CHAPTER 1

OVER VIEW
 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 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

Planning

Analysis

Selection

Financing

Implementation

Review
 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 Major

commitment commitment resource resource
commitment commitment

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

 Key Issues in Project Analysis

Potential Market
Market Analysis
Market Share
Technical Viability
Technical Analysis
Sensible Choices
Risk
Financial Analysis
Return
Benefits and Costs in Shadow
Economic Analysis Prices
Other Impacts
Environmental Damage
Ecological Analysis
Restoration Measures
 Feasibility Study : A Schematic Diagram
P Generation of Ideas
r
e
l
Initial Screening
i
m
Is the Idea Prima Facie Promising
i
n Yes No
a
r
Plan Feasibility Analysis
y Terminate

W Conduct Market Analysis Conduct Technical Analysis

o
r
k Conduct Financial Analysis
E
A v
n a Conduct Economic and Ecological Analysis
a l
l u
y
Is the Project Worthwhile ?
a
s t Yes No
i i
s o
Prepare Funding Proposal Terminate
n
 Key Issues in Major Investment Decisions

• Investment story
• Risks
• DCF Value
• Financing
• Options
 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
Return
decisions

Market value
of the firm

Financing
Risk
decisions
 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.