Capital investment involves a cash outflow in the immediate future in anticipation of returns at a future date. The capital investment decisions assume vital significance in view of their marked bearing on corporate profitability needs no emphasis.
The planning and control of capital expenditure is termed as ‘capital budgeting’. Capital budgeting is the art of finding assets that are worth more than they cost, to achieve a predetermined goal i.e., optimizing the wealth of a business enterprise.
The investment proposals need to be related to the underlying corporate objectives and strategies. A key challenge for all organizations is to identify projects which fit these strategies and promise to be profitable in the broadest sense i.e., to create wealth for the organization. Capital expenditure decisions usually involve large sums of money, have long time-spans and carry some degree of risk and uncertainty.
A capital investment decision involves a largely irreversible commitment of resources that is generally subject to significant degree of risk. Such decisions have a far-reaching efforts on an enterprise’s profitability and flexibility over the long-term.
Acceptance of nonviable proposals acts as a drag on the resources of an enterprise and may eventually lead to bankruptcy. For making a rational decision regarding the capital investment proposals at hand, the decision maker needs some techniques to convert the cash outflows and cash inflows of a project into meaningful yardsticks which can measure the economic worthiness of projects.
Realistic investment appraisal requires the financial evaluation of many factors, such as the choice of size, type, location and timing of investments, taxation, opportunity cost of funds available and alternative forms of financing the outlays. These show that capital investment decisions are difficult on account of their complexity and their strategic significance. The capital investment decision process is shown in figure 29.1.
Capital Investment Process:
The strategic capital investment process is discussed below:
i. Search for Investment Opportunities:
The first and probably most crucial stage in the process involves the recognition of opportunities. This involves a continuous search for investment opportunities which are compatible with the firm’s objectives.
Although business may pursue many goals, survival and profitability are two most important objectives. It require imagination and diligence by management if they are to be detected at any early stage. The earlier opportunity is identified the greater should be the potential returns before competitors and imitators react.
ii. Screening the Alternatives:
Each proposal is then subjected to a preliminary screening process in order to assess whether it is technically feasible, resources required are available and the expected returns are adequate to compensate for the risks involved. The alternatives will be screened and it is neither feasible nor desirable to conduct a full scale evaluation of opportunities.
It is required to determine whether such opportunities are worth further investigation. Readily available information must be used to ascertain whether the opportunity is compatible with the existing business and corporate strategy and the likely returns compensate for the risk involved.
iii. Analysis of Feasible Alternatives:
If a proposal satisfies the screening process it is then analyzed in more detail by gathering technical, economic and other data. Projects are also classified into new projects, expansions or improvements, and ranked within each classification with respect of profitability, risk and degree of urgency.
iv. Evaluation of Alternatives:
This stage will involve the determination of proposal and its investments, inflows and outflows. Investment appraisal techniques and range from the simple payback method and accounting rate of return to the more sophisticated discounted cash flow techniques. The technique selected should be the one which enables a manager to make the best decision in the light of prevailing circumstances.
Once evaluation is completed then proposal will be forwarded to a higher level of management for authorization to take up the project.
vi. Implementation and Control:
If approved, the project will be implemented and its progress is monitored with the aid of feedback reports. These reports will include critical path analysis, capital expenditure progress reports, performance reports comparing actual performance against plans set and post completion audits.
Kinds of Projects:
Depending upon the purpose, the projects can be classified as follows:
i. Balancing Projects:
When the capacity utilization of the plant and machinery is unbalanced due to unutilized capacity in some units, the balancing equipment is installed to remove the bottlenecks and to increase the capacity utilization of total plant.
By installing balancing equipment, there would be free flow in the process and uninterrupted production is ensured and there will be more revenues through higher output and attendant value addition. The value addition that takes place due to addition of balancing equipment should pay for the investment on the project.
ii. Modernization Projects:
Due to technological development, wear and tear, the old plant and machinery that was installed several years back, would require modernization. The old plant may cause high cost of production, frequent interruptions in plant running, high cost of maintenance, low quality products, etc.
In modernization, old machines are removed and new machines are installed in its place in order to cope with the dynamic and competitive business environment. The modernization of plant will reduce the cost of production, increases productivity and improve the morale of the employees. It will also improve the production methods, increase the product quality.
iii. Replacement Projects:
Replacement does not imply a like for like substitution. Replacement of an existing asset with more economic one. If any equipment is deteriorated due to obsolescence and its economic life is completed, it should be replaced with a new machine, which may be equivalent to old machine or it may also be more efficient than the old one.
By such replacement, the operational efficiency is increased, reducing the cost of production, minimization of maintenance cost, increase in capacity utilization etc. Replacement project is similar to the modernization but replacement is taken at individual machine level, but modernization takes place at the complete plant level.
iv. Expansion Projects:
When the current production levels of existing plant could not meet the growing demand for the product in the market, and such growth is of permanent nature, the management would decide to increase the capacity of the plant by installing additional equipment and facilities thereby the total production is increased. Expansion project is undertaken to enlarge its plant capacity with a view to produce a large volume of output than the current level.
v. Diversification Projects:
It is an investment decision to setup an entirely new project which is not connected with existing line of business. The strategic consideration in going for diversification projects is to minimize the risk by having a diversified portfolio of investments. The diversification will increase the asset bases, increase in turnover and profits, better utilization of managerial skills, use of latest technologies etc.
Classification of Projects:
1. Projects can be classified in many ways, namely:
National and international projects
Industrial and non-industrial projects
2. Project based on level of technology:
i. High technology projects
ii. Conventional technology projects
iii. Low technology projects
3. Projects based on size:
a. Large projects
b. Medium projects
c. Small projects
4. Projects based on ownership:
a. Public sector projects
b. Private sector projects
c. Joint sector projects
5. Projects according to purpose:
a. Balancing project
b. Modernization projects
c. Replacement/renewal projects
d. Expansion projects
e. Diversification projects
f. Rehabilitation (of sick units) projects
g. Upgradation projects
h. Maintenance projects
i. Mergers and acquisition
j. New project (innovation or invention)
Forward and Backward Integration:
The following projects are in the form of vertical integration:
i. Backward Integration:
It is the creation of facilities for production of raw materials and components required for current production. It is the setting up of facilities for the production of raw materials and components required for the current operations of the organization.
ii. Forward Integration:
It is the creation of facilities for manufacturing products for which the current products of the organization serve as inputs. It is the use of company’s own products as raw material, which are further processed and increase its value addition, thereby increase in revenues and profits.
Rationale for Diversification:
The rationale for diversification can be attributed to the following reasons:
(a) To achieve consistent growth and profitability (by transferring company’s strategic capability and providing superior value to customer).
(b) When companies objectives are no longer compatible within the scope of current portfolio (the condition occurs when there is a decline in demand, high competitive pressures, quicker product line obsolescence).
(c) To enhance the shareholder’s value.
(d) The grass is greener on the other side or sheep mentality.
The success or failure of diversification depends upon many aspects including management, the core competencies of the company, the existing business, and the new business into which the company wants to diversify.
New Concepts in Financing and Execution of Projects:
In recent industrial liberalization program in India, few projects are emerging with new concept for financing and execution of project.
Different varieties of such projects seen in India are as follows:
i. Build, Own and Operate (B.O.O.):
Under this, the entrepreneur will build the project from his own resources and he will own the project and he is also entitled to operate the project subsequent to its commercial launching. These type of projects are undertaken in core sector like power, steel, oil, railway etc. by the private sector and the Government will give guarantee to buy the output.
ii. Build, Operate and Transfer (B.O.T.):
The private sector is invited by the Government to undertake projects in core sector, when the Government is unable to finance such projects due to scarcity of funds. Under this, the private sector will put the investment in bringing the project, and the Government allows them to operate for certain period and then transfer the project to the Government.
iii. Lease, Rehabilitate, Operate and Transfer (L.R.O.T.):
Under LROT concept, the Government will give a running plant for rehabilitation to put the plant on profitability track or for increasing its production capacity. The Government adopts this concept when it reels under funds constraint.
iv. Engineering, Procurement and Construct (E.P.C.):
In these projects, the contractor takes the complete responsibility to construct, erect, commission and supply the plant and keeps it ready to operate by the owner. It is the responsibility of the contractor to prepare engineering designs, procurement of materials, erection and commissioning the project and then handing over the plant to the owner.
EPC gives full guarantee of all multiprocessor plant. Small and petty contractors who are not financially strong do not get chance to enter into the EPC contracts, thereby no project delays. Financial institutions always prefer to have a single point responsibility agency which has competence and reputation and on whom they can trust.
v. Turnkey Contract:
When single contractor undertakes the responsibility for the entire work and complete it so that the owner merely turns the key and operates the plant, it is called ‘turnkey contract It covers the complete and composite responsibility of engineering, design, manufacturing, supply, construction and commissioning. It is a total package deal for a lump sum consideration.
Turnkey contract may help in cutting down the number of responsibility centres to the extent of one. It reduces the number of agencies the owner is required to coordinate. The turnkey contract may not allow the owner to participate and he cannot become familiar with plant and machinery, checking procedure by the owner is not possible and developing in-house technological services by the owner cannot be adopted.