Chapter Overview LEARNING OBJECTIVES ‘After studying this chapter you should be able to @ Appreciate the importance and difficulties associated with capital investments. I Describe the broad phases of capital budgeting. Discuss the important facets of project analysis. i explain the rationale for maximising the value of the firm. IB Understand the common weaknesses in capital budgeting. company is planning to install a computer system for information processing; the Government of India is thinking of an ambitious plan to link the Ganges and Cauvery rivers; Gautam, a graduate student, is planning to buy a mobike. All these situations involve a capital expenditure decision. Essentially, each of them represents a scheme for investing resources which can be analysed and appraised reasonably independently. The basic characteristic of a capital expenditure (also referred to as a capital investment or capital project or just 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. This definition of a capital expenditure is not necessarily synonymous with how a capital expenditure is defined in accounting. A capital expenditure, from the accounting point of view, is an expenditure which is shown as an asset in the balance sheet. This asset, except in the case of a non-depreciable asset like land, is depreciated over its life. In accounting, the classification of an expenditure as a capital expenditure or a revenue expenditure is governed by certain conventions, by some provisions of law, and by the management’s desire to enhance or depress reported profits. Often, outlays on research and A mini steel plant is considering building a new arc furnace; an insurancedevelopment, major advertising campaigns, and reconditioning of plant and machinery may be treated as revenue expenditures for accounting purposes, even though they are expected to generate a stream of benefits in the future and, therefore, qualify for being capital expenditures. ‘This chapter pravides a hraad averview of the field af project appraisal and capital budgeting. 11 CAPITAL INVESTMENTS: IMPORTANCE AND DIFFICULTIES Importance Capital ‘expenditure decisions often represent the most important decisions taken by a firm. Their importance stems from three inter- related reasons: HH Long-Term Effects The consequences of capital expenditure decisions extend far into the future. The scope of current manufacturing activities of a firm is governed largely by capital expenditures made in the past. Likewise, current capital expenditure decisions provide the framework for future activities. Capital investment decisions have an enormous bearing on the basic character of a firm. I Irreversibility The market for used capital equipment in general is ill- organised. Further, for some types of capital equipment, custom-made to meet specific requirements, the market may virtually be non-existent. Once such an equipment is acquired, reversal of decision may mean scrapping the capital equipment. Thus, a wrong capital investment decision often cannot be reversed without incurring a loss. I substantial Outlays Capital expenditures usually involve substantial outlays. An integrated steel plant, for example, involves an outlay of several thousand crore rupees. Capital costs tend to increase with advanced technology. Difficulties while capital expenditure decisions are extremely important, they also pose difficulties which stem from three principal sources: 1 Measurement Problems Identifying and measuring the costs and benefits of a capital expenditure proposal tend to be difficult. This is more so when a capital expenditure has a bearing on some other activities of the firm (like cutting into the sales of some existing product) or has some intangible consequences (like improving the morale of workers).Mi Uncertainty A capital expenditure decision involves costs and benefits that extend far into the future. It is impossible to predict exactly what will happen in the future. Hence, there is usually a great deal of uncertainty characterising the costs and benefits of a capital expenditure decision Hi Temporal Spread The costs and benefits associated with a capital expenditure decision are often spread out over a long period of time, usually 10-20 years for industrial projects and 20-50 years for infrastructural projects. Such a temporal spread creates some problems in estimating discount rates and establishing equivalences. 1.2 TYPES OF CAPITAL INVESTMENTS Capital investments may be classified in different ways. At the simplest level, capital investments may be classified as physical, monetary, or intangible. Physical assets are tangible investments like land, butlding, plant, machinery, vehicles, and computers. Monetary assets are financial claims against some parties. Deposits, bonds, and equity shares are examples of monetary assets. Intangible assets are not in the form of physical assets or financial claims. They represent outlays on research and development, training, market development, franchises, and so on that are expected to generate benefits over a period of time. Capital investments may also be classified as strategic investments and tactical investments. A strategic investment is one that has a significant impact on the direction of the firm. Tata Motor’s decision to invest in a passenger car project may be regarded as a strategic investment. A tactical investment is meant to implement a current stratogy as officiontly or as profitably as possible. ‘An investment by Tata Motors to replace an old machine to improve productivity represents a tactical investment. Capital investments are often classified by companies in different categories for planning and control. While the system of classification may vary from one firm to another, the following categories are found in most classifications: mandatory investments, replacement investments, expansion investments, diversification investments, R&D investments, and miscellaneous investments. A mandatory investment is a capital expenditure required to comply with statutory requirements. Examples of such investments are a pollution control equipment, a fire fighting equipment, a medical dispensary, and a créche in the factory. A replacement investment is meant to replace worn out equipment withnew equipment to reduce operating costs, increase the yield, and improve quality. An expansion investment is meant to increase the capacity to cater to a growing demand. A diversification investment is aimed at producing new products or services or entering into new geographical areas. R&D investments are meant to develop new products and processes which would sharpen the technological edge of the firm. Finally, miscellaneous investments represent a catch-all category that includes items like interior decoration, recreational facilities, and landscaped gardens. 1.3 PHASES OF CAPITAL BUDGETING Capital budgeting is a complex process which may be divided into six broad phases: planning, analysis, selection, financing, implementation, and review. Exhibit 1.1 portrays the relationship among these phases. The solid arrows reflect the main sequence: planning precedes analysis; analysis precedes selection; and so on. The dashed arrows indicate hat the phases of capital budgeting are not related in a simple, sequential manner. Instead, there are several feedback loops reflecting the iterative nature of the process. Exhibit 1.1 Capital Budgeting Process Planning b----, T i Planning The planning phase of a firm's capital budgeting process isconcerned with the articulation of its broad investment strategy and the generation and preliminary screening of project proposals. The investment strategy of the firm delineates the broad areas or types of investments the firm plans to undertake. This provides the framework which shapes, guides, and circumscribes the identification of individual project opportunities. Once a project proposal is identified, it needs to be examined. To begin with, a preliminary project analysis is done. A prelude to the full blown feasibility study, this exercise is meant to assess (i) whether the project is prima facie worthwhile to justify a feasibility study and (ii) what aspects of the project are critical to its viability and hence warrant an in-depth investigation. Analysis _ If the preliminary screening suggests that the project is prima facie worthwhile, a detailed analysis of the marketing, technical, financial, economic, and ecological aspects is undertaken. The questions and issues raised in such a detailed analysis are described in a subsequent section. The focus of this phase of capital budgeting is on gathering, preparing, and summarising relevant information about various project proposals which are being considered for inclusion in the capital budget. Based on the information developed in this analysis, the stream of costs and benefits associated with the project can be defined. Selection Selection follows, and often overlaps, analysis. It addresses the question—Is the project worthwhile? A wide range of appraisal criteria have been suggested to judge the worthwhileness of a project. They are divided into two broad categories, viz., non-diecounting criteria and discounting criteria. The principal non-discounting criteria are the payback period and the accounting rate of return. The key discounting criteria are the net present value, the internal rate of return, and the benefit cost ratio. The selection rules associated with these criteria are as follows: Criterion ‘Accept Reject Payback period (PBP) PBP < target period BP > target period Accounting rate of return (ARR) ARR» target rate ARR 0 NPV<0 Internal rate of return (IRR) IRR> cost of capital IRR « cost of capital Benefit cost ratio (BCR) BCR>1 BCR<1 To apply the various appraisal criteria, suitable cut-off values (hurdle rate, target rate, and cost of capital) have to be specified. These are essentially a function of the mix of financing and the level of project risk. While the formercan be defined with relative ease, the latter truly tests the ability of the project evaluator. Indeed, despite a wide range of tools and techniques for risk analysis (sensitivity analysis, scenario analysis, simulation analysis, decision tree analysis, portfolio theory, capital asset pricing model, and so on), risk analysis remains the most intractable part of the project evaluation exercise. Financing Once a project is selected, suitable financing arrangements have to be made. The two broad sources of finance for a project are equity and debt. Equity (referred to as shareholders’ funds on balance sheets in India) consists of paid-up capital, share premium, and retained earnings. Debt (referred to as loan funds on balance sheets in India) consists of term loans, debentures, working capital advances and so on. Flexibility, risk, income, control, and taxes (referred to by the acronym FRICT) are the key business considerations that influence the capital structure (debt-equity ratio) decision and the choice of specific instruments of financing. Implementation The implementation phase for an industrial project, which involves setting up of manufacturing facilities, consists of several stages: (i) project and engineering designs, (ii) negotiations and contracting, (iii) construction, (iv) training, and (v) plant commissioning. What is done in these stages is briefly described below: Stage Concerned with Project and engineering Site probing and prospecting, preparation of blueprints, and designs plant designs. plant engineering. selection of specific machineries and equipments. Negotiations and contracting Negotiating and drawing up of legal contracts with respect to project financing, acquisition of technology, construction of bu works, provision af uti machinery and equipment, marketing arrangements, etc. Construction Site preparation, construction of buildings and civil works, ‘rection and installation of machinery and equipment. and , supply of “Training ‘Training of engineers, Wethicians, and workers. (This Catt proceed simultaneously along with the construction work.) Plant commissioning Start up of the plant. (This is a brief but technically crucial stage in the project development cycle.) Translating an investment proposal into a concrete project is a complex, time-consuming, and risk-fraught task. Delays in implementation, which are common, can lead to substantial cost overruns. For expeditious implementationat a reasonable cost, the following are helpful: 1, Adequate Formulation of Projects A major reason for the delay is inadequate formulation of projects. Put differently, if the necessary homework in terms of preliminary studies and comprehensive and detailed formulation of the project is not done, many surprises and shocks are likely to spring on the way. Hence, the need for adequate formulation of the project cannot be over-emphasised. 2. Use of the Principle of Responsibility Accounting Assigning specific responsibilities to project managers for completing the project within the defined time-frame and cost limits is helpful in expeditious execution and cost control. 3. Use of Network Techniques For project planning and control two basic techniques are available - PERT (Programme Evaluation Review Technique) and cPM (critical Path Method). These techniques have, of late, merged and are being referred to by a common terminology, that is network techniques. With the help of these techniques, monitoring becomes easier. Review Once the project is commissioned, the review phase has to be set in motion. Performance review should be done periodically to compare actual performance with projected performance. A feedhack device, it is usefu several ways: (i) It throws light on how realistic were the assumptions underlying the project; (ii) It provides a documented log of experience that is highly valuable in future decision making; (iii) It suggests corrective action to be taken in the light of actual performance; (iv) It helps in uncovering judgmental biases; (v) It induces a desired caution among project sponsors. 1.4 LEVELS OF DECISION MAKING In addition to looking at the various phases of capital budgeting, researchers have also examined different levels of decision making. Gordon, Miller, and Mintzberg, for example, defined three levels of decision making: operating, administrative, and strategic. The key characteristics of decisions at these levels are described below:TTT penny ritraice’ Si aegte decisions decisions decisions Whereis the decision taken Lower level Middle level Top level management management management How structured is the decision Routine Semi-structured Unstructured Whatis the levelof resouice Minor resourse Moderate resource Major resouce commitment commitment commitment ‘commitment What is the time horizon Short-term Medium-term Long-term The three levels (operating, administrative, and strategic) of decision making can be readily applied to capital budgeting decisions, Examples are given below: Operating capital budgeting : Minor office equipment decision Administrative capital : Balancing equipment budgeting decision Strategic capital budgeting : Diversification project decision While the methods and techniques covered in this book are applicable to all levels of capital budgeting decisions, our discussion will mainly be oriented towards administrative and strategic capital budgeting decisions. 1.5 FACETS OF PROJECT ANALYSIS The important facets of project analysis are: Market analysis Mi Technical analysis Financial analysis 1 Economic analysis Ecological analysis Market Analysis Market analysis is concerned primarily with two questions: Ml What would be the aggrogate demand for the proposed product/service in the future? i what would be the market share of the project under appraisal? To answer the above questions, the market analyst requires a wide variety ofinformation and appropriate forecasting methods. The kinds of information required are: 1 Consumption trends in the past and the present consumption level Past and present supply position Ml Production possibilities and constraints i Imports and exports Structure of competition I Cost structure Wi Elasticity of demand i Consumer behaviour, intentions, motivations, attitudes, preferences, and requirements i Distribution channels and marketing policies in use Mi Administrative, technical, and legal constraints Technical Analysis Analysis of the technical and engineering aspects of a project needs to be done continually when a project is formulated. Technical analysis seeks lo determine whether Une prerequisites for the successful commissioning of the project have been considered and reasonably good choices have been made with respect to location, size, process, etc. The important questions raised in technical analysis are: 1 Whether the preliminary tests and studies have been done or provided for? 1 Whether the availability of raw materials, power, and other inputs has heen established? @ whether the selected scale of operation is optimal? 1 Whether the production process chosen is suitable? Whether the equipment and machines chosen are appropriate? Ml Whether the auxiliary equipments and supplementary engincering works have been provided for? 1 Whether provision has been made for the treatment of effluents? I whether the proposed layout of the site, buildings, and plant is sound? Mi whether work schedules have been realistically drawn up? 1 whether the technology proposed to be employed is appropriate from the social point of view? Financial Analysis Financial analysis cooks to ascertain whether the proposed project will be financially viable in the sense of being able to meet the burden of servicing debt and whether the proposed project will satisfy the return expectations of those who provide the capital. The aspects which have tobe looked into while conducting financial analysis are: i Investment outlay and cost of project I Means of financing Cost of capital Ml Projected profitability I Break-even point Cash flows of the project i Investment worthwhileness judged in terms of various criteria of merit Mi Projected financial position Mi Level of risk Economic Analysis Economic analysis, also referred to as social cost benefit analysis, is concerned with judging a project from the larger social point of view. In such an evaluation the focus is on the social costs and benefits of a project which may often be different from its monetary costs and benefits. The questions sought to be answered in social cost benefit analysis are: Ml What are the direct economic benetits and costs of the project measured in terms of shadow (efficiency) prices and not in terms of market prices? i What would be the impact of the project on the distribution of income in the society? 1 what would be the impact of the project on the level of savings and investment in the society? I What would be the contribution of the project towards the fulfillment of certain merit wants like self-sufficiency, employment, and social order? Ecological Analysis _ In recent years, environmental concerns have assumed a great deal of significance — and rightly so. Ecological analysis should be done particularly for major projects which have significant ecological implications (like power plants and irrigation schemes) and environment-polluting industries (like bulk drugs, chemicals, and leather processing). The key questions raised in ecological analysis are: Ml What ic the likely damage caused by the project to the environment? 1 What is the cost of restoration measures required to ensure that the damage to the environment is contained within acceptable limits? Exhibit 1.2 summarises the key issues considered in different types of analysis:Exhibit 1.2 Market Analysis | — Technical Analysis —{ Financial An=tysis. —} Economie Analysis —| Ecological Analysis — Key Issues in Project Analysis Potential Market Market Share Technical Viability \ Sensible Choices Risk Retum Benefits and Costs in Shadow Prices & Other impacts 7 Environmental Damage \ Restoration Measures Feasibility Study: A Schematic Diagram We have looked at the six broad phases of capital budgeting and examined the key facets of project analysis. The feasibility study is budgeting, viz., plan concerned with the first four phases of capital g, analysis, selection (evaluation), and financing, and involves market, technical, financial, economic, and ecological analysis. The schematic diagram of the feasibility study is shown in Exhibit 1.3.Exhibit 1.3 Feasibility Study: A Schematic Diagram Generation of ideas q Initial Screenna ] Is the Idea Prima Facie Promising ? Pian Feasibility Analysis - Terminate ‘Conduct Marke} ‘Conduct Technical Analysis, Analysis L Pemaarramamas}] t Conduct Economie and Ecological Anaive's { isthe Project Worthahile > { No Prepare Funding Proposal | -——~—_,, o-we wae wnoe Kams—3-~e59 porescowem Terminate 1.6 KEY ISSUES IN MAJOR INVESTMENT DECISIONS! While making a major investment decision, the following key issues are examined. Investment Story Before the firm commits to a project, the investment story must make sense to the management. This essentially means that the management must be convinced that the firm enjoys a comparative advantage vis-a-vis its competitors, in investing in the project. Remember that a positive NPV stems from a sustainable comparative advantage. Risks Capital investments invariably are risky propositions. Hence the firm must carefully assess the risks associated with the project and its ability to