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 nonquantifiable 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
Competitors activities
Intangible factors (Firms prestige, workers 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

Accept or Reject criterion: Management of a firm may

establish a Norm or Standard for acceptable payback 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.
(a)

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 projects 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 projects
NPV or IRR
Assumption:pessimistic, expected, and
optimistic
Sensitivity analysis is a way of analysing
change in the projects NPV (or IRR)

Steps involved in the use of

sensitivity analysis

Identification of all those variables, which have

an influence on the projects 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 projects NPV.

Performing the sensitivity analysis NPV for

each forecast under three assumption
NPV (Volume)

Increase?

Decrease?

NPV (Variable cost or

fixed cost)

Increase?

Decrease?

NPV (Selling Price)

Increase?

Decrease?

Project is delayed
More?
Or outlay escalates or
Project life

Less?

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

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