CAPITAL BUDGETING

What capital Budgeting is all about?

Significance, Difficulities of Capital Projects

Types of Capital Projects

CB process, measurements

Leels of CB Decision

!acets of project analysis

"#amples$
%
&
'

($ Before inesting in the projects, is it necessary to
determine the feasibility of these projects?

)nalysis of potential additions to fi#ed assets*
Long+term decisions, inole large e#penditures*
-ery important to firm.s future*
Process of planning, analy/ing, selecting, financing,
implementing 0 reie1ing Capital "#penditure
CAPITAL BUDGETING

Long time period: conse2uences of capital e#penditure
e#tends into the future and 1ill hae to be endured for a
longer period 1hether the decision is good or bad*
Substantial expenditure: it inoles large sums of money
and necessitates a careful planning and ealuation*
Irreersibilit!: the decisions are 2uite often irreersible,
because there is little or no second hand mar3et for may
types of capital goods*
Signi"i#an#e o" CB

Difficulties
4
There are three basic reasons 1hy capital
e#penditure decisions pose difficulties for the
decision ma3er* These are$
4
Un#ertaint!: the future business success is
today.s inestment decision* The future in the real
1orld is neer 3no1n 1ith certainty*
4
Di""i#ult to measure in $uantitatie terms: "en
if benefits are certain, some might be difficult to
measure in 2uantitatie terms*
4
Time Element: the problem of phasing properly
the aailability of capital assets in order to hae
them come 5on stream6 at the correct time*

Types of C7
% Physical assets
& 8onetary assets
' 7ntangible assets
% Strategic 7nestment
& Tactical 7nestment
8andatory, 9eplacement, "#pansion, Diersification,
90D and 8isc*

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Different methods of measurement

Paybac3

)erage return on boo3 alue

:et present alue

7nternal rate of return

Profitability inde#

!inancing
7nest in projects that yield a return greater than the minimum
acceptable hurdle rate*
A The hurdle rate should be higher for ris3ier projects and reflect
the financing mi# used + o1ners. funds Be2uityC or borro1ed money
BdebtC
A 9eturns on projects should be measured based on cash flo1s
generated and the timing of these cash flo1s, they should also
consider both positie and negatie side effects of these projects*
Choose a financing mi# that minimi/es the hurdle rate and
matches the assets being financed*

Cost o" Capital
The opportunity cost of an inestment, that is, the rate of return that
a company 1ould other1ise be able to earn at the same ris3 leel as
the inestment that has been selected* !or e#ample, 1hen an
inestor purchases stoc3 in a company, he?she e#pects to see a
return on that inestment* Since the indiidual e#pects to get bac3
more than his?her initial inestment, the cost of capital is e2ual to
this return that the inestor receies, or the money that the company
misses out on by selling its stoc3*
<urdle 9ate
The re2uired rate of return in a discounted cash flo1 analysis, aboe
1hich an inestment ma3es sense and belo1 1hich it does not*
>ften, this is based on the firmDs cost of capital or 1eighted aerage
cost of capital, plus or minus a ris3 premium to reflect the projectDs
specific ris3 characteristics* also called re2uired rate of return*

'(eig)ted aerage #ost o" #apital
"#pected return on a portfolio of all the firmDs securities*
=sed as a hurdle rate for capital inestment*
'Cost o" #apital
The re2uired return for a capital budgeting project*
'*urdle rate
The re2uired return in capital budgeting*

Deriation o" t)e *urdle %ate
The hurdle rate is deried from the cost of capital* This is
the aerage cost of funds that a company uses, and is
based on the aerage cost of its debt, e2uity, and arious
other funding sources that are combinations of these t1o
basic forms of funds*
!or e#ample, if a company has determined its cost of capital
to be %EF, then the discounted cash flo1s from all of its
ne1 capital inestments, using that discount rate, must yield
a positie return* 7f they do not, then the funds flo1
resulting from its capital inestments 1ill not be sufficient for
the company to pay for the funds it inested*
Thus, the primary basis upon 1hich to reie1 potential
capital inestments is the hurdle rate*

Example:
) company may choose to use seeral hurdle rates, depending on the
nature of the inestment* !or e#ample, if the company must install
e2uipment to ma3e its production emissions compliant 1ith PCB 2uality
standards, then there is no hurdle rate at all A the company must complete
the 1or3, or be fined by the goernment*
)t the opposite e#treme, a company may assign a high hurdle rate to all
projects that are considered unusually ris3y* !or e#ample, if capital
projects are for the e#tension of a current production line, there is ery little
perceied ris3, and a hurdle rate that matches the cost of capital is
deemed sufficient*
<o1eer, if the capital e#penditure is for a production line that creates
e2uipment in a ne1 mar3et, 1here the company is the first entrant, and no
one 3no1s 1hat 3ind of sales 1ill result, the hurdle rate may be set a
number of percentage points higher than the cost of capital* Thus,
different hurdle rates can apply to different situations*

Leels o" de#ision ma+ing
De#ision Appli#ations ,"or example- De#ided b!
>perating
decisions
9outine maintenance and
minor office e2uipment
Lo1er+leel mgmt*
)dministratie
decisions
Gearly maintenance and
Balancing e2uipment
8iddle+leel mgmt
Strategic
decisions
"#pansions, diersifications Top+leel mgmt?Board
7n addition to arious phases of capital budgeting, it is
important to loo3 at different leels of decision+ma3ing*
These are operating, administratie and strategic
decision ma3ing leels*

.ACETS &. P%&/ECT ANAL0SIS

8ar3et analysis

Technical analysis

!inancial analysis

"conomic analysis

"cological analysis

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%
st
step in project analysis
Purpose:

"stimate potential si/e of the mar3et for

product?serice B)ggregate demandC

8ar3et share that is li3ely to be proposed

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Purpose:
Determines 1hether the prere2uisites for the
successful commissioning of the project has been
considered and good choice has been made 1ith
respect to$

Location

Si/e

Process*******

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Purpose:
Financial viability of the project.

)ble to meet debt sericing

Satisfy e#pectation return of capital proiders

% 9is3
& 9eturn

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Purpose:

@udging a project from larger social point of ie1*

"aluation focus$ social cost 0 benefits of the

project different from monetary C0B*

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Purpose:

8ajor projects 1hich hae significant ecological

implications
% "nironmental Damage
& 9estoration 8easures

Condu#t a 1ar+et Anal!sis
&erie2
Whether you are starting a ne1 business or
launching a ne1 product, conducting a mar3eting
analysis is the first step in determining if there is a
need or audience for your idea*
Hno1ing the mar3etDs needs and ho1 it is currently
sericed proides you 1ith 3ey information that is
essential in deeloping your product?serice and
mar3eting plan*

)lthough the 2uality of the product is critical, your
deelopment of the best product on the mar3et 1ill not
necessarily correlate 1ith the most sales*
=p to IJ percent of a productDs price can be for
mar3eting* The company 1ho 1ins the mar3eting game
generally 1ill capture the larger share of the mar3et*

*o2 2ill #ondu#ting a mar+et anal!sis )elp3


%* Prepare to enter a ne1 mar3et
&* Launch a ne1 product?serice
'* Start a ne1 business

8ar3eting )nalysis
What 7s 7t? Why Should We Do 7t?

)lthough the terms Kmar3etingK and Kmar3eting
analysisK can both be described as games of
information, they are not to be confused*

1ar+eting encompasses all of the actiities that go
into promoting a product or serice*
) mar+eting anal!sis is the actual assessment of
the target population, competition and needs for
mar3eting that product or serice*

T)e mar+eting anal!sis pro#ess #an be bro+en
do2n into six steps:
%* Defining the problem
&* )nalysis of the situation
'* >btaining data that is specific to the problem
L* )nalysis and interpreting the data
I* !ostering ideas and problem soling
E* Designing a plan

So, 1hy should you embar3 on the mar3et
analysis process? The primar! reasons
are$
M To determine if there is a mar3et for
your products or serices
M To establish the need for deeloping a
mar3eting plan
M To ascertain mar3et information that 1ill
assist in the sale of your product or
serice

1ar+et Anal!sis 4uestionnaire
These 2uestions 1ill enhance your understanding and 3no1ledge of
your target mar3et and industry, and ultimately determine$ 7s there a
need for my product or serice?
%* What defined mar3et am 7 trying to reach?
&* What specific companies are sericing this mar3et?
a* )re they successful?
b* )re there other companies sericing this mar3et 1ith a
similar product?
c* )re they successful?
d* What is their mar3et share?

Complete Pro#ess
De"ining 5T)e Problem5
Defining the problem is crucial to conducting a
successful mar3eting analysis*
This may re2uire a great deal of time but it is 1ell
1orth the time and energy e#pended*
Defining the objecties is tantamount to a successful
mar3eting campaign*
8any indiiduals 1aste aluable time performing
good research on the 1rong problem*

4uestions t)at 2ill assist in de"ining t)e problem:
%* )re 1e trying to mar3et our entire product or serice line? >r, are 1e trying to
hone in on a ne1 product or a ne1 serice?
&* What specific mar3eting strategies hae 1e utili/ed in the past t1o years?
a* <o1 has each strategy affected sales?
b* What strategies are 1e currently using?
c* <o1 do our competitors mar3et their product?
'* <o1 much money is allocated to mar3eting?
L* When ma3ing a sale, do 1e surey our customers to determine a referral
source?
a* Do 1e than3 our referral source?
I* Why 1ould someone choose our product?
a* What differentiates our product from our competitorsD products?
b* Why do people choose our competitorsD products or serices?
c* Do 1e need to enhance our current product or serice?
E* Who are our customers?
a* )re they from a specific region?
b* <o1 do 1e attract ne1 customers?
c* <o1 do 1e increase sales from current customers?

8any companies .AIL to understand the nature of
the problem before trying to sole problems related to
sales*
A #lassi# example occurred in the soft drin3 industry
1hen Co+e and Pepsi, the t1o top soft drin3 rials
increased the intensity of mar3eting efforts to battle
for higher sales*
)t the same time, Dr Pepper5s reenues began to
decline, a problem that 1as attributed to a 1ea3
promotional campaign*
Subse2uently, the 6Be a Pepper6 slogan 1as
instituted* )lthough the ads 1ere a hit, reenues
continued to decrease* The mar3eting managers had
to reanaly/e their problem*

!ocused research reealed that the target
population for Dr Pepper differed from Co3e and
Pepsi*
7t 1as found that Dr PepperDs target mar3et beliee
life should be lied in accordance 1ith oneDs o1n set
of personal alues and not based on the
e#pectations of others*
Cola drin3ers, on the other hand, try to 1in the
approal of others* Despite the catchy slogan, Dr
PepperDs mar3eters turned a1ay prospects 1ith a
campaign that inited them to be part of a large
group of KPeppers*K

The soft drin3 industry clearly e#emplifies the importance
of defining the problem*
7t is important not to confuse the symptom 1ith the
problem*
7f a company is haing trouble selling a certain product, it
doesnDt mean that there isnDt a need*
The problem may be distribution and?or pricing*
8ista3ing symptoms for problems 1ill lead to misguided
research and serious mista3es*

Anal!sis &" T)e Situation
)n analysis of the situation is an informal surey
of 1hat information is aailable in the problem
area*
The analysis 1ill help define the problem and
ascertain the need for additional information* This
process entails informal tal3s 1ith informed
people*
7nformed indiiduals can be people 1ith
3no1ledge about the industry or product* 7n some
instances, customers are contacted to proide
information*

E7A1PLE
When the mar3eting manager is unfamiliar 1ith the situation, the
analysis step is of primary importance* 7t is important to
understand the problem area + including the nature of the target
mar3et, competition, the mar3eting mi# and the e#ternal
enironment*
Without this 3no1ledge, costly mista3es may result* )n e#ample
of this problem 1ould be a retailer 1ho 1ants to surey his
customers* ) research firm is hired to do in+store interie1s*
<o1eer, as an e#ample, the contracted firm is not a1are that
many of the stores are in the process of being renoated*
)s a result, the information collected reeals the customerDs
focus on the appearance, noise leel and difficulty finding items
due to construction* The information 1ould be of no alue*

The analysis should focus on both primar! and
se#ondar! resear#)*
Primar! resear#) is research that is proactiely
created for a specific purpose* Primary research may
include focus groups, 2ualitatie sureys and phone
interie1s* This is information you collect yourself*
7n contrast, se#ondar! resear#) is research that has
already been conducted for other purposes* !rom it
aluable information can be gleaned* Secondary
research can be found in libraries, online, through
periodicals, boo3s, etc* The easiest and most efficient
1ay of accessing this type of data is on the 7nternet*

&btaining Spe#i"i# Data
The ne#t step re2uires gathering primary
research and performing a formal research
project* 8any approaches can be used to collect
primary data*
The purpose is for the research to identify 1hat
customers thin3 about some topic or behaior
patterns*
9esearch can be done in person or through a
surey* (uestioning can be 2ualitatie or
2uantitatie* )nother research option is to use
obseration of customers and their purchases or
utili/ation of a product or serice*

(ualitatie research utili/es open+ended 2uestions to
obtain in+depth ans1ers* Closed+ended 2uestions
re2uiring yes or no ans1ers are aoided*
The idea is to hae people share their thoughts on a
topic 1ithout giing them e#tensie directions or
guidelines*
"#amples of 2ualitatie research 2uestions include$
KWhat do you thin3 about 1hen you decide on a place
to shop for your 3idsD clothes?K

The consumers are free to ans1er as they chose$ one
might tal3 about conenient location, another about
serice, and others about the type of designer clothing
aailable*
Depth is the important factor in this type of research*
!ollo1+up 2uestions can be as3ed of each indiidual to
better understand their response and shopping habits*
The 2ualitatie approach re2uires the researcher to
e#ercise judgment in summari/ing all the information*
Depth is the 3ey*

(uantitatie research differs from 2ualitatie in that it
gathers parametric statistical information, i*e*,
information 1ith a number to it*
Sample si/es are generally larger and more
representatie of the mar3et* !rom the statistics or
data generated, conclusions can be dra1n* Surey
research is usually 2uantitatie in nature* 7t see3s
structured responses, 1hich can be summari/ed in
numbers, li3e percentages, aerages or other usable
statistics*
)n e#ample of 2uantitatie research is 1hat
percentage of the consumers shopping in grocery
stores purchase coffee* )n aerage score can be
calculated*

Surey 2uestionnaires often proide fi#ed responses to
2uestions to simplify the reply*
This multiple choice format ma3es it faster and easier
for the respondent* Simple fill+in+the+number, circle+
the+range or e#act ans1er 2uestions are also 1idely
used*
) mar3et researcher might as3 ho1 many suppliers
you use for household appliances or 1hat is your
salary range Bmultiple choices gien 1ith ranges of
salariesC*
!i#ed responses are computer+friendly, 1hich is ho1
most sureys are analy/ed*

Data Anal!sis and Interpretation
Data analysis and interpretation is critical in analy/ing
the mar3et*
What does this information mean?

Can one use the data in a constructie 1ay to define
the problem and then establish a plan?
7n 2uantitatie research, this step most often inoles
statistics* 7n the mar3etplace one can find many
statistical pac3ages Bcomputer+basedC to analy/e the
data*

7t is impossible to collect data on eery person in a
select population, therefore samples are necessary*
) sample population is a part of the releant
population*
<o1 1ell the sample reflects the releant population
dictates its alidity*
9esults from a sample that is not representatie 1ill
negatiely impact your mar3eting*

Example o" Poor Sampling:
) store manager has his staff conduct phone sureys
during the hours that the store is open* The surey is
conducted bet1een %%$JJ am and &$JJ p*m*
This surey does not represent the general population,
as it doesnDt include people 1ho 1or3 during those
hours* The sample 1ill only assess indiiduals 1ho
donDt 1or3 or just happen to be home then* The 2uality
of the research data is another consideration*
The data must be alid + in other 1ords, you must be
measuring 1hat you 1ant to measure* ) poorly
1orded 2uestion can be ambiguous, leading to
incorrect information*

.ostering Ideas And Problem Soling
7n this step, the research results are used to ma3e
mar3eting decisions*
The findings should be applied in mar3eting planning* 7f
the research doesnDt proide the information necessary
to ma3e these decisions, the company, 1hether small or
large, has 1asted its time, money and manpo1er on
unnecessary data*
The final step must be anticipated throughout the entire
process*

1ar+eting Plan
This si#+step process of mar3et analysis is critical in
designing a mar3eting plan that is tailored to your
specific product or serice*
The process can be e#tremely helpful in disclosing a
significant but preiously unrecogni/ed problem*
By finding and focusing on the real problem, the
researcher and business o1ner can moe 2uic3ly to a
useful solution*

Shukriya !!!