Preface to the Seventh Edition

This book is now nearly three decades old. Its longevity may be attributed to the growing number of academics and practitioners who have found it useful, relevant, and readable.

My effort has been to present the key principles and techniques for evaluating capital expenditure proposals that have been developed primarily by financial economists. The book explains the rationale behind these principles and suggests ways and means to improve project appraisal and capital budgeting in practice.

The book spans the gamut of capital budgeting, defined in its broadest sense. Beginning with project planning, it culminates in the review of projects undertaken. In this respect, it is wider in coverage than other books in the field.

Numerous examples have been included to illustrate the principles and techniques. Where necessary, two or more examples in the ascending order of complexity have been included. Apart from analytical methods, the book discusses strategic, qualitative, and organisational considerations which impinge on capital budgeting decisions. It also describes and evaluates business practices in various areas.

The book is primarily designed for two categories of readers—students and practitioners. Students of professional programmes (like MBA, CFM, CFA, ACA, and AICWA) and post graduate courses in Commerce, Finance, and Economics will benefit from this book. The book will also prove a valuable reference to corporate policy makers who formulate and shape corporate investment strategies; to consultants and others who prepare project feasibility studies; to executives who have a say in the selection of projects and development of the firm’s capital budget; to officials of banks and financial institutions who evaluate projects as lenders and investors; and to managers who are concerned with implementing as well as reviewing projects.

The key guidelines relevant to project planning, analysis, selection, financing, implementation, and review discussed in this book are:

  • Develop a strategy that leads to sustainable competitive advantage.
  • Sharpen the ability of the firm to identify promising investment opportunities.
  • Formulate the project, considering the interrelationships among various aspects.
  • Forecast realistically the incremental cash flows attributable to the project.
  • Establish a hurdle rate that is consistent with the risk exposure of the project.
  • Calculate the net present value of the project and value the real options.
  • Blend judgment with analytical reasoning.
  • Choose a financing structure that lowers the cost of capital, preserves financial flexibility, and mitigates agency costs.
  • Formulate the project adequately, assign specific responsibilities to project managers, and use network techniques for project planning and control.
  • Conduct post-audit and periodically review project performance.

CHANGES IN THE SEVENTH EDITION

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Enthused by the overwhelming response to the previous edition, I revised and updated most of the chapters and appendices.

To strengthen the book further, I added the following material:

  • Fifteen new sections: 1.6 : Key Issues in Major Investment Decisions;6.10: Financial Modeling Using Spreadsheet; 12.1: Pros and Cons of Multiple Costs of Capital; 12.3: Hurdle Rate and Cost of Capital; 16.9: Strategy as a Portfolio of Real Options; 16.11: Mistakes Made in Real Option Valuation; 17.5: Reverse Financial Engineering; 17.6: Group Process; 17.7: Impact on Earnings; 18.6: Credit Risk Rating; 19.7: Managing Risks in Private Infrastructure Projects; 19.8: Public Private Partnerships; 19.9: Recommendations of the Committee on Infrastructure Financing; 21.6: Essence of Project Management; and 23.7: Disciplining the Capital Budgeting Process for Small Ticket Items.
  • Four new minicases on the following topics: ‘Market and Demand Analysis,’ ‘Special Decision Situations,’ ‘Social Cost Benefit Analysis,’ and ‘Venture Capital and Private Equity.’
  • A number of boxes containing valuable perspectives and practical insights.

ORGANISATION OF THE BOOK

Organised in terms of the broad phases of capital budgeting, this book is divided into seven parts:

Part 1Planning: Part 1 covers the planning phase of capital budgeting. Chapter 1 provides an overview of capital budgeting. Chapter 2 discusses the key concepts, models, and considerations that are helpful in articulating the capital allocation strategy of a firm. Chapter 3 looks at the ways and means of generating project ideas and screening them at a preliminary level.

Part 2Analysis:Part 2 focuses on gathering and analysing basic information about the project. Chapter 4 discusses the key steps involved in market and demand analysis. Chapter 5 dwells on the various facets of technical analysis. Chapter 6 explains how financial estimates and projections relating to a project are developed.

Part 3Selection–I: The content on the selection phase is very extensive. It has thus been split into two parts, Selection–I (Part 3) and Selection–II (Part 4). Part 3 consists of chapters 7–11. Chapter 7 discusses the principles of compounding and discounting. Chapter 8 covers extensively the various investment appraisal criteria. Chapter 9 shows how project cash flows are defined. Chapter 10 explains the concept and measurement of cost of capital. Finally, Chapter 11 expounds the techniques for measuring and evaluating the stand-alone risk of a project.

Part 4Selection–II: Concerned with more advanced techniques of selection or broader methodologies of evaluation, Part 4 consists of chapters 12–17. Chapter 12 discusses how the project rate of return can be fine tuned. Chapter 13 looks at how capital budgeting decisions may be made in certain special situations. Chapter 14 presents the methodology of social cost benefit analysis. Chapter 15 shows how the capital budget may be drawn up in face of constraints, using the technique of mathematical programming. Chapter 16 explains the key insights provided by the option pricing theory and how the same may be employed for valuing the options embedded in capital projects. Chapter 17 explores the qualitative, strategic, and organisational issues relating to capital budgeting.

Part 5Financing:Consisting of chapters 18-20, Part 5 discusses how projects may be financed. Chapter 18 discusses various sources of finance used for setting up a project. Chapter 19 focuses on financing of infrastructure projects. Chapter 20 explains the concept and practice of venture capital and private equity.

Part 6Implementation:Part 6 includes two chapters which look at the implementation of the selected projects. Chapter 21 discusses various aspects of project management. Chapter 22 explains how network techniques (PERT, CPM, and Network Cost System) may be employed for project planning, scheduling, and control.

Part 7Review:Part 7 discusses various issues involved in project review (Chapter 23). It also covers the administrative aspects of capital budgeting.

ANCILLARY MATERIAL

To enhance the utility of the book for students and instructors, the following ancillary materials are available.

Spreadsheets Mr. Venugopal Unni developed Excel spreadsheets for all the major numerical exhibits in the book. These spreadsheets may be downloaded from the website of Tata McGraw-Hill (

Solved Problems A number of solved problems have been prepared for various chapters of the book. They can be downloaded from the website of Tata McGraw-Hill((

Additional Problems and Minicases To enable students to practice more, a number of additional problems and minicases have been prepared. They can be downloaded from the website of Tata Mc-Graw Hill ((

Solutions Manual and Powerpoint Presentations A solutions manual containing solutions to the end of the chapter problems and cases and powerpoint presentations of all chapters are hosted on the web site of Tata McGraw-Hill (( This can be accessed by the instructors who adopt the book. They may contact Tata McGraw-Hill for assistance in accessing the solutions manual and powerpoint presentation.

I look forward to receiving suggestions from the readers for further improving the content of this book.

Prasanna Chandra

Acknowledgements

I am indebted to my students and the participants of executive development programmes conducted by me for providing the stimulus for writing this book. They pointed to me the need for a comprehensive book, akin to a manual, on managing capital expenditures.

In writing this book I have drawn on materials from a variety of disciplines that have a bearing on different facets of project appraisal and capital budgeting. I owe a profound intellectual debt to numerous authors whose ideas and contributions have shaped my thinking on this subject.

I am extremely thankful to Venugopal Unni for thoroughly combing the book and adding useful material. I am grateful to Prof. G. Sabarinathan, Prof. Padmini Srinivasan, Suman Saha, Prof. Naganna, Prof. Y.L.R. Murthy, Prof. Pratap Subramanyam, and Pradeep Lath for their valuable contributions to this book. I am indebted to a number of practitioners who have generously shared their views with me and to Chandra sekhar of Tata McGraw-Hill for his interest in this book. I am thankful to Renuka for her help in preparing the manuscript of this book. My deepest gratitude is to my wife, Padma, for her unstinted support.

At places I have drawn on my articles published in Indian Management, Chartered Accountant, Management Accountant, Decision, Chartered Financial Analyst, and Lok Udyog. I am grateful to the editors of these journals.

Prasanna Chandra

Author’s Profile

Dr. Prasanna Chandra, Director of Centre for Financial Management, is an MBA, PhD (Finance). He hasaboutfour decades of teaching experience in postgraduate and executive education programmes. He was a Professor of Finance at Indian Institute of Management, Bangalore for nearly two decades. He was a Visiting Professor of Finance at Southern Illinois University, USA, for two years.

He has been a member of several committees including the Capital Issues Advisory Committee, the High Powered Committee on Insurance Sector Reforms, and the SEBI Committee on Derivatives. He has served or is serving on the boards of a number of organizations including Power Finance Corporation, Torrent Pharmaceuticals Limited, Unit Trust of India Investment Advisory Services Limited, Inter-Connected Stock Exchange of India, IFCI, IIM (B), ICFAI, Templeton Mutual Fund, Bangalore Stock Exchange Limited, and Karnataka Soaps and Detergents Limited. He has been a consultant to many organizations.

Dr Chandra has conducted executive seminars for a number oforganizations like INDAL, Infosys, Tata Motors, ITC, NIIT, Tata Steel, Sasken Communications, TATA-IBM, Tata Power, BHEL, Bharat Shell, ANZ Grindlays, HMT, Canara Bank, Vysya Bank, ONGC, Wipro, GAIL, Microsoft, Motorala, and Hindustan Unilever.

His other books include Financial Management: Theory and Practice, Investment Analysis and Portfolio Management, Managing Investments, Finance Sense, Fundamentals of Financial Management, and Valuation of Equity Shares. He has authored over 70 articles in professional journals and business periodicals. Dr Chandra has been a Fullbright Scholar and a UNDP Fellow. He has received several honours including the Best Teacher Award from the association of Indian Management Schools.