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Finance > Capital Budgeting

Capital Budgeting

A capital expenditure is an outlay of cash for a project that is expected to produce a cashinflow over a period of time exceeding one year. Examples of projects include investmentsin property, plant, and equipment, research and development projects, large advertisingcampaigns, or any other project that requires a capital expenditure and generates a futurecash flow.

Because capital expenditures can be very large and have a significant impact on thefinancial performance of the firm, great importance is placed on project selection. Thisprocess is called capital budgeting.

Criteria for Capital Budgeting Decisions

Potentially, there is a wide array of criteria for selecting projects. Some shareholders maywant the firm to select projects that will show immediate surges in cash inflow, others maywant to emphasize long-term growth with little importance on short-term performance.Viewed in this way, it would be quite difficult to satisfy the differing interests of all theshareholders. Fortunately, there is a solution.

The goal of the firm is to maximize present shareholder value. This goal implies thatprojects should be undertaken that result in a positive net present value, that is, thepresent value of the expected cash inflow less the present value of the required capital

expenditures. Using net present value (NPV) as a measure, capital budgeting involvesselecting those projects that increase the value of the firm because they have a positiveNPV. The timing and growth rate of the incoming cash flow is important only to the extentof its impact on NPV.

Using NPV as the criterion by which to select projects assumes efficient capital markets sothat the firm has access to whatever capital is needed to pursue the positive NPV projects.In situations where this is not the case, there may be capital rationing and the capitalbudgeting process becomes more complex.

Note that it is not the responsibility of the firm to decide whether to please particular groupsof shareholders who prefer longer or shorter term results. Once the firm has selected the

projects to maximize its net present value, it is up to the individual shareholders to use thecapital markets to borrow or lend in order to move the exact timing of their own cashinflows forward or backward. This idea is crucial in the principal-agent relationship thatexists between shareholders and corporate managers. Even though each may have theirown individual preferences, the common goal is that of maximizing the present value of thecorporation.

Alternative Rules for Capital Budgeting

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While net present value is the rule that always maximizes shareholder value, some firmsuse other criteria for their capital budgeting decisions, such as:

y Internal Rate of Return (IRR)y Profitability Indexy Payback Period

y Return on Book Value

In some cases, the investment decisions resulting from the IRR and profitability indexmethods agree with those of NPV. Decisions made using the payback period and return onbook value methods usually are suboptimal from the standpoint of maximizing shareholdervalue.

Obj.

Define ³capital budgeting´ and identify the steps involved in the capital budgeting process. Explain the procedure used to generate long-term project proposals within the firm. Justify why cash, not income, flows are the most relevant to capital budgeting decisions.

Summarize in a ³checklist´ the major concerns to keep in mind as one prepares todetermine relevant capital budgeting cash flows. Define the terms ³sunk cost´ and ³opportunity cost´ and explain why sunk costs must be ignored, whereas opportunity costsmust be included, in capital budgeting analysis. Explain how tax considerations, as well asdepreciation fortax purposes, affect capital budgeting cash flows. Determine initial,interim, and terminal period ³after-tax, incremental, operating cash flows´ associated witha capital investmentproject. Note : If any other Objectives information is there plz let meknow

PHASES

Overview of project management

Introduction

SAIL wants to modernise all its existing plants, and TATA wants to divest its old businesses to enter intonew economy ventures. Such situations require a sound capital expenditure (budgeting) decision. Thebasic feature of capital expenditure is that it involves a current outlay of funds in the expectation of astream of future benefits. This section provides a broad overview of capital budgeting.

Phases of capital budgeting Capital budgeting is a complex process and there are f ive broad phases. These are planning, analysis,selection, implementation and overview.

Planning

The planning phase involves investment strategy and the generation and preliminary screening of projectproposals. The investment strategy provides the framework that shapes, guides and circumscribes theidentification of individual project opportunities.

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Capital Budgeting Process

Analysis

If the preliminary screening suggests that the project is worth investing, a detailed analysis of themarketing, technical, financial, economic, and ecological aspects is conducted.

Selection

The selection process addresses the question²is the project worth investing? A wide range of appraisalcriteria 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: -

Non-discounting criteria Accept Reject

Pay Back Period (PBP) PBP < target period PBP >target period

Accounting Rate of

Return (ARR) ARR > target rate ARR < target rate

Discounting criteria Accept Reject

Net Present Value (NPV) NPV > 0 NPV < 0

Internal Rate of Return

(IRR) IRR > cost of capital IRR < cost of capital

Benefit-Cost Ratio (BCR) BCR >1 BCR < 1

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Implementation

The implementation phase for an industrial project, which involves the setting up of manufacturingfacilities, consists of several stages:

I. Project and engineering designs

II. Negotiations and contracting

III. Construction

IV. Training

V. Plant commissioning

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:

y It focuses on realistic assumptions

y It provides experience, which will be valuable in future decision making

y It suggests corrective action

y It helps to uncover judgmental biases

y It advocates the need for caution among project sponsors.

Levels of decision making

In addition to various phases of capital budgeting, it is important to look at different levels of decision-making. These are operating, administrative and strategic decision making levels.

Decision Applications (for example) Decided by

Operating

decisions

Routine maintenance and

minor office equipment Lower-level mgmt.

Administrative

decisions

Yearly maintenance and

Balancing equipment Middle-level mgmt

Strategicdecisions Expansions, diversifications Top-level mgmt/Board

Portfolio planning tools

Several tools are available to guide strategic planning, decisions, and resource allocation. These tools arecalled portfolio-planning tools.

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The two most relevant and popular tools are:

BCG product portfolio matrix.

General Electric¶s stoplight matrix.

Social cost benefit analysis

Social Cost Benefit Analysis (SCBA) is referred to as economic analysis. In this method, an investmentproject is evaluated from the point of view of society (economy) as a whole. SCBA is gaining importance,due to government investment and support. The various approaches and concepts in this methodologyare:

Little- Mirrlees approach

Unido approach

Shadow prices

SCBA practice by f inancial institutions

Public investment decision in India

What Is Market Demand Analysis?By Osmond Vitez, eHow Contributor

Companies use market demand analysis to understand how much consumer demand exists for a

product or service. This analysis helps management determine if they can successfully enter amarket and generate enough profits to advance their business operations. While several methods of

demand analysis may be used, they usually contain a review of the basic components of an

economic market.

Market Identification

1. The first step of market analysis is to define and identify the specific market to target with new

products or services. Companies will use market surveys or consumer feedback to determine their

satisfaction with current products and services. Comments indicating dissatisfaction will

lead businesses to develop new products or services to meet this consumer demand. While

companies will usually identify markets close to their current product line, new industries may be

tested for business expansion possibilities.

Business Cycle

2. Once a potential market is identified, companies will assess what stage of the business cycle the

market is in. Three stages exist in the business cycle: emerging, plateau and declining. Markets in

the emerging stage indicate higher consumer demand and low supply of current products or

services. The plateau stage is the break-even level of the market, where the supply of goods meets

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current market demand. Declining stages indicate lagging consumer demand for the goods or

services supplied by businesses.

Product Niche

3. Once markets and business cycles are reviewed, companies will develop a product that meets a

specific niche in the market. Products must be differentiated from others in the market so they meet

a specific need of consumer demand, creating higher demand for their product or service. Many

companies will conduct tests in sample markets to determine which of their potential product styles

is most preferred by consumers. Companies will also develop their goods so that competitors cannot

easily duplicate their product.

Growth Potential

4. While every market has an initial level of consumer demand, specialized products or goods can

create a sense of usefulness, which will increase demand. Examples of specialized products are

iPods or iPhones, which entered the personal electronics market and increased demand through their

perceived usefulness by consumers. This type of demand quickly increases the demand for current

markets, allowing companies to increase profits through new consumer demand.Competition

5. An important factor of market analysis is determining the number of competitors and their current

market share. Markets in the emerging stage of the business cycle tend to have fewer competitors,

meaning a higher profit margin may be earned by companies. Once a market becomes saturated

with competing companies and products, fewer profits are achieved and companies will begin to lose

money. As markets enter the declining business cycle, companies will conduct a new market

analysis to find more profitable markets.

Technical Analysis

6. Technology SelectionInput Requirements and UtilitiesProduct MixPlant Capacity and Functional LayoutLocation of the ProjectMachinery and EquipmentConsideration of Alternatives

Financial Analysis

Project Cost

Means of Financing the Project

Share CapitalTerm LoansDebenture CapitalDeferred CreditMiscellaneous Sources

Working Capital Requirements and Financing

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Time Value of Money

Costs of Different Sources of Finance

Cost of Debt

Cost of Preference CapitalCost of Equity Capital

Cost of External EquityWeighted Average Cost of Capital

Evaluation of Project Investments

Non-Discounted CriteriaDiscounted Cash Flow Criteria

Risk Analysis of Project Investments

Techniques of Risk Analysis

Sensitivity Analysis

Scenario Analysis

Social Cost Benefit Analysis

UNIDO Approach

Financial Analysis

Financial Analysis refers to the assessment of a business to deal with the planning, budgeting, monitoring,

forecasting, and improving of all financial details within an organization.

Understand, Identify, Analyze and Adjust

Understanding your organization¶s financial health is a fundamental aspect of responding to today¶s increasingly

stringent financial reporting requirements. To avoid risks, organizations must quickly

y identify ascertain financial ratios and trends acrossin liabilities and assets

y analyze and adjust planned and forecasted amounts

y act to provide regulatory statements as needed

Financial Analysis applications built on the MicroStrategy platform make these activities easier and more efficient.

Business intelligence applications within the Financial Analysis application area include:

y Budgeting and Budget Analysis

y Financial Performance Management

y Revenue Analysis

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y Cost Analysis

y Expense Analysis

y Cash Flow Analysis

y Balance Sheet Analysis

y Accounts Receivable Analysis

y Accounts Payable Analysis

y Invoicing and Billing Analysis

y Profit and Loss Statements

Financial Analysis with MicroStrategy

The unique strengths of the MicroStrategy platform are well suited for performing even the most demanding of

Financial Analysis applications. Using MicroStrategy, Financial users have their detailed reporting, their scorecard of

metrics, and their interactive dashboards at their fingertips via a single interface. From Profit Margin or Current Ratio

to Assent Turnover or Debt to Equity, users have unlimited access to financial ratios and analytics when performing

financial analysis with any MicroStrategy reporting tool.

The MicroStrategy platform offers analytics that can be used to answer key financial questions:

y What is the aging distribution of Accounts Payable and Accounts Receivable?

y

Are there any customers with payment problems; if so, who needs to be notified?

y What are the values of assets and liabilities on a given date?

y What is the value of assets, liabilities, and owners¶ equity on a given date?

y What is the breakdown of expenses by business units?

y Which business units are hitting their targets?

y What are the revenue trends by business units?

y What are the trends in revenue, by revenue types?

y What is the forecasted revenue? Has this forecast changed? Why have revenue forecasts changed?

y What is the actual amount of profit margin by business unit or region? What are the associated trends?

y What is the breakdown of costs by vendors, and what are the associated trends?

y What is the change in cash position from period to period?

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4. Stability- the firm's ability to remain in business in the long run, without having to sustain significant losses in

the conduct of its business. Assessing a company's stability requires the use of both the income statement and

the balance sheet, as well as other financial and non-financial indicators.

[edit]Methods

Financial analysts often compare financial ratios (of solvency, profitability, growth, etc.):

Past Performance - Across historical time periods for the same firm (the last 5 years for example),

Future Performance - Using historical figures and certain mathematical and statistical techniques,

including present and future values, This extrapolation method is the main source of errors in financial

analysis as past statistics can be poor predictors of future prospects.

Comparative Performance - Comparison between similar firms.

These ratios are calculated by dividing a (group of) account balance(s), taken from the balance sheet and / or the income statement, by another, for example :

N et income / equity = return on equity (ROE)

N et income / total assets = return on assets (RO A )

Stock price / earnings per share = P/E ratio

Comparing financial ratios is merely one way of conducting financial analysis. Financial

ratios face several theoretical challenges:

They say little about the firm's prospects in an absolute sense. Their insights about

relative performance require a reference point from other time periods or similar firms.

One ratio holds little meaning. As indicators, ratios can be logically interpreted in at least

two ways. One can partially overcome this problem by combining several related ratios to

paint a more comprehensive picture of the firm's performance.

Seasonal factors may prevent year-end values from being representative. A ratio's values

may be distorted as account balances change from the beginning to the end of an

accounting period. Use average values for such accounts whenever possible.

Financial ratios are no more objective than the accounting methods employed. Changes

in accounting policies or choices can yield drastically different ratio values.

They fail to account for exogenous factors like investor behavior that are not based upon

economic fundamentals of the firm or the general economy ( fundamental analysis)[1].

Financial analysts can also use percentage analysis which involves reducing a series of

figures as a percentage of some base amount[2]. For example, a group of items can be

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expressed as a percentage of net income. When proportionate changes in the same figure

over a given time period expressed as a percentage is known as horizontal analysis[3]. Vertical

or common-size analysis, reduces all items on a statement to a ³common size´ as a

percentage of some base value which assists in comparability with other companies of

different sizes [4].

Another method is comparative analysis. This provides a better way to determine trends.

Comparative analysis presents the same information for two or more time periods and is

presented side-by-side to allow for easy analysis

UNIDO

UNIDO:United Nations Industrial Development Organization Approach

UNIDO approach is one of the methods of calculating Social cost benefit analysis (SCBA).infact very

popular.Normally we calculate financial benefits from a project while evaluating it,but this method

caculates economic benefits from the project.although earlier it was commonly used by government

organizations but now it is being used by private players also.In this analysis the monetary priced arereplaced by shadow prices.shadow prices are prices at perfect market conditions,also caled as

economic prices.thus the market prices are replaced by the Econmic prices and then the benefit or

returns are calculated.in aditon to this, adjustment is made for Externalities(+ve like road

facility,hospital facility etc. or -ve externalities lik pollution),savings(a rupee saved is valued more

than a rupee consumed),redistribution of income(a rupee distributed to poor is valued more than a

rupee distributed to rich) ,taxes are not considerd and merits.then finally the economic rate of return

is calculated by the same method as IRR is calculate

UNIDO usually targets one or more of the following levels:y Micro-level: Assistance on the micro-level involves direct support to a group of companies

belonging to the same sector, region, cluster, supply chain, etc. Due to limited outreach and up-

scaling effects, this level is targeted only on a pilot basis for demonstration andCSR case buildingpurposes.

y Meso-level: Support on this level focuses on business support and advisory institutions (public or private) that aim at expanding their service portfolio and strengthening their institutional capacity.In this context,UNIDO provides assistance to these intermediary institutions to foster the uptakeCSR concepts in their sphere of influence.

y Macro-level: On the macro level,UNIDO involves in the field of CSR related policy work with aview to support government institutions in determining what public policies best support a country¶sprivate sector in its efforts to apply socially and environmentally responsible business practices.

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