UNIT I

Concept of Capital Budgeting

• Finance Manager is concerned with Planning and
Financing investment decisions.
• Financing Decisions relate to determination of
amount of long term finance and decision on
sources for financing the same.
• Investment decisions also termed as “Capital
Budgeting Decisions” involve cost - benefit analysis.
• Investment decisions are based on careful
consideration of factors like profitability, safety,
liquidity, solvency etc.
 Why Capital Budgeting
• Capital investment means investments in projects which by
nature involve huge expenditure and results of the same are
known only after a long time.
• Why Capital investment is necessary
• For investments in New Projects
• Replacement of worn out/ out dated assets.
• Expansion of existing capacity –
• To meet high demand or inadequate production capacity.
• Diversification – to reduce risk
• Research and Development – Ensuring updated technology.
• Miscellaneous – Installation of Pollution Control equipment,
other legal requirements.
 Capital Expenditure Budget
• It is the formal plan of Capital expenditure on new
projects/ purchase of fixed assets.
• Provides for the capital outlay available for
procurement of capital assets during the Budget
period.
• It is prepared by taking into consideration
• Future demand projections/growth of industry the
available production capacities, allocation of
existing resources and
• likely improvement in production techniques.
 Types of Capital Investment
• Physical Asset
• Monetary Asset
• Intangible Asset

• Other classification
• Strategic Investments
• Tactic Investment
 Phases of Capital Budgeting
• Planning
• Analysis
• Selection
• Financing
• Implementation
• Review
 Level of Decision Making
• Operating Decision
• Administrative Decision
• Strategic Decision
 Facets of Project Analysis
• Market Analysis
• Technical Analysis
• Financial Analysis
• Economic Analysis
• Ecological Analysis
 Objective of Capital Budgeting
• Establishing Priorities
• Cash Planning
• Construction Planning
• Eliminating Duplication
• Revising Plan
 Key Criteria for allocation of Resource
• Profitability
• Risk
• Growth
 Strategy
• Alfred Chandler “ the determination of the
basic long-term goals and objectives of the
enterprise, and the adoption of course of
action and allocation of resource necessary for
carrying out those goals”
 Formulation of Strategy
Environment Analysis
Customers Internal Analysis
Competitors Technical Know How
Supplier Marketing and Distribution
Regulation Capability
Infrastructure Logistic
Social/Political environment Financial resource

Opportunity and threat Strength and weakness

Identify opportunity Determine Core Capability

Find the fit between core

capability and external
opportunity

Firm’s Strategy
 Grand Strategy

Growth Stability Contraction

Vertical
Concentration Liquidation Divestiture
Integration

Diversification
 BCG Matrix

HIGH LOW

High Stars Question

Marks
Low Cash Cows Dogs
 GE MATRIX
Business Strength
Strong Average Weak
High INVEST INVEST HOLD
Attractiveness

INVEST HOLD DIVEST

Medium
Industry

Low HOLD DIVEST DIVEST

Criteria: Industry Attractiveness Criteria- Business Strength

Industry Size Market Share
Industry growth Technological Know How
Industry Profitability Product Quality
Capital Intensity After Sales Service
Technological Stability Price Competitiveness
Competitive intensity Low Operating Cost
Cyclicality Productivity
 McKinsey Matrix

Competitive Position
Strong Average Weak
Winner Winner Question Mark
Attractiveness

High

Medium Winner Average Business Loser

Industry

Low Profit Producer Loser Loser

 Business Level Strategies
• Cost Leadership- Economies of Scale
Improving Capacity Utilization
Improving R & D
Marketing Outlay
Example: Hero Honda, Walmart,
Dell Computer

• Differentiation: Unique Product or Service- to pay

high price

Example: Coca-Cola, Rolex,

Raymond

• Focus: Narrow line or market or product

Cost Focus- General Motor,

McDonald Nissan
 Strategic Planning and Capital Budgeting

Managerial Vision,
Environmental Corporate
Values and Attitude
Assessment Appraisal

Strategic Plan

Capital Product Strategy,

Budgeting Market Strategy,
Production
Strategy and so
on
 Idea Generation
• Stimulating the flow of ideas:

• SWOT Analysis

• Clear Articulation of objective

• Fostering a conducive climate

 SWOT Analysis
• Strength
• Weakness
• Opportunity
• Threats
• Opportunity is a chance for firm growth due to
favorable circumstances.
• A Treat is a factor in a company’s external
environment that poses a danger to its well-
being.
 Clear Articulation of Objectives
• Cost Reduction
• Increase in capacity utilization
• Improvement in contribution margin
• Expansion into promising field
 Fostering a Conducive climate
• To tap the creativity of people and to harness
their entrepreneurial urges, a conducive
organizational climate has to be fostered.

• Ex; Bell Telephone Laboratory

• 3M Corporation
 Monitoring the Environment
Economic Sector
State of the Economy
Overall rate of growth
Growth rate of primary, Secondary,
Tertiary
Cyclical Fluctuation
Linkage with the world Economy
Trade Surplus/Deficit
Balance of Payment
Technological Sector
Emergence of new technologies
Access to technical know-how, foreign as
well as indigenous
Receptiveness on the part of industry
Government Sector
Industrial policy
Government programs and project
Tax Framework
Subsidies, incentives, and concessions
Import and Export policies
Financing norms
Lending condition of financial
institution and commercial banks
Socio-Demographic Sector
Population Trend
Age Shifts in population
Income distribution
Educational Profile
Employment of Women
Attitudes towards consumption and
investment
 Competition sector
Supplier Sector
Number of firms in the industry Availability and cost of raw material
Degree of homogeneity and Availability and cost of energy
differentiation among product Availability and cost of money
Entry barrier
Marketing practice and policies
 Corporate Appraisal
Marketing and Distribution Production and Operation
Market Image Condition and capacity of p&m
Product Line Availability of raw material
Market Share Degree of vertical integration
Distribution Network Locational Advantage
Customer Loyalty Cost structure
Marketing and distribution cost
Finance and Accounting
Financial leverage
Cost of Capital
Tax situation
Relationship with shareholder
Cash Flow and Liquidity

Research and Development Corporate Resource and personnel

Research Capabilities of the firm Corporate and Image
Track Record of new product Clout with Govt and Regulatory Agencies
development Dynamism of Top Management
Laboratories and testing facilities Competence of Commitment of
Coordination between research Employees
and operation State of Industrial relation
 Tool for Identifying Investment opportunity
Potential
Entrants

• Threat of new Entrants

Bargaining power of
supplier
• Bargaining supper of Buyer

Supplier The Industry Rivalry among Buyer

Existing Firms

• Threat of Substitute

Substitutes
 Life Cycle Approach
• Pioneering Stage
• Rapid Growth Stage
• Maturity and Stabilization Stage
• Decline Stage
 Preliminary Screening
• Compatibility with the promoter
• Consistency with governmental priorities
• Availability of Inputs
• Adequacy of Market
• Reasonableness of cost
• Acceptability of risk
 Project Rating Index
• Identify Factors relevant for project rating
• Assign weight to these factor according to
importance.
• Rate the project proposal on various factors,
using suitable rating scale.
• For each factor multiply the factor rating with
the factor weight to get the factor score.
• Add all the factor to get the overall project
rating index
 Source of Positive Net Present Value
• Economies of Scale
• Product differentiation
• Cost Advantage
• Marketing reach
• Technology Edge
• Government policy
 Qualities of Successful Entrepreneur
• Willingness to make sacrifices
• Leadership
• Decisiveness
• Confidence in the project
• Marketing orientation
• Strong Ego
 Factor
Factor Weight VG (5) G (4) A (3) P (2) VP (1) Score

Input Availability 0.25 3 0.75

Technical Know-How 0.1 4 0.4

Reasonableness of cost 0.05 4 0.2

Adequacy of market 0.15 5 0.75

substitute product 0.05 4 0.2

Stability 0.1 4 0.4

Dependence of firm's
strength 0.2 5 1
Consistency with govt
priorities 0.1 3 0.3

SUM 4