Objective of Capital Budgeting

Finance theory rests on the premise that managers should manage
their firms resources with the objective of enhancing the firms
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 firms 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.