INVESTMENT DECISIONS

Module: BLB20059-M MANAGING RISK

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

Project Management by Prasana Chandra Centre for Financial Management, Bangalore Overview of Management

CAPITAL INVESTMENTS : IMPORTANCE AND DIFFICULTIES Importance Long term effects Irreversibility Substantial outlays

Difficulties Measurement problems

Uncertainty
Temporal spread
Project Management by Prasana Chandra Centre for Financial Management, Bangalore Overview of Management

TYPES OF INVESTMENTS
Mandatory Investments

Replacement investments
Expansion investments

Diversification investments
R & D investments

Miscellaneous investments

Project Management by Prasana Chandra Centre for Financial Management, Bangalore Overview of Management

CAPITAL BUDGETING PROCESS

Planning Analysis Selection

Financing Implementation
Review
Project Management by Prasana Chandra Centre for Financial Management, Bangalore Overview of Management

LEVELS OF DECISION MAKING

Operating decisions Where is the decision taken How structured is the decision What is the level of resource commitment What is the time horizon Lower level management Routine Administrative decisions Middle level management Semi structured Strategic decisions Top level management Unstructured Major resource commitment Long term

Minor resource Moderate resource commitment Short term commitment Medium term

Project Management by Prasana Chandra Centre for Financial Management, Bangalore Overview of Management

KEY ISSUES IN PROJECT ANALYSIS

Potential Market

Market Analysis
Market Share Technical Viability

Technical Analysis
Sensible Choices Risk

Financial Analysis Economic Analysis Ecological Analysis

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Return Benefits and Costs in Shadow Prices

Other Impacts Environmental Damage Restoration Measures
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FEASIBILITY STUDY : A SCHEMATIC DIAGRAM

P r e l i m

Generation of Ideas
Initial Screening Is the Idea Prima Facie Promising Yes Plan Feasibility Analysis Terminate Conduct Market Analysis Conduct Technical Analysis No

i
n a r y W

o
r k

Conduct Financial Analysis

E v a l u a t i o n

A n a l y s i s

Conduct Economic and Ecological Analysis Is the Project Worthwhile ? Yes Prepare Funding Proposal No Terminate

Centre for Financial Management, Bangalore Overview of Management

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 economic growth and the rate of improvement in our standard of living.

Centre for Financial Management, Bangalore

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BASIC CONSIDERATIONS: RISK AND RETURN

Investment decisions

Return
Market value of the firm

Financing decisions

Risk

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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
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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
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 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. Centre for Financial Management, Bangalore
Overview of Management