Capital expenditure Decisions
Session 1
Meaning
• Corporate finance is strategic in nature and can be viewed
from three angles
– How a firm finances its investments ( capital structure
decisions)
– How it manages short-term financial requirements (working
capital decisions)
– The allocation of funds (capital expenditure decisions)
Capital expenditure Decisions
•Is the process of making investment decisions in capital expenditure.
•It is long term planning for making and financing proposed capital outlays.
•It is concerned with the allocation of the firm’s scarce financial resources
among the available market opportunities
•These involve selecting the best from various mutually exclusive projects
that require current outlay of funds in the expectation of future stream of
benefits extending far into future
– Outlay means outflow or investment
– Benefits mean inflows or income generating out of the investment
Features





Require long term commitment of funds
Has long term effect on profitability
substantial outlays
Difficult and expensive to reverse
Difficulties of Investment decisions because
 Decision extends to a series of years beyond the
current accounting period
 Uncertainties of future
 Higher degree of risk
Overall objective is to
• maximize the profitability of a firm or the return on
investment
(Either by increasing revenue or decreasing the costs)
Types
Examples
Mandatory investments
Replacement Projects
Expansion Projects
Diversification Projects
Research and
Development Projects
• Miscellaneous Projects
•
•
•
•
•
Grouping
• Accept/ Reject
• Mutually Exclusive
Project Decisions
• Capital Rationing
Decisions
Steps
• Identification of Potential Investment Opportunities
• Assembling of Investment Proposals
– Replacement, Expansion, New Product, Obligatory and welfare
•
•
•
•
Decision Making
Preparation of Capital Budget and Appropriations
Implementation
Performance Review
Project evaluation Techniques
Evaluation
Techniques
Tradition
al
Pay back
period
ARR
Modern
NPV
BCR
IRR
ACC
TRADITIONAL METHODS –
Pay Back period
• Pay back period means the length of time required to
recover the initial cash outlay on the project
• The shorter the payback period, the more desirable the
project is
• Seen under two situations
– Projects with EVEN CASH FLOWS
– Projects with UNEVEN CASH FLOWS
• Accept/reject criteria: accept the project with shorter
payback periods
• For even cash flows
Pay back period =
Cash Outlay
Annual cash inflows
• For uneven cash flows ( if the outlay is 1,00,000)
Y
Cash inflow of A
Cash inflow of B
1
50,000
20,000
2
30,000
20,000
3
20,000
20,000
4
10,000
40,000
5
10,000
50,000
6
-
60,000
Pay back period of A = 50+30+20 = 1 Lakh
= 3yrs
Pay back period of B = 20+20+20+40 = 1Lakh
= 4 yrs
Alternatively --• Determine the cumulative cash inflows
Year
A inflow
Cum
inflow
B inflow
Cum
inflow
1
50,000
50,000
20,000
20,000
2
30,000
80,000,
20,000
40,000
3
20,000
1,00,000
20,000
60,000
4
10,000
1,10,000
40,000
1,00,000
5
10,000
1,20,000
50,000
1,50,000
6
-
60,000
2,10,000
Locate the year against which 1,00,000 appears
That is the pay back period
The project with shorter pay back period is selected, here it is A
Example
2
A project cost Rs 5,00,000 and yields annually a profit of Rs 80,000 after
depreciation @ 12% p.a but before tax and depreciation if 50%. Calculate the pay
back period.
Profit before tax & Depreciation
Less Depreciation
Profit before tax
Less Tax @ 50%
Profit after tax
Add Depreciation @ 12%on 5,00,000
= 80,000
= 60,000
= 20,000
= 10,000
= 10,000
= 60,000
70,000
Pay back period = Cost of the project = 5,00,000 = 7.14 years
Annual Cash flow
70,000
• Advantages
– Simple
– Rough and ready method to
weed out risky projects the
cash inflows of which is more
after the pay back period
– Emphasis on cash inflows so
useful for firms with liquidity
crises
– Useful while evaluating a
single project.
• Disadvantages
– Fails to consider TMV
– Does not consider projects
which generate inflows
substantially after the pay
back period
– It treats each asset/project
in isolation
– Does not measure the true
profitability as the period
considered is very short, but
the life of the asset/project
is very long
– Does not take cost of capital
into consideration
Improved pay back period methods
• Post Pay-back profitability method
• Pay-back Reciprocal method
• Post-Pay back period method
• Discounted Pay-Back method
• Post Pay-back profitability method
Step 1 Calculate Post Pay back profitability
= Annual cash inflow ( Estimated life – Pay back period)
Step 2 Calculate Post Pay back Profitability Index
= (PPP / initial investment)*100
• Pay-back reciprocal method
= Annual Cash inflow / total investment
This is used to estimate the internal rate of return generated by a
project
• Post pay back period
The project with greatest post pay-back period is accepted
because it continues to generate revenue to the firm
Illustration
Calculate the discounted pay-back period method from
the following information
Cost of the project
Life of the project
Annual Cash Inflow
Cut off rate 10 %
= Rs 6,00,000
= 5 years
= 2,00,000
Discounted Payback method
Year
Cash
flow
Discounting
factor
Present value Cumulative discounted
Net cash flow
1
2,00,000 0.909
1,81,800
1,81,800
2
2,00,000 0.826
1,65,200
3,47,000
3
2,00,000 0.751
1,50,200
4,97,200
4
2,00,000 0.683
1,36,600
6,33,800
5
2,00,000 0.621
1,24,200
7,58,000
The outlay of Rs 6,00,000 will be recovered between the
3rd and the 4th years
Precisely = 3 years + 1,02,800
1,36,600
= 3 ¾ years
Average/Accounting Rate of Return
•
•
•
It is the average profit after tax divided by the average book value of the
investment over the life of the project
ARR =
Average annual Profit after Tax
Net Average Investment
In order to calculate profit after tax
From profit, deduct
1.
2.
3.
4.
Depreciation
Interest
Tax
Add depreciation ( As depreciation is a non-cash item )
Accept/reject Criteria: Accept Project with higher ARR
Illustration:
A project requires an investment of Rs 5,00,000 and has a scrap value of Rs
20,000 after five years. It is expected to yield profits after depreciation and
taxes during the five years amounting to Rs. 40,000, Rs. 60,000, Rs.70,000,
Rs.50,000 and Rs. 20,000. Calculate the average rate of return on the
investment.
• Total Profit = 40000+60000+70000+50000+20000 =
2,40,000
• Average profit = 2,40,000 = Rs. 48,000
5
• Net investment = Rs 5,00,000 – 20,000 = Rs. 4,80,000
• ARR = 48,000 * 100
4,80,000
= 10%
X Ltd is considering the purchase of machine. Two machines are available E
and F. The cost of machine is Rs.6,00,000. Each machine has an expected life
of 5 years. Net profits before tax and after depreciation during the expected
life of the machines are given below
Year
Machine E
Machine F
1
15,000
5,000
2
20,000
15,000
3
25,000
20,000
4
15,000
30,000
5
10,000
20,000
Total
85,000
90,000
Assume the tax rate to be 50%
Statement of Profitability
Machine E
Year
Machine F
PBT
TAX
PAT
PBT
TAX
PAT
1
15,000
7500
7500
5,000
2500
2500
2
20,000
10000
10000
15,000
5000
5000
3
25,000
12500
12500
20,000
10000
10000
4
15,000
15000
15000
30,000
15000
15000
5
10,000
5000
5000
20,000
10000
10000
42,500
90,000
85,000
Av. PAT
Av. Invt
ARR
42500/5 = 8500
60,000/2 = 30,000
(8500/30000)*100 = 28.33%
45000
45000/5 = 9000
60,000/2 = 30,000
(9000/30000)*100 = 30%
Machine F is more profitable than Machine E as the ARR is greater
Advantages
• Simple
• Based on accounting
information available
• considers the entire
life of the project
• Takes the average of
the best estimate of
profits
• Disadvantages
• Based on accounting
profit and not cash
flows
• Does not take TMV
• Does not provide any
guidance on what
target rate of return
should be
Modern methods
- Net Present Value
• Refers to the sum of the present values of all the cash
flow positive as well as negative
• That are expected to occur over the life of the project
• Since it discounts the cash flows, it is considered
better than the traditional methods
• The firms discount the cash flows at the cost of capital
estimated previously for the components of capital
involved in the project
Steps
• Compute the cut-off rate, which is the cost of
capital/minimum required rate of return for the
providers of funds
• Compute the present value of the total investment
outlay
• Compute the present value of the inflows at the cut-off
rate ( cash inflows after depreciation and taxes)
• Calculate the NPV which is PV of outflows – PV of
inflows
• accept /reject criteria: That project/asset which
generates maximum positive NPV
Illustration
If suppose a project has a life of 5 years and it requires an initial outlay of Rs 35000.
Calculate its Net Present Value. Also find whether the project is worth investing.
Year
Cash inflows
Discount factor
@10%
Discounted cash
flows
1
10000
0.909
9900
2
12000
0.826
9912
3
12000
0.751
9012
4
14000
0.683
9562
5
15000
0.621
9315
The sum of present values = 9900+9912+9012+9562+9315 = Rs 47701.
Since it is more than the initial outlay of Rs 35,000, it is worth investing in the project.
Advantages
• It recognizes the time value of
money and is suitable to be
applied in a situation with
uniform cash outflows and
uneven cash inflows or cash
flows at different periods of time.
• Takes into account the earnings
over the entire life of
asset/project
• Takes into consideration the
objective of maximum
profitability
Disadvantages
• More difficult to understand and
operate
• May not give good results while
comparing projects with unequal
lives as the project having net
present value but realized
Internal rate of return (IRR)
• It is that rate of interest at which the net present value
of a project is equal to zero
• Or it is the rate which equates the present value of
cash inflows with that of the outflows
• In NPV, the cost of capital becomes the discount rate,
in IRR, the discount rates which makes the NPV 0 has to
be worked out
• This is done usually with trial and error method
Steps to determine IRR
• Find the average annual net cash flow from the given cash flows
• Divide the initial outlay by the average annual net cash flow, the
answer is the PVIFA factor
• Look out for the interest rate against which the factor appears
for the given life of the project
• Multiply each of the cash flows by the PV values under the
interest factor found earlier, through the life of the project
• That factor for which the difference between the initial outlay and
the sum of the discounted cash flows is zero is the IRR.
• Accept/Reject criteria: Accept the project with IRR< k(
WACC)
A company has the following pattern of cash flows
Year Cash flows
( in lakhs)
0
(10)
1
5
2
5
3
3.08
4
1.20
Calculate the IRR
PVIFA =
Initial outlay
average annual cash flow
10
3.57 {(5+5+3.08+1.20)/4}
2.801
• From the PVIFA table, the interest factor corresponding to four years is
nearly 15%
• Taking the base interest as 15%, we start trial and error method
• At 15%, (-10 +(5*0.870)+(5*0.756)+(3.08*0.658)+(1.2*0.572) = 0.84
• At 16%, (-10+(5*0.862)+(5*0.743)+(3.08*0.641)+(1.2*0.552) = 0.66
• At18%, (-10+(5*0.848)+(5*0.719)+(3.08*0.609)+(1.2*0.516) = 0.33
• At 20% (-10 +(5*0.833)+(5*0.694)+(3.08*0.579)+(1.2*0.482) = 0
• So IRR is 20%
Benefit – Cost Ratio
•
•
•
•
•
•
It is also referred to as Profitability Index
BCR = PV /I
PV stands for Present value of Future cash flows
I stands for Initial investment
NCBR = BCR -1
Accept/Reject criteria : BCR>1 or NCBR>0, Accept
BCR<1 or NCBR<0, Reject
Evaluation
• The method is useful to rank • It provides no means for
a set of projects in the order
aggregating several smaller
of decreasingly efficient use
projects into a package than
of capital
can be compared with a
large project
• When the investment outlay
is spread over more than
one period, this criterion
cannot be applied.
Zeta Ltd is considering the following projects
PROJECTS
INITIAL
OUTLAY
CASH
INFLOWS
PROJEC
TS
Cf
NPV
A
20
7.5
A
7.5
(7.5*3.433)-20 =5.75
B
4.5
1.5
B
1.5
(1..5*3.433)-4.5=0.65
C
7
2.5
C
2.5
(2.5*3.433) -7 = 1.58
D
8
3.5
D
3.5
(3.5*3.433)-8=4.02
PROJECT
S
BCR
A
25.75/20
1.27
B
5.15/4.5
1.14
C
8.58/7
1.23
D
12.02/8
1.50
Annual Capital Charge
• Used for evaluating mutually exclusive projects or
alternatives which provide similar service
• Steps
•First determine the PV of the initial investment and operating costs
using the cost of capital (k) as the discount rate
•Then, determine PVIFA using (k,n) in the table
•Divide the PV of the cash flows by the PVIFA, the answer is annual
capital charge
•Accept/Reject criteria: Accept the project/asset
with lesser Annual Capital Charge
Illustration