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Chapter 1 Overview

This document provides an overview of capital investments and the capital budgeting process. It discusses the importance of capital investments, types of capital projects, levels of decision making, facets of project analysis like market analysis and financial analysis. It also outlines the phases of the capital budgeting process from planning to implementation to review. Finally, it discusses common weaknesses found in capital budgeting systems.

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sarikasree
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38 views

Chapter 1 Overview

This document provides an overview of capital investments and the capital budgeting process. It discusses the importance of capital investments, types of capital projects, levels of decision making, facets of project analysis like market analysis and financial analysis. It also outlines the phases of the capital budgeting process from planning to implementation to review. Finally, it discusses common weaknesses found in capital budgeting systems.

Uploaded by

sarikasree
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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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
 Objectives of capital budgeting
 Common weaknesses in capital budgeting
What is a project?
•A non routine, non repetitive undertaking, requiring
contributions from multiple disciplines,with specific time, cost
and performance objectives.
•A one-time endeavor, delineated by a start and a completion.
•A typical project will have:
# A charter (mission)
# Requirements/Specifications
# Deliverables
# Resources ( people,money,materials,time,knowledge)
# Constraints
# Uncertainty
Features
• Fixed objectives
• Fixed lifespan
• Entrusted to a single entity
• Requires team work
• Has a life cycle
• Is unique
• Requires frequent changes
• Made to order
• High level of subcontracting
• Risk and uncertainty
Capital Investments : Importance and Difficulties

Importance
 Long – term effects
 Irreversibility
 Substantial outlays
Difficulties
 Measurement problems
 Uncertainty
 Temporal spread
The Project Life Cycle

•Concept Phase
•Definition Phase
•Planning and Organizing Phase
•Implementation Phase
•Clean Up Phase
COMMENCEMENT OF OPERATIONS
Capital Budgeting Process

Planning

Analysis

Selection

Financing

Implementation

Review
Types of Investment Strategies
BASELINE (Tangible Physical Assets)
 Mandatory Investments (Reconditioning and repair)
 Replacement investments
 Modernization Investments
 Capacity Expansion investments
 Diversification investments (Vertical/Concentric/Conglomerate)
 Divestment
DISCRETIONARY (Intangible Assets)
 R & D investments
 Market Development
 HR Development
Levels of Decision Making
Tactical Vs Strategic

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

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
Basic Considerations : Risk and Return

Investment
Return
decisions

Market value
of the firm

Financing
Risk
decisions
The two sides of a project
Financing Side Investment Side
Year Rupees Year Rupees
0 +1000 0 -1000
1 -1150 1 +1200
Cost of Funds Rate of Return
1000 = 1150 / (1+k) 1000 = 1200 / (1+r)
k = 15% r = 20%
Compare r with k
Do not include cash flows related to k on the investment side.
(Financial Charges Exclusion Principle).
i.e. Do not include financing cost of Rs. 150 as an outflow and
reduce Rs. 1200 to Rs.1050.
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.

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