chapter 2, cpital investments, imp, n difficulties

8/6/2019 Chapter 2, Cpital Investments, Imp, n Difficulties

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Capital investments

Importance and difficulties


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y

Capital investments: Importance and difficulties

y Types of capital investments

y Phases of capital budgeting

y Levels of decision making

y Facets of project analysis

y Feasibility study: A schematic diagram

y Objectives of capital budgeting

y Common weaknesses in capital budgeting

Outline


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Capital Investments : Importance and Difficulties

Importance

y Long term effects

y Irreversibility

y Substantial outlays

Difficulties

y Measurement problems

y Uncertainty

y Temporal spread


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Types of Investments

y Mandatory Investments

y Replacement investments

y Expansion investments

y Diversification investments

y R & D investments

y Miscellaneous investments


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Capital Budgeting Process

Financing

Implementation

Selection

Analysis

Review

Planning

conception


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Levels ofDecision Making

Operating Administrative Strategic

decisions decisions decisions

y Where is the decision taken Lower level Middle level Top level

management management management

y How structured is the decision Routine Semi structured Unstructured

y What is the level of resource Minor resource Moderate resource Major resource

commitment commitment commitment commitment

y What is the time horizon Short term Medium term Long term


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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

PricesOther Impacts

Ecological AnalysisEnvironmental Damage

Restoration Measures


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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

NoYes

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Objective of Capital Budgeting

Finance theory rests on the premise that managers should managetheir 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.


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Basic Considerations : Risk and Return

Investment

decisions

Financing

decisions

Return

Risk

Market value

of the firm


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Common Weaknesses in Capital Budgeting

y Poor alignment between strategy and capital budgeting

y Deficiencies in analytical techniques

y Poor identification of base case

y Inadequate treatment of risk

y Improper evaluation of options

y Lack of uniformity in assumptions

y Neglect of side effects

y No linkage between compensation and financial measures

y Reverse financial engineering

y Weak integration between capital budgeting and expense budgeting

y Inadequate post - audits


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Summing Up

y Essentially a capital project represents a scheme for investing resources that can

be analysed and appraised reasonably independently

y 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

y 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

y While capital expenditure decisions are extremely important, they pose

difficulties which stem from three principal sources: measurement

problems, uncertainty, and temporal spread

y Capital budgeting is a complex process which may be divided into six

broad phases: planning, analysis, selection, financing, implementation and

review


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y One can look at capital budgeting decisions at three levels: operating,

administrative, and strategic

y The important facets of project analysis are : market analysis, technical analysis,

financial analysis, economic analysis, and ecological analysis

y 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

y 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.

chapter 2, cpital investments, imp, n difficulties

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