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Chapter 10

Chapter 10 ECON 2560

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ECON 2560
Tahsin Mehdi

Chapter 10 ECON 2560 Project Analysis HOW FIRMS ORGANIZE THE INVESTMENT PROCESS  Promising investment opportunities have to be identified and they have to fit in with the firm’s strategic goals  To evaluate opportunities properly, financial managers need unbiased cash flow forecasts that haven’t been skewed to “sell” a project to upper management  Large firms especially need to have set systems to facilitate effective communication across the organization Stage 1: The Capital Budget Capital Budget: List of planned investment projects  Generally, once a year head office will ask each division/plant to provide a list of investments they’d like to make  Budget is then reviewed and pruned by senior management  Once budget has been approved, it generally remains the basis for planning over the next year  Senior management’s concern is to see that the capital budget matches the firm’s strategic plans Stage 2: Project Authorizations  Annual budget is important b/c it allows everyone to exchange ideas before attitudes have hardened and person commitments have been made  At a later stage will need to make a detailed proposal describing details of project Some firms use a 4-fold breakdown… 1. Outlays required by law or company policy: These outlays don’t need to be justified on financial grounds.  Main issue is whether requirements are satisfied at the lowest possible cost 2. Maintenance or Cost Reduction (e.g. machine replacement): Engineering analysis is also important in machine replacement, but new machines have to pay their own way 3. Capacity expansion in existing businesses: Projects in this category are less straightforward; these decisions may hinge on forecasts of demand, possible shifts in technology and the reactions of competitors 4. Investment for new products: Projects in this category are most likely to depend on strategic decisions st  The 1 projects in a new area may NOT have positive NPVs if considered in isolation BUT may give firm valuable option to undertake follow-up projects Problems & Some Solutions  In most firms, capital budgeting is a cooperative effort Some Challenges…. Ensuring that forecasts are consistent: Inconsistent assumptions often creep into investment proposals  To ensure consistency many firms begin the capital budgeting process by establishing forecasts of economic indicators such as inflation & the growth in national income, as well as forecasts of particular items that are important to the firm’s business Eliminating Conflicts of Interest: While managers want to do a good job they are also concerned about own futures  If manager interests conflict w. shareholder interests it will likely result in poor investment decisions Reducing Forecast Bias: Someone who wants to have project proposal accepted is also likely to look on the bright side when forecasting the project cash flows  Optimism is a common feature in financial forecasts  Project sponsors likely to overstate their case deliberately only if the head office encourages them to do so Sorting the Wheat fro
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