Capital Expenditure Decisions

Presentation By : Sandip Gaudana

SGN

Structure

What is ‘Capital Expenditure’ Importance of Cap Ex Decisions Process Appraisal Methods

Non Discounting Discounting

What is Capital Expenditure ?

It is a Decision to invest

Current Funds into

Long Term Assets

In Anticipation of

Expected flow of benefits

Over a series of years.

Types of Cap Ex Decisions

 Expansion of existing business

 Expansion of new business

 Replacement and modernisation

Importance

Growth Risk Funding Irreversibility Complexity

Process

Project Generation

Project Evaluation

Project Selection

Project Execution

Methods of Appraisal

Methods

Non Discounted Discounted

Pay Back Period

Accounting Rate of Return

Net Present Value

Internal Rate of Return

Profitability Index

Non Discounted Methods

Pay Back Period Accounting Rate of Return

Pay Back Period

Payback is the number of years required to recover the original cash outlay invested in a project.

0Initial InvestmentPayback = =

Annual Cash Inflow

C

C

Example : Equal Cash Flow Assume that a project requires an outlay of Rs

40,000 and yields annual cash inflow of Rs 10,000 for 7 years.

The payback period for the project is:

Payback = 40,000 = 4 Years

10,000

Example : Unequal Cash Flow

A project requires a cash outlay of Rs 20,000, and generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during the next 4 years. What is the project’s payback?

3 Years + 12 * (1,000/3,000) Months 3 Years, 4 Months

Acceptance & Ranking

The project would be accepted if its payback period is less than the maximum or standard payback period set by management.

As a ranking method, it gives highest ranking to the project, which has the shortest payback period.

Some Aspects

Certain virtues: Simplicity Cost effective Short-term effects

Serious limitations: Cash flows after payback ignored Cash flow patterns Administrative difficulties

Accounting Rate of Return

The accounting rate of return is the ratio of the average after-tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly.

Average incomeARR =

Average investment

Example (Project Cost Rs. 40,000)

Year 1 2 3 4 5

EBDT 10,000 12,000 14,000 16,000 20,000

(-) Dep 8,000 8,000 8,000 8,000 8,000

EBT 2,000 4,000 6,000 8,000 12,000

(-) Tax 50% 1,000 2,000 3,000 4,000 6,000

PAT 1,000 2,000 3,000 4,000 6,000

Average = 3,200

BV (Beg) 40,000 32,000 24,000 16,000 8,000

BV (End) 32,000 24,000 16,000 8,000 ---

Average 36,000 28,000 20,000 12,000 4,000

Avg 20,000

ARR = 3,200 * 100 ARR = 16 %

20,000

Acceptance Rule

This method will accept all those projects whose ARR is higher than the minimum rate established.

This method would rank a project as number one if it has highest ARR.

Discounted Methods

Net Present Value Internal Rate of Return Profitability Index

Net Present Value

Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows.

Steps Decide Appropriate rate for discounting Calculate Present Value of Cash Inflow NPV = PV of Cash inflows – PV of cash Outflow

Example

Project X costs Rs 2,500 now and is expected to generate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 through 5. The opportunity cost of the capital may be assumed to be 10 per cent.

Example

2 3 4 5

1, 0.10 2, 0.10 3, 0.10

4, 0.10 5, 0.

Rs 900 Rs 800 Rs 700 Rs 600 Rs 500NPV Rs 2,500

(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)

NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )

+ Rs 600(PVF ) + Rs 500(PVF

10)] Rs 2,500

NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683

+ Rs 500 0.620] Rs 2,500

NPV Rs 2,725 Rs 2,500 = + Rs 225

Acceptance Rule

Accept the project when NPV is positive (NPV > 0) Reject the project when NPV is negative (NPV < 0) May accept the project when NPV is zero (NPV =

0)

The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected.

Some Aspect

NPV is most acceptable investment rule for the following reasons: Time value Measure of true profitability

Limitations: Involved cash flow estimation Discount rate difficult to determine

Internal Rate of Return

The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received after one period.

Internal Rate of Return is the discount rate which makes NPV = 0.

Calculation of IRR : Equal Cashflow

An investment cost Rs 6,000 and provide annual cash inflow of Rs 2,000 for 5 years.

Step : 1 Calculation of Factor

Factor = Original Investment (6,000) = 3

Avg. Cash flow per year (2,000) Referring to Annuity table for 5 years @ 18% ( Rs.

3.127) & @ 20 % ( Rs. 2.99)

Example (Continued)

1 2 3 4 3 6

Year Cash Inflow Disc. Fact @ 18%

(2 X3)PV of Inflow

Disc. Fact @ 20%

(2 X 5)PV of Inflow

1 2,000 0.847 1,694 0.833 1,666

2 2,000 0.717 1,436 0.694 1,388

3 2,000 0.609 1,218 0.579 1,158

4 2,000 0.516 1,032 0.482 964

5 2,000 0.437 874 0.402 804

Total 6,254 5.980

IRR = A + [(C- O)/(C-D)] * (B-A)

18 + [ (6,254 – 6,000) / (6254-5980)] * (20-18)

18 + ( 254 / 274) * 2

18 + 1.854

IRR = 19.854 %

Acceptance Rule

Accept the project when r > k. Reject the project when r < k. May accept the project when r = k.

Some Aspects

IRR method has following merits: Time value Profitability measure Acceptance rule

IRR method may suffer from: Tedious & Difficult to understand Mutually exclusive projects

Profitability Index

Profitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment.

Example

An investment cost Rs 6,000 and provide annual cash inflow of Rs 2,000 for 5 years, consider discounting rate of 18 %

1 2 3 4

Year Cash Inflow

D F @ 18%

(2 X3)PV

1 2,000 0.847 1,694

2 2,000 0.717 1,436

3 2,000 0.609 1,218

4 2,000 0.516 1,032

5 2,000 0.437 874

Total 6,254

Profitabilty Index = PV of Cash Inflow

PV of investment

= 6,254 / 6,000

Profitability Index = 1.05

Acceptance Rule

The following are the PI acceptance rules: Accept the project when PI is greater than one.

PI > 1 Reject the project when PI is less than one.

PI < 1 May accept the project when PI is equal to one.

PI = 1 The project with positive NPV will have PI

greater than one. PI less than means that the project’s NPV is negative.

Some Aspects

Recognises the time value of money. A project with PI greater than one will have

positive NPV and if accepted, it will increase shareholders’ wealth.

Like NPV method, PI criterion also requires calculation of cash flows and estimate of the discount rate. In practice, estimation of cash flows and discount rate pose problems.

Which is more suitable ?

Observations…by authors

Most commonly used method for evaluating investment of small size is Pay Back Period

For some of the projects, ARR is used as principal method and Pay Back is supplementary.

Discounted Techniques are gaining importance in Large investments having substantial outlay.

Findings of a Survey

Survey by U Rao Cherukeri revealed the following

DCF methods have gained importance over a period of time ( Particularly the IRR)

ARR & PBP are widely used as supplementary evaluation methods.

WACC is commonly used as discount rate. Most often used in india is 15 %

Ranking in US

1. Internal Rate of Return (IRR)

2. Net Present Value (NPV)

3. Accounting Rate of Return (ARR)

4. Pay Back Period (PBP)

5. Profitability Index (PI)

?

Thank You !!!