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 Share
Technical Viability
Sensible Choices
Financial Analysis
Risk
Return
Economic Analysis
Benefits and Costs in Shadow
Prices
Other Impacts
Ecological Analysis
Environmental 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
No Yes

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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.
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 firms 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.