STRATEGIC INVESTMENT AND FINANCE

DECISIONS
 INVESTMENT DECISIONS
• PROJECT
 According to Newman
“a project typically has a distinct
mission that it is designed to achieve
and a clear termination point, the
achievement of the mission”
 “a project is an organised unit dedicated
to the attainment of a goal, the successful
completion of a development project on
time”
 projects can differ in their size, nature,

objectives, time duration and complexity,

yet they partake(quality) of the following
three basic attributes:
(i) A course of action (sequence of
activities)
(ii) Specific objectives and
(iii) Definite time perspective
 PROJECT CLASSIFICATION

 Quantifiable and Non-Quantifiable

Projects

‘quantifiable projects/ projects concerned

with industrial development, power
generation, and mineral development fall
in this category
(can determine the quantity of output)
 PROJECT CLASSIFICATION
 Projects involving health education and
defence are the examples of non-
quantifiable projects.

 Sectoral Projects
(i) Agriculture and Allied Sector

(ii)Irrigation and Power Sector

(iii)Industry and Mining Sector

(iv)Transport and Communication Sector

(v)Social Services Sector

 PROJECT CLASSIFICATION
 Techno-Economic Projects
• intensity oriented classification
If large investment is made in plant and
machinery, the projects will be termed
as ‘capital intensive’
projects involving large number of human
resources will be termed as ‘labour
intensive’.
 PROJECT CLASSIFICATION
• Causation oriented classification
demand based or raw material based
projects.(availability of certain raw
materials, skills or other inputs makes the
project raw material-based)
• Magnitude-Oriented Classification
size of investment involved in the projects
techno-economic characteristics is found
useful in facilitating the process of
feasibility appraisal of the project
 Project identification and Selection
project selection consists of two main steps
a. Project Identification
b. Project Selection
Project Identification
 The investment proposal may be for setting

up a new unit, expansion or improvement of

existing facilities
 A project is a specific, finite task to be

accomplished in order lo generates cash flows

 The stages of Project Selection
Preliminary Selection stage on the basis of
their
Technical, Economic and Financial
soundness
 Pre-feasibility studies give output of
plant of economic size, raw material
requirement, sales realisation, total
cost of production, capital input/output
ratio, labour requirement, power and
other infrastructure facilities and
economic policy of the government
FEASIBILITY STUDY
 Feasibility studies can be prepared either by the

entrepreneur or consultants or experts.

 Feasibility study should examine public policy with
respect to the industry
 Alternative techniques of production in terms of process
choice and ecology friendliness, choice of raw material
and choice of plant size.
 Preliminary estimates of sales revenue, capital costs and

operating costs for different alternatives along with their

profitability
 An essential part of the feasibility study is the schedule of

implementation and estimates ofexpenditure during

construction.
PROJECT REPORT
 project report is a detailed plan of follow-up of

project through various stages of implementation.

 A project report should contain an examination of

public policy with respect to the industry, listing
of equipment by type, size and cost and
specification of sources of supply for equipment,
broad specification of outputs and alternative
techniques of production in terms of choice of
process
PROFITABLE PROJECT COSTING TIPS

Profit is the key to success

 PROFITABLE PROJECT MANAGEMENT
 pre-project planning plus an understanding of

what a project is and what can be at stake.

 Managing it almost always involves:

• Applying technical knowledge, people,

communications skills, and management talent.
• Attempting to meet contract requirements and
customer commitments on time and within budget.
• Trying meeting customer expectations
 BENEFITS OF GOOD PROJECTS
MANAGEMENT

 Collaboration right can be seen in staff morale

and customer satisfaction.
 The firm can introduce change, increase
productivity, enhance its capabilities or of a
client or build new relationships
 ESSENTIALS OF PROFITABLE PROJECT
MANAGEMENT
 Define scope, deadlines and goals
 Communicate, Communicate and Collaborate
 Meet deadlines even if the firm must reduce scope
 Run every project the same way
 Chose proven projects technology, deploy it
properly
 Monitor real-time costs
 Manage the client as much as the project
PROJECT MANAGEMENT AND PROJECT
INVESTMENT
MANAGEMENT
 Project management requires

technical, marketing and financial

skill
 project investment management

requires only financial knowledge

a) What do you mean by Project?
b) What are the classifications of Project?
c) Explain the concept of Project identification
and selection
d) What are the profitable project costing tips?
e) Discuss the essentials of profitable project
management
 EVALUATION OF INVESTMENT
OPPORTUNITIES
 project appraisal help to select the best project
among available alternative projects.
 economic, financial, technical, market, managerial
and social aspects are analysed.
 capital budgeting techniques are available to
evaluate worthiness of projects.
 IMPORTANCE OF CAPITAL BUDGETING
‘Capital budgeting’ is the most vital activity which
can ‘make or mar’ a future financial health.
 Huge amount of investment

 Permanent and irreversible commitment of funds

 Long term impact on profitibility

 Growth and Expansion

 Cost over runs

 Multiplicity of variables

 Top management activities

 FACTORS INFLUENCING CAPITAL
EXPENDITURE DECISIONS
Financial and non-financial, which influence the
capital expenditure decisions.
 Availability of funds
 Future earnings
 Legal compulsions
 Degree of uncertainty or risk
 Urgency
 Research and Development projects
 Obsolescence
 Competitor’s activities
 Intangible factors (Firm’s prestige, worker’s safety, social welfare, etc.,)
 TYPES OF CAPITAL EXPENDITURE

 Capital Expenditure which increases

revenue
 Capital Expenditure which reduces
costs
 CLASSIFICATION OF CAPITAL
EXPENDITURE PROPOSALS
 Independent proposals
 Dependent proposals
 Mutually exclusive proposals
SOME IMPORTANT ASPECTS OF CAPITAL
EXPENDITURE DECISIONS
 Cash out flow needed for a proposal
• Cash cost of the new project or machine or
equipment
• Cost of installation
• Working capital needed to operate the machine or
to implement the projects
• Cash inflows from sale of old asset in case of
replacement of assets
• Tax effects of implementing the proposal
 Required return on investments
 Measurement of returns from Investment
proposals
 Measurement of returns from Investment
proposals
 Assessment of ‘Risk’ or ‘Uncertainty’
involved in Projects
 METHODS OF CAPITAL BUDGETING (OR)
“METHODS OF EVALUATIONS OF INVESTMENT
PROPOSALS”
 Provide a basis for distinguishing between
acceptable and non-acceptable projects.
 Rank different proposals in order of priority.
 Have suitable approach to choose from among
the alternatives available;
 Adopt ‘Criterion’ which can assess any kind of
project;
 Be logical by recognising the time value of
money and the importance of returns.
(A) Traditional methods:
 Pay –back period method

 Improvement in traditional approach to pay-back period

method.
 Accounting rate of return or average rate of return

method.
(B)Non Traditional Methods (or) Discounted cash flow
methods (D.C.F. Methods)
 Net Present Value (N.P.V) method

 Profitability Index (or) Excess present Value Index

Method (P.I. Method)

 Internal rate of return (I.R.R.) method. Each of the above

methods is explained
 Traditional Methods
• Pay-Back Period Method
• Pay - back period
 Investment decisions based on
pay-back period
(a) Accept or Reject criterion: Management of a firm may
establish a ‘Norm’ or ‘Standard’ for acceptable pay-
back period, usually based on cost of capital. It is called
‘cut-off’ point.
(b) Ranking of Projects:

lower pay-back period being ranked higher and vice

versa.
(c) When pay-back period of two or more projects is equal,
the project with higher initial cash inflows is preferred
over the projects with lower initial cash inflows.
Advantages of pay-back period method
 It is simple to understand and easy to calculate.

 Profit is recognized only after the pay-back period.

So, it acts as a guideline for dividend policy in the

case of new firms
Disadvantages
 It ignores post-pay-back period returns

 It completely ignores ‘Time value’ of money

 Pay-back period method does not measure

profitability of projects at all because

 it is concerned with a short period of a project’s life

time.
 Improvements in traditional approach to pay –
back period method
 (a) Post Pay – back profitability method

(b) Post pay-back period method:

(c) Pay-back Reciprocal method (or)

‘Unadjusted rate of return method:
1) Why capital expenditures are deemed very
important?
2) Discuss the phases of capital budgeting.
3) What is NPV? What are the limitations of NPV?
4) What is IRR and how is it calculated?
5) Evaluate payback as an investment criterion.
6) How Accounting Rate of Return is calculated?
What are the pros and cons of ARR?
 RISK ANALYSIS IN INVESTMENT
DECISION
 NATURE OF RISK

cash flows cannot be forecasted accurately

 General economic conditions

 Industry factors

 Company factors

 The most common measures of risk are standard

deviation and coefficient of variations.

 STATISTICAL TECHNIQUES FOR RISK
ANALYSIS
 How is probability defined?
 How are probabilities estimated?
 How are they used in the risk analysis
techniques?
 How do statistical techniques help in resolving
the complex problem of analyzing risk in
capital budgeting?
 Probability Defined
 This is referred to as “best estimate” or “most
likely” forecast.
 Probability Defined
 The forecast should describe more accurately
the degree of confidence in his forecasts

 the chance or probability of the annual cash flows

being either Rs 200,000 (maximum) or Rs 80,000
(minimum) 20 per cent each.
 There is a 60 per cent probability that annual cash
flows may be Rs 170,000.
 RISK AND UNCERTAINTY
 Expected Net Present Value
 Expected net present value= Sum of present
values of expected net cash flows

 ENCF-Expected Net Cash Flows

 K-Discount rate
VARIANCE OR STANDARD DEVIATION: ABSOLUTE
MEASURE OF
RISK
Coefficient of Variation: Relative Measure of
Risk
 Project X has an expected value of Rs 6,000 and a
standard deviation of Rs 1,095.45, while Project Y
has an expected value of Rs 8,000 and a standard
deviation of Rs 2,097.62.
 Project Y may be preferred, because of the larger
expected net present value.
 CONVENTIONAL TECHNIQUES OF RISK
ANALYSIS
 non-conventional techniques of handling risk in
capital budgeting
 Payback
 (i) focusing attention on the near term future and
thereby emphasizing the liquidity of the firm through
recovery of capital
 by favoring short term projects over what may be
riskier, longer term projects.
 Risk-Adjusted Discount Rate

 The greater the risk and the greater the

premium required
 risk premium be incorporated into the capital

budgeting analysis through the discount rate.

A higher rate will be used for riskier projects
Certainty Equivalent
 and a lower rate for less risky projects.
 Risk-Adjusted Discount Rate

Certainty Equivalent
 SENSITIVITY ANALYSIS

 The net present value or the internal rate of

return of a project is determined by analysing
the after-tax cash flows
 To determine the reliability of the project’s
NPV or IRR
 Assumption:pessimistic, expected, and
optimistic
 Sensitivity analysis is a way of analysing
change in the project’s NPV (or IRR)
 Steps involved in the use of
sensitivity analysis
 Identification of all those variables, which have
an influence on the project’s NPV (or IRR).
 Definition of the underlying (mathematical)
relationship between the variables.
 Analysis of the impact of the change in each of
the variables on the project’s NPV.
 Performing the sensitivity analysis NPV for
each forecast under three assumption

NPV (Volume) Increase? Decrease?

NPV (Variable cost or Increase? Decrease?
fixed cost)
NPV (Selling Price) Increase? Decrease?
Project is delayed More? Less?
Or outlay escalates or
Project life
 DCF BREAK-EVEN ANALYSIS
 SCENARIO ANALYSIS
• pessimistic, optimistic and expected
• Increase in volume of sales
• Reduces selling price
• Increase variable cost
 SIMULATION ANALYSIS
 The Monte Carlo simulation or simply the
simulation analysis considers the
 interactions among variables and probabilities
of the change in variables
 Identify the variable that influence cash
inflows and outflows
 Revenue depends upon volume and sale price
 DECISION TREES FOR SEQUENTIAL
INVESTMENT DECISIONS
Steps in Decision Tree Approach
 Define investment

 Identify decision alternatives

 Draw a decision tree

 Analyze data
 RISK ANALYSIS IN
PRACTICE
 price of raw material and other inputs
 price of product
 product demand
 government policies
 technological changes
 project life
 Inflation
 selling price, product demand, technical
changes and government policies.
 The most commonly used methods of risk
analysis in practice are:
 sensitivity analysis
 conservative forecasts
 TYPES OF INVESTMENTS AND
DISINVESTMENTS
 TYPES OF INVESTMENT DECISIONS
 Expansion of existing business
 Expansion of new business
 Replacement and modernisation
 DIFFERENT AVENUES FOR
DIVESTMENT
 Self off
 Spin