This document discusses capital investment decisions and the capital budgeting process. It covers the importance and difficulties of capital investments, types of investments, phases of capital budgeting including planning, analysis, selection, financing and review. It also discusses levels of decision making, facets of project analysis including market, technical and financial analysis. It outlines objectives of capital budgeting to maximize firm value and risks. Finally, it identifies common weaknesses in capital budgeting practices.

1. WEEK 3
INVESTMENT DECISIONS
Module: BLB20059-M
MANAGING RISK

2. 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

3. 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

4. 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

5. CAPITAL BUDGETING PROCESS
Planning
Analysis
Selection
Financing
Implementation
Review
Project Management by Prasana Chandra © Centre for Financial Management, Bangalore

6. LEVELS OF DECISION MAKING
Operating
Administrative
decisions
decisions
Lower level
Middle 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
• Where is the decision taken
•
Strategic
decisions
Top level
Project Management by Prasana Chandra © Centre for Financial Management, Bangalore

7. KEY ISSUES IN PROJECT ANALYSIS
Potential Market
Market Analysis
Market Share
Technical Viability
Technical Analysis
Sensible Choices
Risk
Financial Analysis
Economic Analysis
Return
Benefits and Costs in Shadow
Prices
Other Impacts
Environmental Damage
Ecological Analysis
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Restoration Measures

8. FEASIBILITY STUDY : A SCHEMATIC DIAGRAM
Generation of Ideas
P
r
e
Initial Screening
l
i
m
Is the Idea Prima Facie Promising
i
No
Yes
n
a
Plan Feasibility Analysis
r
Terminate
y
W
o
Conduct Market Analysis
Conduct Technical Analysis
r
k
A
n
a
l
y
s
i
s
E
Conduct Financial
Analysis
v
a
Conduct Economic and Ecological Analysis
l
u
a
Is the Project Worthwhile ?
Yes
t
i
o
Prepare Funding Proposal
n
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No
Terminate

9. OBJECTIVE OF CAPITAL BUDGETING
Finance theory rests on the premise that managers should manage their firm’s
resources with the objective of enhancing the firm’s 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

10. BASIC CONSIDERATIONS: RISK AND RETURN
Investment
decisions
Return
Market value
of the firm
Financing
decisions
Risk
© Centre for Financial Management, Bangalore

11. 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
© Centre for Financial Management, Bangalore

12. 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
©
reviewCentre for Financial Management, Bangalore

13. • 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 firm’s 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